UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
Quarterly report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended March 31, 2006
Commission file number 0-16090
Hallmark Financial Services, Inc.
---------------------------------
(Exact name of registrant as specified in its charter)
Nevada 87-0447375
------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification No.)
777 Main Street, Suite 1000, Fort Worth, Texas 76102
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (817) 348-1600
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes X No ___
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes ___ No X
Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act). Yes ___ No X
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: Common Stock, par value
$.03 per share - 86,909,647 shares outstanding as of May 12, 2006.
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
INDEX TO FINANCIAL STATEMENTS
Page Number
-----------
Consolidated Balance Sheets at March 31, 2006
(unaudited) and December 31, 2005 3
Consolidated Statements of Operations (unaudited) for
the three months ended March 31, 2006 and March 31, 2005 4
Consolidated Statements of Stockholders' Equity and
Comprehensive Income (unaudited) for the three months
ended March 31, 2006 and March 31, 2005 5
Consolidated Statements of Cash Flows (unaudited) for
the three months ended March 31, 2006 and March 31, 2005 6
Notes to Consolidated Financial Statements (unaudited) 7
Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
($ in thousands)
March 31 December 31
ASSETS 2006 2005
------ ---------- ----------
(unaudited) (audited)
Investments:
Debt securities, available-for-sale,
at market value $ 97,210 $ 79,360
Equity securities, available-for-sale,
at market value 4,513 3,403
Short-term investments, available-for-sale,
at market value 335 12,281
---------- ----------
Total investments 102,058 95,044
Cash and cash equivalents 65,034 44,528
Restricted cash and investments 41,762 13,802
Premiums receivable 45,078 26,530
Accounts receivable 32,364 2,083
Prepaid reinsurance premium 1,314 767
Reinsurance recoverable 1,577 444
Deferred policy acquisition costs 11,091 9,164
Excess of cost over fair value
of net assets acquired 31,781 4,836
Intangible assets 27,794 459
Deferred federal income taxes - 3,992
Other assets 9,290 7,257
---------- ----------
Total assets $ 369,143 $ 208,906
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Notes payable $ 48,968 $ 30,928
Note payable to related party 12,500 -
Convertible notes payable (net of
$8,453 unamortized discount) 16,547 -
Structured settlements 23,804 -
Unpaid losses and loss adjustment expenses 43,672 26,321
Unearned premiums 57,853 36,027
Unearned revenue 11,184 4,055
Reinsurance balances payable 310 116
Accrued agent profit sharing 519 2,173
Accrued ceding commission payable 11,650 11,430
Pension liability 2,954 2,932
Deferred federal income taxes 6,081 -
Current federal income tax payable 2,220 300
Accounts payable and other accrued expenses 38,017 9,436
---------- ----------
Total liabilities 276,279 123,718
Commitments and Contingencies
Stockholders' equity:
Common stock, $.03 par value (authorized
100,000,000 shares; issued 86,956,610
shares in 2006 and 86,856,610 shares in 2005) 2,609 2,606
Additional paid in capital 69,034 62,907
Retained earnings 24,715 22,289
Accumulated other comprehensive income (loss) (3,417) (2,597)
Treasury stock, at cost (46,963 shares in 2006
and 14,819 in 2005) (77) (17)
---------- ----------
Total stockholders' equity 92,864 85,188
---------- ----------
$ 369,143 $ 208,906
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statements of Operations
(Unaudited)
($ in thousands, except per share amounts)
Three Months Ended
March 31
------------------------
2006 2005
---------- ----------
Gross premiums written $ 47,735 $ 10,634
Ceded premiums written (1,956) -
---------- ----------
Net premiums written 45,779 10,634
Change in unearned premiums (17,345) (594)
---------- ----------
Net premiums earned 28,434 10,040
Investment income, net of expenses 2,357 411
Realized loss (83) -
Finance charges 687 540
Commission and fees 12,264 4,812
Processing and service fees 857 1,634
Other income 4 8
---------- ----------
Total revenues 44,520 17,445
Losses and loss adjustment expenses 16,690 6,026
Other operating costs and expenses 21,026 8,705
Interest expense 1,585 3
Interest expense from amortization
of discount on convertible notes 1,117 -
Amortization of intangible asset 573 7
---------- ----------
Total expenses 40,991 14,741
Income before tax 3,529 2,704
Income tax expense 1,103 889
---------- ----------
Net income $ 2,426 $ 1,815
========== ==========
Common stockholders net income per share:
Basic $ 0.02 $ 0.04
========== ==========
Diluted $ 0.02 $ 0.04
========== ==========
Convertible noteholders net income per share:
Basic $ 0.02 n/a
==========
Diluted $ 0.02 n/a
==========
The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity and Comprehensive Income
(Unaudited)
($ in thousands)
Three Months Ended
March 31,
------------------------
2006 2005
---------- ----------
Common Stock
Balance, beginning of period $ 2,606 $ 1,106
Issuance of common stock upon option exercises 3 -
---------- ----------
Balance, end of period 2,609 1,106
Additional Paid-In Capital
Balance, beginning of period 62,907 19,647
Discount on convertible notes 6,032 -
Equity based compensation 24 9
Exercise of stock options 71 (16)
---------- ----------
Balance, end of period 69,034 19,640
Retained Earnings
Balance, beginning of period 22,289 13,103
Net income 2,426 1,815
---------- ----------
Balance, end of period 24,715 14,918
Accumulated Other Comprehensive Income (Loss)
Balance, beginning of period (2,597) (759)
Additional minimum pension liability, net of tax - 30
Unrealized gains (losses) on securities, net of tax (820) (511)
---------- ----------
Balance, end of period (3,417) (1,240)
Treasury Stock
Balance, beginning of period (17) (441)
Acquisition of treasury shares (100) -
Exercise of stock options 40 29
---------- ----------
Balance, end of period (77) (412)
------------------------
Stockholders' Equity $ 92,864 $ 34,012
========================
Net income $ 2,426 $ 1,815
Additional minimum pension liability, net of tax - 30
Unrealized gains (losses) on securities, net of tax (820) (511)
------------------------
Comprehensive Income $ 1,606 $ 1,334
========================
The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statement of Cash Flows
(Unaudited)
($ in thousands)
Three Months Ended
March 31
------------------------
2006 2005
---------- ----------
Cash flows from operating activities:
Net income $ 2,426 $ 1,815
Adjustments to reconcile net income to cash
provided by (used in) operating activities:
Depreciation and amortization expense 800 72
Interest expense related to amortization
of discount on convertible notes 1,117 -
Deferred federal income tax expense (1,756) 266
Realized loss on investments 83 -
Change in prepaid reinsurance premiums (547) -
Change in premiums receivable (17,430) (255)
Change in accounts receivable (4,230) 1,103
Change in deferred policy acquisition costs (1,927) (372)
Change in unpaid losses and loss
adjustment expenses 7,861 (443)
Change in unearned premiums 17,882 594
Change in unearned revenue (2,230) 229
Change in accrued agent profit sharing (1,654) (1,417)
Change in reinsurance recoverable (493) 1,146
Change in reinsurance balances payable (455) -
Change in current federal income tax
payable/recoverable 1,033 (1,177)
Change in accrued ceding commission payable 220 (4)
Change in all other liabilities 7,906 (1,618)
Change in all other assets 976 (180)
---------- ----------
Net cash provided by (used in)
operating activities 9,582 (241)
---------- ----------
Cash flows from investing activities:
Purchases of property and equipment (106) (52)
Premium finance notes repaid, net of
finance notes originated (1,745) -
Acquisition of subsidiaries,
net of cash acquired (25,964) -
Change in restricted cash and investments (25,138) 29
Purchases of debt and equity securities (4,532) (5,076)
Maturities and redemptions
of investment securities 3,923 1
Net redemptions (purchases)
of short-term investments 11,946 (1,297)
---------- ----------
Net cash used in investing activities (41,616) (6,395)
---------- ----------
Cash flows from financing activities:
Proceeds from exercise of employee stock options 40 13
Proceeds from issuance of convertible debt 25,000 -
Proceeds from note payable to related party 12,500 -
Proceeds from revolving loan on credit facility 15,000 -
---------- ----------
Net cash provided by financing activities 52,540 13
---------- ----------
Increase (decrease) in cash and cash equivalents 20,506 (6,623)
Cash and cash equivalents at beginning of period 44,528 12,901
---------- ----------
Cash and cash equivalents at end of period $ 65,034 $ 6,278
========== ==========
Supplemental Cash Flow Information:
Interest paid $ 983 $ 3
---------- ----------
Taxes paid $ 1,800 $ 1,800
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The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
1. General
Hallmark Financial Services, Inc. ("Hallmark" and, together with
subsidiaries, "we", "us", "our") is an insurance holding company engaged in
the sale of property and casualty insurance products to businesses and
individuals. Our business involves marketing and underwriting commercial
insurance in Texas, New Mexico, Idaho, Oregon, Montana, Louisiana and
Washington; marketing and underwriting non-standard personal automobile
insurance in Texas, New Mexico and Arizona; marketing general aviation
insurance in 44 states; claims administration; and other insurance related
services. We pursue our business activities through subsidiaries whose
operations are organized by producing companies into our Hallmark General
Agency operating segment ("HGA Segment"), which includes the commercial
insurance products and services handled by Hallmark General Agency, Inc.
("HGA") and Effective Claims Management, Inc.; our Texas General Agency
operating segment ("TGA Segment"), which includes the commercial insurance
products and services handled by Texas General Agency, Inc. ("TGA"), Pan
American Acceptance Corporation ("PAAC") and TGA Special Risk, Inc.
("TGASRI"); our Phoenix General Agency operating segment ("PGA Segment"),
which includes the non-standard personal automobile insurance products and
services handled by American Hallmark General Agency, Inc. and Hallmark
Claims Services, Inc. (both of which do business as Phoenix General
Agency); and our aviation operating segment ("Aerospace Segment"), which
includes the general aviation insurance products and services handled by
Aerospace Holdings LLC ("Aerospace") and its wholly owned subsidiaries. The
subsidiary companies in our TGA Segment and Aerospace Segment were all
acquired effective January 1, 2006. The retained premium produced by our
operating segments is supported by our insurance company subsidiaries:
American Hallmark Insurance Company of Texas ("AHIC"); Phoenix Indemnity
Insurance Company ("PIIC"); and Gulf States Insurance Company ("GSIC"), a
wholly owned subsidiary of TGA which was acquired by Hallmark effective
January 1, 2006.
2. Basis of Presentation
Our unaudited consolidated financial statements included herein have
been prepared in accordance with accounting principles generally accepted in
the United States of America ("GAAP") and include our accounts and the
accounts of our subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation. Certain information and
footnote disclosures normally included in financial statements prepared
in accordance with GAAP have been condensed or omitted pursuant to rules
and regulations of the Securities and Exchange Commission ("SEC") for
interim financial reporting. These financial statements should be read in
conjunction with our audited financial statements for the year ended
December 31, 2005 included in our Annual Report on Form 10-K filed with the
SEC.
The interim financial data as of March 31, 2006 and 2005 is unaudited.
However, in the opinion of management, the interim data includes all
adjustments, consisting only of normal recurring adjustments, necessary for
a fair statement of the results for the interim periods. The results of
operations for the period ended March 31, 2006 are not necessarily
indicative of the operating results to be expected for the full year.
Reclassification
Certain previously reported amounts have been reclassified in order to
conform to current year presentation. Such reclassification had no effect
on net income or stockholders' equity.
Use of Estimates in the Preparation of the Financial Statements
Our preparation of financial statements in conformity with GAAP
requires us to make estimates and assumptions that affect our reported
amounts of assets and liabilities and our disclosure of contingent assets
and liabilities at the date of our financial statements, as well as our
reported amounts of revenues and expenses during the reporting period.
Actual results could differ materially from those estimates.
Recently Issued Accounting Standards
In December 2002, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure" ("SFAS 148"). SFAS
148 amended FASB Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("SFAS 123") to provide
alternative methods of transition for voluntary change to the fair value
based method of accounting for stock-based employee compensation. In
addition, SFAS 148 amended the disclosure requirements of SFAS 123 to
require prominent disclosures in both annual and interim financial
statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results.
Effective January 1, 2003, we adopted the prospective method provisions of
SFAS 148. Under the prospective method, we have applied the fair value
based method of accounting for our stock-based payments for option grants
after December 31, 2002.
In December 2004, FASB issued Statement of Financial Accounting
Standards No. 123R "Share-Based Payment" ("SFAS 123R"), which revises SFAS
123 and supersedes Accounting Principles Board ("APB") Opinion No. 25 ("APB
25"). SFAS 123R eliminates an entity's ability to account for share-based
payments using APB 25 and requires that all such transactions be accounted
for using a fair value based method. In April 2005, the SEC deferred the
effective date of SFAS 123R from the first interim or annual period
beginning after June 15, 2005 to the next fiscal year beginning after June
15, 2005. We adopted SFAS 123R on January 1, 2006 using the modified-
prospective transition method. Under the modified-prospective transition
method, compensation cost recognized during the period should include
compensation cost for all share-based payments granted to, but not yet
vested as of January 1, 2006, based on grant date fair value estimates in
accordance with the original provisions of SFAS 123 and compensation cost
for all share-based payments granted after January 1, 2006 in accordance
with SFAS 123R. Since we adopted the fair value method of SFAS 123 under
the prospective method provision of SFAS 148 beginning January 1, 2003, we
have a small amount of unvested share-based payments granted prior to
January 1, 2003. During the first three months of 2006, we recognized
approximately $3 thousand of additional compensation expense under SFAS
123R. SFAS 123R also requires the benefits of tax deductions in excess of
recognized stock compensation cost to be reported as a financing cash flow,
rather than as an operating cash flow as previously required. (See Note 4,
"Share-Based Payment Arrangements.")
Had compensation cost for all of our stock option grants under our
stock compensation plans been determined based on fair value at the grant
date in accordance with the fair value provisions of SFAS 123, our net
income and earnings per share for the three months ended March 31, 2005
would have been the pro forma amounts indicated below. Actual results for
the three months ended March 31, 2006 have been determined in accordance
with the fair value provisions of SFAS 123R and, therefore, pro forma
results for such period are not necessary.
Three Months
Ended
March 31,
(in thousands) 2005
------
Net income as reported $ 1,815
Add: Stock-based compensation expenses
included in reported net income, net of
related tax effects 6
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards, net
of related tax effects (9)
------
Pro forma net income $ 1,812
======
Earnings per share:
Basic-as reported $ 0.04
======
Basic-pro forma $ 0.04
======
Diluted-as reported $ 0.04
======
Diluted-pro forma $ 0.04
======
3. Business Combinations
We account for business combinations using the purchase method of
accounting. The cost of an acquired entity is allocated to the assets
acquired (including identified intangible assets) and liabilities assumed
based on their estimated fair values. The excess of the cost of an acquired
entity over the net of the amounts assigned to assets acquired and
liabilities assumed is an asset referred to as "excess of cost over net
assets acquired" or "goodwill." Indirect and general expenses related to
business combinations are expensed as incurred.
Effective January 1, 2006, we acquired all of the issued and
outstanding capital stock of TGA and certain affiliated companies
(collectively, the "TGA Group") for an aggregate cash purchase price of
up to $45.6 million, consisting of unconditional consideration of $37.6
million and contingent consideration of $8.0 million. Of the unconditional
consideration, $13.9 million was paid at closing and $14.3 million will be
paid on or before January 1, 2007 and $9.5 million will be paid on or before
January 1, 2008. The payment of any contingent consideration is conditioned
on the sellers complying with certain restrictive covenants and TGA Group
achieving certain operational objectives related to premium production and
loss ratios. The contingent consideration, if any, will be payable on or
before March 30, 2009, unless the sellers elect to defer payment until March
30 of any subsequent year in order to permit further development of the loss
ratios. In addition to the purchase price, we will pay $2.0 million to the
sellers in consideration of their compliance with certain restrictive
covenants, including a covenant not to compete for a period of five years
after closing. Of this additional amount, $750 thousand was paid at
closing, $750 thousand will be paid on or before January 1, 2007 and $500
thousand will be paid on or before January 1, 2008.
TGA is a managing general agency involved in the marketing,
underwriting and servicing of property and casualty insurance products,
with a particular emphasis on commercial automobile and general liability
risks produced on an excess and surplus lines basis. The other affiliated
companies in the TGA Group are TGA's wholly owned insurance subsidiary,
GSIC, which reinsures a portion of the business written by TGA; TGASRI,
which brokers mobile home insurance; and PAAC, which finances premiums on
property and casualty insurance products marketed by TGA and TGASRI. The
acquisition is expected to significantly expand the scope of our insurance
marketing operations and provide opportunities for increased underwriting by
our insurance company subsidiaries. Interim GAAP financial statements for
TGA Group are not available for 2005 and, therefore, quarterly supplemental
pro forma disclosures are not included in this report.
Effective January 1, 2006, we also acquired all of the issued and
outstanding membership interests in Aerospace for an aggregate consideration
of up to $15.0 million, consisting of unconditional consideration of $12.5
million due in cash at closing and contingent consideration of up to $2.5
million. The unconditional consideration of $12.5 million is allocated
$11.9 million to the purchase price and $0.6 million to the seller's
compliance with certain restrictive covenants, including a covenant not to
compete for a period of five years after closing. The payment of contingent
consideration is conditioned on the seller complying with its restrictive
covenants and Aerospace achieving certain operational objectives related to
premium production and loss ratios. The contingent consideration, if any,
will be payable in cash on or before March 30, 2009, unless the seller
elects to defer a portion of the payment in order to permit further
development of loss ratios.
Aerospace, through various wholly owned subsidiaries, including
Aerospace Insurance Managers, Inc., is involved in the marketing and
servicing of general aviation property and casualty insurance products with
a particular emphasis on private and small commercial aircraft. With the
acquisition of Aerospace, Hallmark entered the general aviation market as
part of our continuing strategy to expand into specialty lines businesses.
Interim GAAP financial statements for Aerospace are not available for 2005
and, therefore, quarterly supplemental pro forma disclosures are not
included in this report.
4. Supplemental Cash Flow Information
Effective January 1, 2006, we acquired TGA Group and Aerospace. (See
Note 3, "Business Combinations.") In conjunction with the acquisitions,
cash and cash equivalents were used in the acquisitions as follows (in
thousands):
TGA Group Aerospace
--------------------
Fair value of tangible assets excluding
cash and cash equivalents $ 52,906 $ 8,391
Fair value of intangible assets acquired 31,585 12,575
Capitalized direct expenses 232 36
Structured settlement (23,542) -
Liabilities assumed (48,522) (7,697)
--------------------
Cash and cash equivalents used in acquisitions $ 12,659 $ 13,305
====================
For the three months ended March 31, 2006 and 2005, we had non-
cash stock-based compensation expense of $25 thousand and $9 thousand,
respectively.
5. Share-Based Payment Arrangements
Our 2005 Long Term Incentive Plan ("2005 LTIP") is a stock compensation
plan for key employees and non-employee directors that was approved by the
shareholders on May 26, 2005. There are 5,000,000 shares authorized for
issuance under the 2005 LTIP. Our 1994 Key Employee Long Term Incentive
Plan (the "Employee Plan") and 1994 Non-Employee Director Stock Option Plan
(the "Director Plan") both expired in 2004.
As of March 31, 2006, there were incentive stock options to purchase
530,000 shares of our common stock outstanding under the 2005 LTIP, leaving
4,470,000 shares reserved for future issuance. As of March 31, 2006, there
were incentive stock options to purchase 611,500 shares outstanding under
the Employee Plan and non-qualified stock options to purchase 150,000 shares
outstanding under the Director Plan. In addition, as of March 31, 2006,
there were outstanding non-qualified stock options to purchase 100,000
shares of our common stock granted to certain non-employee directors outside
the Director Plan in lieu of fees for service on our board of directors in
1999. The exercise price of all such outstanding stock options is equal to
the fair market value of our common stock on the date of grant.
Options granted under the Employee Plan prior to October 31, 2003, vest
40% six months from the date of grant and an additional 20% on each of the
first three anniversary dates of the grant and terminate ten years from the
date of grant. Options granted under the 2005 LTIP and the Employee Plan
after October 31, 2003, vest 10%, 20%, 30% and 40% on the first, second,
third and fourth anniversary dates of the grant, respectively, and terminate
five years from the date of grant. All options granted under the Director
Plan vest 40% six months from the date of grant and an additional 10% on
each of the first six anniversary dates of the grant and terminate ten years
from the date of grant. The options granted to non-employee directors
outside the Director Plan fully vested six months after the date of grant
and terminate ten years from the date of grant.
A summary of the status of our stock options as of and changes during
the year-to-date ended March 31, 2006 is presented below:
Weighted
Average
Weighted Remaining Aggregate
Average Contractual Intrinsic
Number of Exercise Term Value
Shares Price (Years) ($000)
--------------------------------------------
Outstanding at January 1, 2006 1,516,500 $ 0.82 - -
Granted - $ - - -
Exercised (125,000) $ 0.92 - -
Forfeited or expired - $ - - -
---------
Outstanding at March 31, 2006 1,391,500 $ 0.81 5.6 $ 1,226
Exercisable at March 31, 2006 487,000 $ 0.55 3.7 $ 553
There were no options granted in either the first quarter of 2006 or
2005. The total intrinsic value of options exercised during the first
quarter of 2006 and 2005 was $103 thousand and $19 thousand, respectively.
The total cost of share-based payments charged against income before income
tax benefit for the first quarter of 2006 and 2005 was $22 thousand and $9
thousand, respectively. The amount of related income tax benefit recognized
in income for the first quarter of 2006 and 2005 was $8 thousand and $3
thousand, respectively. As of March 31, 2006, there was $0.4 million of
total unrecognized compensation cost related to non-vested share-based
compensation arrangements granted under our plans, of which $0.1 million is
expected to be recognized in each of 2006, 2007, 2008 and 2009.
The fair value of each stock option granted is estimated on the date of
grant using the Black-Scholes option pricing model. Expected volatilities
are based on historical volatility of Hallmark's shares. The risk-free
interest rates for periods within the contractual term of the options are
based on rates for U.S. Treasury Notes with maturity dates corresponding to
the options expected lives on the dates of grant.
6. Segment Information
The following is business segment information for the three months ended
March 31, 2006 and 2005 (in thousands):
Three Months Ended
March 31,
2006 2005
-------- --------
Revenues:
---------
HGA Segment $ 17,540 $ 6,280
TGA Segment 14,099 -
PGA Segment 10,797 11,161
Aerospace Segment 1,869 -
Corporate 215 4
-------- --------
Consolidated $ 44,520 $ 17,445
======== ========
Pre-tax income (loss):
HGA Segment $ 3,360 $ 1,068
TGA Segment 1,728 -
PGA Segment 2,051 2,442
Aerospace Segment (109) -
Corporate (3,501) (806)
-------- --------
Consolidated $ 3,529 $ 2,704
======== ========
The following is additional business segment information as of the dates
indicated (in thousands):
Mar. 31, Dec. 31,
2006 2005
-------- --------
Assets
------
HGA Segment $ 141,198 $ 136,220
TGA Segment 109,655 -
PGA Segment 68,187 68,264
Aerospace Segment 22,112 -
Corporate 27,991 4,422
-------- --------
Consolidated $ 369,143 $ 208,906
======== ========
7. Reinsurance
We reinsure a portion of the risk we underwrite in order to control the
exposure to losses and to protect capital resources. We cede to reinsurers
a portion of these risks and pay premiums based upon the risk and exposure
of the policies subject to such reinsurance. Ceded reinsurance involves
credit risk and is generally subject to aggregate loss limits. Although the
reinsurer is liable to us to the extent of the reinsurance ceded, we are
ultimately liable as the direct insurer on all risks reinsured. Reinsurance
recoverables are reported after allowances for uncollectible amounts. We
monitor the financial condition of reinsurers on an ongoing basis and review
our reinsurance arrangements periodically. Reinsurers are selected based on
their financial condition, business practices and the price of their product
offerings. Refer to Note 6 of our Form 10-K for the year ended December 31,
2005 for more discussion of our reinsurance.
The following table shows earned premiums ceded and reinsurance loss
recoveries by period (in thousands):
Three Months Ended
March 31,
2006 2005
-------- --------
Ceded earned premiums $ 1,397 $ -
Reinsurance recoveries $ 776 $ (391)
8. Notes Payable
On June 21, 2005, our newly formed trust subsidiary completed a private
placement of $30.0 million of 30-year floating rate trust preferred
securities. Simultaneously, we borrowed $30.9 million from the trust
subsidiary and contributed $30.0 million to AHIC in order to increase
policyholder surplus. The note bears an initial interest rate of 7.725%
until June 15, 2015, at which time interest will adjust quarterly to the
three month LIBOR rate plus 3.25 percentage points. As of March 31, 2006,
the note balance was $30.9 million.
On January 27, 2006, we borrowed $15.0 million under the revolving
credit facility with The Frost National Bank to fund the cash required to
close the TGA Group acquisition. As of March 31, 2006, the balance on the
revolving note was $15.0 million. (See Note 3, "Business Combinations" and
Note 12, "Credit Facility.")
Also included in notes payable is $3.0 million of various short-term
notes payable to banks by PAAC, bearing variable interest rates ranging from
4.75% to 7.75%. These notes are secured by PAAC's finance notes receivables.
The line of credit available under PAAC's current borrowing arrangements is
$5.0 million, approximately $3.0 million of which was borrowed at March 31,
2006. PAAC's borrowing arrangements contain various restrictive covenants
which, among other things, require maintenance of minimum amounts of
tangible net worth and working capital. At March 31, 2006, PAAC was not in
compliance with certain of such covenants but had received a waiver for the
violations.
9. Note Payable to Related Party
On January 3, 2006, we executed a promissory note payable to Newcastle
Partners, L.P. in the amount of $12.5 million in order to obtain funding to
complete the acquisition of Aerospace. The promissory note bears interest
at the rate of 10% per annum. The unpaid principal balance of the
promissory note, together with all accrued and unpaid interest, is due and
payable on demand at any time after June 30, 2006. As of March 31, 2006 the
promissory note balance was $12.5 million.
10. Convertible Notes Payable
On January 27, 2006, we issued $25.0 million in subordinated
convertible promissory notes to Newcastle Special Opportunity Fund I, L.P.
and Newcastle Special Opportunity Fund II, L.P., which are investment
partnerships managed by an entity controlled by Mark E. Schwarz, our
Chairman and Chief Executive Officer. Each convertible note bears interest
at 4% per annum until paid or converted, which rate increases to 10% per
annum in the event of default. Interest is payable quarterly in arrears
commencing March 31, 2006. The convertible notes mature on July 27, 2007,
and may not be prepaid. Conversion of the convertible notes is in all
events subject to shareholder approval. Following shareholder approval, the
principal of the convertible notes must be converted by the holders into
shares of our common stock on or before maturity at a conversion rate of
$1.28 per share (subject to certain anti-dilution provisions).
In accordance with the FASB Emerging Issues Task Force ("EITF") Issue
No. 98-5 "Accounting for Convertible Securities with Beneficial Conversion
Features or Contingently Adjustable Conversion Ratios" and EITF Issue No.
00-27 "Application of Issue No. 98-5 to Certain Convertible Instruments,"
the convertible notes contain a beneficial conversion feature requiring a
discount to the carrying amount of the notes equal to (i) the difference
between the stated conversion rate and the market price of our common stock
on the date of issuance, multiplied by (ii) the number of shares into which
the notes are convertible. Per EITF Issue No. 98-5 and EITF Issue No. 00-
27, upon issuance we recorded a $9.6 million discount to the convertible
notes which will be amortized straight line as interest expense over the
term of the convertible notes, with any unamortized balance of the discount
expensed upon conversion of the notes. The discount to the convertible
notes was offset by increases to deferred federal income taxes and
additional paid in capital, resulting in a temporary increase in our book
value which will decline as the discount is amortized. Ultimately, the
discount on the convertible notes will have no effect on our book value.
Interest expense resulting from amortization of the discount on the
convertible notes during the first fiscal quarter of 2006 was $1.1 million,
resulting in a convertible notes balance of $16.5 million as of March 31,
2006. This interest expense had the effect of reducing our operating income
for the period, but had no effect on our cash flow.
11. Structured Settlements
In connection with the acquisition of the TGA Group, we recorded a
payable for the future guaranteed payments of $25.0 million discounted
at 4.4%, the rate of two year US Treasuries (the only investment permitted
on the trust account securing such future payments which is classified
in restricted cash and investments on our balance sheet). (See Note
3, "Business Combinations.") As of March 31, 2006, the balance of the
structured settlements was $23.8 million.
12. Credit Facility
On June 29, 2005, we entered into a credit facility with The Frost
National Bank. The credit facility was amended and restated on January 27,
2006 to a $20.0 million revolving credit facility, with a $5.0 million
letter of credit sub-facility. We borrowed $15.0 million under the
revolving credit facility to fund the cash required to close the TGA Group
acquisition. Principal outstanding under the revolving credit facility
generally bears interest at the three month Eurodollar rate plus 2.00%,
payable quarterly in arrears. We pay letter of credit fees at the rate of
1.00% per annum. Our obligations under the revolving credit facility are
secured by a security interest in the capital stock of all of our
subsidiaries, guaranties of all of our subsidiaries and the pledge of
substantially all of our assets. The revolving credit facility contains
covenants which, among other things, require us to maintain certain
financial and operating ratios and restrict certain distributions,
transactions and organizational changes. The amended and restated credit
agreement terminates on January 27, 2008. As of March 31, 2006, there was
$15.0 million outstanding under our revolving credit facility, and we were
in compliance with or had obtained waivers of all of our covenants. In the
third quarter of 2005, we issued a $4.0 million letter of credit under this
facility to collateralize certain obligations under the agency agreement
between HGA and Clarendon National Insurance Company effective July 1, 2004.
13. Deferred Policy Acquisition Costs
The following table shows total deferred and amortized policy acquisition
costs by period (in thousands):
Three Months Ended
March 31,
2006 2005
-------- --------
Deferred $ (8,720) $ (6,087)
Amortized 6,793 5,715
-------- --------
Net Deferred $ (1,927) $ (372)
======== ========
14. Earnings per Share
The following table sets forth basic and diluted weighted average
shares outstanding for the periods indicated (in thousands):
Three Months Ended
March 31,
2006 2005
-------- --------
Common Stockholders:
--------------------
Weighted average shares - basic 86,874 42,471
Effect of dilutive securities 788 694
-------- --------
Weighted average shares - assuming dilution 87,662 43,165
======== ========
Convertible Noteholders:
------------------------
Weighted average shares - basic and assuming
dilution 19,531 n/a
======== ========
For the basic and diluted earnings per share calculation for the three
months ended March 31, 2006, net income was allocated $2.0 million to common
stockholders and $0.4 million to holders of convertible notes. For the
three months ended March 31, 2006 and 2005, no shares attributable to
outstanding stock options were excluded from the calculation of diluted
earnings per share.
In accordance with FASB Statement of Financial Accounting Standards No.
128, "Earnings Per Share" ("SFAS 128"), we have restated the basic and
diluted weighted average shares outstanding for the three months ended March
31, 2005 for the effect of a bonus element from our stockholder rights
offering completed in the second quarter of 2005. According to SFAS 128,
there is an assumed bonus element in a rights issue whose exercise price is
less than the market value of the stock at the close of the rights offering
period. This bonus element is treated as a stock dividend for reporting
earnings per share.
15. Net Periodic Pension Cost
The following table details the net periodic pension cost incurred by
period (in thousands):
Three Months Ended
March 31,
2006 2005
-------- --------
Interest cost $ 171 $ 181
Amortization of net loss 40 19
Expected return on plan assets (157) (184)
-------- --------
Net periodic pension cost $ 54 $ 16
======== ========
We contributed $32 thousand and $36 thousand to our frozen defined
benefit cash balance plan during the first three months of 2006 and 2005,
respectively. Refer to Note 13 of our Form 10-K for the year ended December
31, 2005 for more discussion of our retirement plans.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
Introduction
Hallmark Financial Services, Inc. ("Hallmark" and, together with
subsidiaries, "we", "us", "our") is an insurance holding company engaged in
the sale of property and casualty insurance products to businesses and
individuals. Our business involves marketing and underwriting commercial
insurance in Texas, New Mexico, Idaho, Oregon, Montana, Louisiana and
Washington; marketing and underwriting non-standard personal automobile
insurance in Texas, New Mexico and Arizona; marketing general aviation
insurance in 44 states; claims administration; and other insurance related
services. We pursue our business activities through subsidiaries whose
operations are organized by producing companies into our Hallmark General
Agency operating segment ("HGA Segment"), which includes the commercial
insurance products and services handled by Hallmark General Agency, Inc.
("HGA") and Effective Claims Management, Inc.; our Texas General Agency
operating segment ("TGA Segment"), which includes the commercial insurance
products and services handled by Texas General Agency, Inc. ("TGA"), Pan
American Acceptance Corporation ("PAAC") and TGA Special Risk, Inc.
("TGASRI"); our Phoenix General Agency operating segment ("PGA Segment"),
which includes the non-standard personal automobile insurance products and
services handled by American Hallmark General Agency, Inc. and Hallmark
Claims Services, Inc. (both of which do business as Phoenix General Agency);
and our aviation operating segment ("Aerospace Segment"), which includes the
general aviation insurance products and services handled by Aerospace
Holdings LLC ("Aerospace") and its wholly owned subsidiaries. The subsidiary
companies in our TGA Segment and Aerospace Segment were all acquired
effective January 1, 2006. The retained premium produced by our operating
segments is supported by our insurance company subsidiaries: American
Hallmark Insurance Company of Texas ("AHIC"); Phoenix Indemnity Insurance
Company ("PIIC"); and Gulf States Insurance Company ("GSIC"), a wholly owned
subsidiary of TGA which was acquired by Hallmark effective January 1, 2006.
Financial Condition and Liquidity
Sources and uses of funds. Our sources of funds are from insurance
related operations, financing activities and investing activities. Major
sources of funds from operations include premiums collected (net of policy
cancellations and premiums ceded), commissions, and processing and service
fees. On a consolidated basis, our cash and investments (excluding
restricted cash and investments) at March 31, 2006 were $167.1 million
compared to $139.6 million at December 31, 2005. Most of this increase is
attributable to the acquisitions of TGA and certain affiliated companies
(collectively, the "TGA Group") on January 1, 2006, which contributed $20.0
million in cash and investments as of March 31, 2006.
Net cash provided by our consolidated operating activities was $9.6
million for the first three months of 2006 compared to net cash used of $0.2
million for the first three months of 2005. The increase in operating cash
flow primarily resulted from the retention of HGA Segment and TGA Segment
business in the first quarter 2006 that was not retained by us in the first
quarter of 2005. The net effect on operating cash flows was an increase of
$9.8 million resulting from an increase in collected premiums net of paid
loss and loss adjustment expenses partially offset by lower collected
commission and claim fee revenue.
Cash used by investing activities during the first three months of 2006
was $41.6 million as compared to $6.4 million for the same period in 2005.
The increase in cash used by investing activities is mostly due to the
acquisitions of TGA Group and Aerospace in the first quarter of 2006 which
used $26.0 million, net of cash acquired. Also contributing to the increase
in cash used by investing activities was the funding of $25.0 million to a
trust account securing the future guaranteed payments to the TGA Group
sellers, as well as PAAC's $1.7 million repayment of premium finance notes,
net of premium finance notes originated. Partially offsetting these uses
was a $13.2 million increase in net redemptions of short-term investments in
the first quarter of 2006 versus the same period in 2005 and $3.9 million in
maturities and redemptions of investment securities in 2006.
Cash provided by financing activities during the first three months of
2006 was $52.5 million as compared to $13 thousand for the same period of
2005. The cash provided in 2006 was primarily from the issuance of three
debt instruments in January. The first was a promissory note payable to
Newcastle Partners, L.P. in the amount of $12.5 million to fund the cash
required to close the Aerospace acquisition. This note bears interest at
the rate of 10% per annum. The unpaid principal balance of the promissory
note, together with all accrued and unpaid interest, is due and payable on
demand at any time after June 30, 2006. The second debt instrument was
$25.0 million in subordinated convertible promissory notes to the Newcastle
Special Opportunity Fund I, L.P. and Newcastle Special Opportunity Fund II,
L.P. Each convertible note bears interest at 4% per annum until paid or
converted, which rate increases to 10% per annum in the event of default.
Interest is payable quarterly in arrears commencing March 31, 2006.
Conversion of the notes is in all events subject to shareholder approval.
Following shareholder approval, the principal of the notes must be converted
by the holders into approximately 19.5 million shares of our common stock
(subject to certain anti-dilution provisions) on or before maturity on July
27, 2007. Absent shareholder approval, principal and all accrued but unpaid
interest is due at maturity. The notes may not be prepaid. The $25.0
million raised with these notes was used to fund a trust account securing
future guaranteed payments to the TGA Group sellers. The third debt
instrument was $15.0 million borrowed under our revolving credit facility
with Frost Bank to fund the cash required to close the TGA Group
acquisition.
As a holding company, Hallmark is dependent on dividend payments and
management fees from its subsidiaries to meet operating expenses and debt
obligations. As of March 31, 2006, Hallmark had $1.5 million in cash and
invested assets. Cash and invested assets of our non-insurance subsidiaries
were $3.9 million as of March 31, 2006.
Property and casualty insurance companies domiciled in the State of
Texas are limited in the payment of dividends to their shareholders in any
twelve-month period, without the prior written consent of the Texas
Department of Insurance, to the greater of statutory net income for the
prior calendar year or 10% of statutory policyholders' surplus as of the
prior year end. Dividends may only be paid from unassigned surplus funds.
During 2006, AHIC's ordinary dividend capacity is $6.4 million. PIIC,
domiciled in Arizona, is limited in the payment of dividends to the lesser
of 10% of prior year policyholder's surplus or prior year's net investment
income, without prior written approval from the Arizona Department of
Insurance. During 2006, PIIC's ordinary dividend capacity is $1.6 million.
GSIC, domiciled in Oklahoma, is limited in the payment of dividends to
the greater of 10% of prior year policyholder's surplus or prior year's
statutory net income, without prior written approval from the Oklahoma
Insurance Department. During 2006, GSIC's ordinary dividend capacity is
$0.1 million. None of AHIC, PIIC or GSIC paid a dividend to Hallmark during
the first three months of 2006.
Credit facility. On June 29, 2005, we entered into a credit facility
with The Frost National Bank. The credit facility was amended and restated
on January 27, 2006 to a $20.0 million revolving credit facility, with a
$5.0 million letter of credit sub-facility. We borrowed $15.0 million under
the revolving credit facility to fund the cash required to close the
TGA Group acquisition. Principal outstanding under the revolving credit
facility generally bears interest at the three month Eurodollar rate plus
2.00%, payable quarterly in arrears. We pay letter of credit fees at the
rate of 1.00% per annum. Our obligations under the revolving credit
facility are secured by a security interest in the capital stock of all of
our subsidiaries, guaranties of all of our subsidiaries and the pledge of
substantially all of our assets. The revolving credit facility contains
covenants which, among other things, require us to maintain certain
financial and operating ratios and restrict certain distributions,
transactions and organizational changes. The amended and restated credit
agreement terminates on January 27, 2008. As of March 31, 2006, there was
$15.0 million outstanding under our revolving credit facility, and we were
in compliance with or had obtained waivers of all of our covenants. In the
third quarter of 2005, we issued a $4.0 million letter of credit under this
facility to collateralize certain obligations under the agency agreement
between HGA and Clarendon National Insurance Company effective July 1, 2004.
Trust preferred securities. On June 21, 2005, our newly formed trust
subsidiary completed a private placement of $30.0 million of 30-year
floating rate trust preferred securities. Simultaneously, we borrowed $30.9
million from the trust subsidiary and contributed $30.0 million to AHIC in
order to increase policyholder surplus. The note bears an initial interest
rate of 7.725% until June 15, 2015, at which time interest will adjust
quarterly to the three month LIBOR rate plus 3.25 percentage points. As of
March 31, 2006, the note balance was $30.9 million.
Conclusion. Based on budgeted and year-to-date cash flow information,
we believe that we have sufficient liquidity to meet our projected insurance
obligations, operational expenses and capital expenditure requirements for
the foreseeable future. However, we expect additional capital to be
required to satisfy the debt obligations to Newcastle which are payable on
demand after June 30, 2006. We have previously indicated our intent to
obtain such additional capital through a rights offering of our common
stock to existing shareholders during 2006. While a rights offering is
still being considered, we are also exploring additional alternatives to
satisfy our capital needs. There can be no assurance that we will be able
to obtain the required additional capital on advantageous terms.
Results of Operations
Management Overview. During the first quarter of fiscal 2006, our
total revenues were $44.5 million, representing a 155.2% increase over the
$17.4 million in total revenues for the comparable period of fiscal 2005.
The increase in total revenues for the first three months of fiscal 2006 as
compared to the first three months of fiscal 2005 was primarily attributable
to the acquisitions of TGA Group and Aerospace in the first quarter of 2006,
which contributed $16.0 million in revenue. The retention of business
produced by the HGA Segment and underwritten by AHIC that was previously
retained by third parties also contributed $10.3 million to the increase in
quarterly revenue.
We reported net income of $2.4 million for the three months ended
March 31, 2006, as compared to $1.8 million in the same period in the prior
year. The increase in net income for the first three months of 2006 versus
the same period in 2005 was primarily attributable to the retention of the
HGA Segment business and quarterly results from the TGA Group, partially
offset by interest expense from the amortization of a deemed discount on
convertible promissory notes.
During the first quarter of fiscal 2006, we recorded a $1.1 million
interest expense from amortization attributable to the deemed discount on
convertible promissory notes issued in January, 2006. (See Note 10,
"Convertible Notes Payable.") In the absence of this non-cash expense, our
net income for the three months ended March 31, 2006 would have been $3.1
million, representing a 72.5% increase over the similar period of fiscal
2005.
The following is a reconciliation of our net income without such interest
expense to our reported results (in thousands). Management believes this
reconciliation provides useful supplemental information in evaluating the
operating results of our business. This disclosure should not be viewed as
a substitute for net income determined in accordance with GAAP:
Quarter Ended
March 31, 2006
--------------
Income excluding interest expense from
amortization of discount, net of tax $ 3,130
Interest expense from amortization of discount 1,117
Less related tax effect (413)
--------------
704
--------------
Net income $ 2,426
==============
On a common stockholder diluted per share basis, net income was $0.02
for the three months ended March 31, 2006 and $0.04 for the same period in
2005. The decrease in diluted earnings per share to common stockholders was
due to the combined impact of issuing 50.0 million shares in a stockholder
rights offering in the second quarter of 2005 and allocating a portion of
net income to the holders of convertible notes in the first quarter of 2006.
(See Note 14, "Earnings Per Share.")
The following is additional business segment information for the three
months ended March 31, 2006 and 2005 (in thousands):
Three Months Ended
March 31,
2006 2005
-------- --------
Revenues:
---------
HGA Segment $ 17,540 $ 6,280
TGA Segment 14,099 -
PGA Segment 10,797 11,161
Aerospace Segment 1,869 -
Corporate 215 4
-------- --------
Consolidated $ 44,520 $ 17,445
======== ========
Pre-tax income (loss):
HGA Segment $ 3,360 $ 1,068
TGA Segment 1,728 -
PGA Segment 2,051 2,442
Aerospace Segment (109) -
Corporate (3,501) (806)
-------- --------
Consolidated $ 3,529 $ 2,704
======== ========
First Quarter 2006 as compared to the First Quarter 2005
HGA Segment
Beginning in the third quarter of 2005, our HGA Segment (formerly
known as the Commercial Lines Operation) began retaining written premium
through AHIC that was previously retained by third parties. This resulted
in net written premium for the HGA Segment of $21.7 million for the quarter
ended March 31, 2006.
Total revenue for the HGA Segment of $17.5 million for the first
quarter of 2006 was $11.2 million more than the $6.3 million reported in the
first quarter of 2005. This 179.3% increase in total revenue was primarily
due to net premiums earned of $14.3 million for the quarter from the
issuance of AHIC policies produced by the HGA Segment. Increased net
investment income contributed an additional $0.9 million to the increase in
revenue for the quarter. These increases in revenue were partially offset
by lower ceding commission revenue of $3.3 million and lower processing and
service fees of $0.7 million, in both cases due to the shift from a third
party agency structure to an insurance underwriting structure.
Pre-tax income for Hallmark General Agency of $3.4 million for the
first quarter of 2006 increased $2.3 million, or 214.6%, over the $1.1
million reported for the first quarter of 2005. Increased revenue, as
discussed above, was the primary reason for the increase in pre-tax income,
partially offset by increased loss and loss adjustment expenses of $7.8
million and additional production expenses of $0.9 million.
TGA Segment
The members of the TGA Segment were all acquired effective January 1,
2006. The $14.1 million of revenues was derived mostly from third party
commission revenue of $9.2 million on the portion of business produced by
the TGA Segment that was retained by third parties and from $4.3 million of
earned premium on produced business that was assumed by GSIC or AHIC. The
remaining $0.6 million of revenue was derived from investment income and
finance charges.
Pre-tax income for the TGA Segment of $1.7 million was due to revenue
as discussed above less (i) incurred loss and loss adjustment expenses of
$2.6 million on the portion of the business assumed by GSIC or AHIC, (ii)
$9.7 million in operating expenses, comprised mostly of commission expense
and salary related expenses, and (iii) $0.5 million of amortization of
intangible assets acquired in the acquisition of the TGA Group.
PGA Segment
Net premium written for our PGA Segment (formerly known as the Personal
Lines Operation) increased $0.5 million during the first quarter of 2006 to
$11.1 million compared to $10.6 million in the first quarter of 2005.
Revenue for the PGA Segment decreased 3.3% to $10.8 million for the
first quarter of 2006 from $11.2 million for the same period in 2005. Lower
earned premium of $0.3 million was primarily due to the timing and pattern
of written premium. Also contributing to the decrease in revenue was $0.1
million of third party commission revenue recognized in the first quarter of
2005 that was discontinued due to the 100% assumption of the Texas non-
standard automobile premium beginning late in 2004.
Pre-tax income for the PGA Segment decreased $0.4 million, or 16.0%,
for the first quarter of 2006 compared to the first quarter of 2005. Lower
revenue as discussed above was the primary cause of the decrease in pre-tax
income for the quarter.
Aerospace Segment
The members of the Aerospace Segment were all acquired effective January
1, 2006. The $1.9 million of revenues was derived mostly from third party
commission revenue of $1.7 million on the portion of business produced by
Aerospace Insurance Managers, Inc. ("AIM"), a wholly owned subsidiary of
Aerospace, which is retained by third parties. An additional $0.1 million
of revenue was derived from earned premium on business assumed by Mannequin
PCC Ltd. Cell A-22 ("Mannequin"), a wholly owned captive cell of Aerospace
located in Guernsey. Mannequin currently assumes approximately 2.5% of the
business produced by AIM.
Pre-tax loss for the Aerospace Segment of $0.1 million for the first
quarter of 2006 was due to revenue discussed above less (i) operating
expenses of $1.7 million, comprised mostly of commission expense and salary
related expenses, (ii) loss and loss adjustment expenses of $0.2 million,
and (iii) $0.1 million of amortization of intangible assets acquired in the
acquisition of Aerospace.
Corporate
Corporate pre-tax loss was $3.5 million for the first quarter of 2006
as compared to $0.8 million for the same period in 2005. The increased loss
was primarily due to interest expense of $1.5 million in the first quarter
of 2006 comprised of (i) $0.6 million from the trust preferred securities
issued in the second quarter of 2005 (see Note 8, "Notes Payable"), (ii)
$0.3 million from the related party promissory note issued in January 2006
(see Note 9, "Note Payable to Related Party"), (iii) $0.2 million of
amortization of the discount on the future guaranteed payments to the TGA
Group sellers (see Note 11, "Structured Settlements"), (iv) $0.2 million
from borrowings under our revolving credit facility with The Frost National
Bank in January 2006 (see Note 8, "Notes Payable" and Note 12, "Credit
Facility"), and (v) $0.2 million from the issuance of convertible notes
issued in January 2006 (see Note 10, "Convertible Notes Payable"). Also
contributing to the increase in pre-tax loss for the quarter was $1.1
million in interest expense from amortization attributable to the deemed
discount on convertible promissory notes issued in January, 2006. (See Note
10, "Convertible Notes Payable.") This expense had no impact on our cash
flow and will ultimately have no effect on our book value.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
As of March 31, 2006, there had been no material changes in the market
risks described in the Company's Form 10-K for the year ended December 31,
2005.
Item 4. Controls and Procedures.
The Chief Executive Officer and Chief Financial Officer of the Company
have evaluated the Company's disclosure controls and procedures and have
concluded that, as of the end of the period covered by this report, such
disclosure controls and procedures were effective in ensuring that
information required to be disclosed by the Company in the reports that it
files or submits under the Securities Exchange Act of 1934 is timely
recorded, processed, summarized and reported. The Chief Executive Officer
and Chief Financial Officer also concluded that such disclosure controls and
procedures were effective in ensuring that information required to be
disclosed by the Company in the reports that it files or submits under such
Act is accumulated and communicated to the Company's management, including
its Chief Executive Officer and Chief Financial Officer, as appropriate, to
allow timely decisions regarding required disclosure. During the most
recent fiscal quarter, there have been no changes in the Company's internal
controls over financial reporting that have materially affected, or are
reasonably likely to materially affect, the Company's internal control over
financial reporting.
Risks Associated with Forward-Looking Statements Included in this Form 10-Q
This Form 10-Q contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, which are intended to be covered by the
safe harbors created thereby. These statements include the plans and
objectives of management for future operations, including plans and
objectives relating to future growth of the Company's business activities
and availability of funds. The forward-looking statements included herein
are based on current expectations that involve numerous risks and
uncertainties. Assumptions relating to the foregoing involve judgments with
respect to, among other things, future economic, competitive and market
conditions, regulatory framework, weather-related events and future business
decisions, all of which are difficult or impossible to predict accurately
and many of which are beyond the control of the Company. Although the
Company believes that the assumptions underlying the forward-looking
statements are reasonable, any of the assumptions could be inaccurate and,
therefore, there can be no assurance that the forward-looking statements
included in this Form 10-Q will prove to be accurate. In light of the
significant uncertainties inherent in the forward-looking statements
included herein, the inclusion of such information should not be regarded as
a representation by the Company or any other person that the objectives and
plans of the Company will be achieved.
PART II
OTHER INFORMATION
Item 1. Legal Proceedings.
The Company is engaged in legal proceedings in the ordinary course of
business, none of which, either individually or in the aggregate, are
believed likely to have a material adverse effect on the consolidated
financial position of the Company or the results of operations, in the
opinion of management. The various legal proceedings to which the Company
is a party are routine in nature and incidental to the Company's business.
Item 1A. Risk Factors.
In addition to the other information set forth in this report, you
should carefully consider the risk factors discussed in Part I, "Item 1A.
Risk Factors" in our Annual Report on Form 10-K for the year ended December
31, 2005, which could materially affect our business, financial condition or
future results. There have been no material changes from the risk factors
described in such Annual Report on Form 10-K, except as follows:
If we are unable to raise additional capital or restructure our indebtedness
to Newcastle, we may have difficulty satisfying current liquidity
requirements.
We funded the acquisition of Aerospace by borrowing $12.5 million from
Newcastle on January 3, 2006. The principal and accrued interest of this
bridge loan are payable on demand at any time after June 30, 2006. We have
previously announced our intention to retire this debt through a rights
offering of our common stock to existing shareholders during 2006. Although
such a rights offering is still under consideration, we are also exploring
other alternatives to satisfy our capital needs. If we are unable to obtain
additional capital or restructure the payment schedule of the bridge loan,
we may be unable to repay the bridge loan when demand is made. Any default
under the bridge loan to Newcastle would also be an event of default under
our primary secured credit facility and, therefore, could have a material
adverse affect on our liquidity and operations.
The failure to maintain favorable financial strength ratings could
negatively impact our ability to compete successfully.
Third party rating agencies assess and rate the claims-paying ability of
insurers based upon criteria established by the agencies. Financial
strength ratings are used by agents and clients as an important means of
assessing the financial strength and quality of insurers. During 2005,
A.M. Best, a nationally recognized insurance industry rating service and
publisher, upgraded the financial strength rating of PIIC from "B (Fair)" to
"B+ (Very Good)" and upgraded the financial strength rating of AHIC from "B
(Fair)" to "A- (Excellent)". To maintain these ratings, the capitalization
and operating performance of our insurance subsidiaries must be consistent
with projections provided to A.M. Best. Our failure to maintain our current
financial strength ratings could adversely affect our ability to sell
insurance policies and inhibit us from competing effectively.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Information previously furnished in our Current Report on Form 8-K filed
February 2, 2006.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 5. Other Information.
None.
Item 6. Exhibits.
The following exhibits are filed herewith or incorporated herein by
reference:
Exhibit
Number Description
------ -----------
3(a) Articles of Incorporation of the registrant, as amended
(incorporated by reference to Exhibit 3(a) to the
registrant's Annual Report on Form 10-KSB for the fiscal
year ended December 31, 1993).
3(b) By-Laws of the registrant, as amended (incorporated by
reference to Exhibit 3(b) to the registrant's Quarterly
Report on Form 10-Q for the quarter ended June 30, 2005).
3(c) Amendment of Article VII of the Amended and Restated Bylaws
of Hallmark Financial Services, Inc., adopted July 19, 2002
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2002).
4(a) Specimen certificate for Common Stock, $0.03 par value
per share, of the registrant (incorporated by reference to
Exhibit 4 to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1991).
4(b) Indenture dated as of June 21, 2005, between Hallmark
Financial Services, Inc. and JPMorgan Chase Bank, National
Association (incorporated by reference to Exhibit 4.1 to
the registrant's Current Report on Form 8-K filed June 27,
2005).
4(c) Amended and Restated Declaration of Trust of Hallmark
Statutory Trust I dated as of June 21, 2005, among Hallmark
Financial Services, Inc., as sponsor, Chase Bank USA,
National Association, as Delaware trustee, and JPMorgan
Chase Bank, National Association, as institutional trustee,
and Mark Schwarz and Mark Morrison, as administrators
(incorporated by reference to Exhibit 4.2 to the registrant's
Current Report on Form 8-K filed June 27, 2005).
4(d) Form of Junior Subordinated Debt Security Due 2035
(incorporated by reference to Exhibit 4.1 to the
registrant's Current Report on Form 8-K filed June 27,
2005).
4(e) Form of Capital Security Certificate (incorporated by
reference to Exhibit 4.2 to the registrant's Current Report
on Form 8-K filed June 27, 2005).
4(f) Promissory Note dated January 3, 2006, between Hallmark
Financial Services, Inc. and Newcastle Partners, L.P.
(incorporated by reference to Exhibit 4.1 to the registrant's
Current Report on Form 8-K filed January 5, 2006).
4(g) First Restated Credit Agreement dated January 27, 2006,
between Hallmark Financial Services, Inc. and The Frost
National Bank (incorporated by reference to Exhibit 4.1 to
the registrant's Current Report on Form 8-K filed February
2, 2006).
4(h) Convertible Promissory Note dated January 27, 2006,
between Hallmark Financial Services, Inc. and Newcastle
Special Opportunity Fund I, L.P. and Newcastle Special
Opportunity Fund II, L.P. (incorporated by reference to
Exhibit 4.2 to the registrant's Current Report on Form
8-K filed February 2, 2006).
10(a) Form of Purchase Agreement dated January 27, 2006,
between Hallmark Financial Services, Inc. and Newcastle
Special Opportunity Fund I, Ltd. and Newcastle Special
Opportunity Fund II, L.P. (incorporated by reference to
Exhibit 10.1 to the registrant's Current Report on Form
8-K filed February 2, 2006).
10(b) Form of Registration Rights Agreement dated January 27,
2006, between Hallmark Financial Services, Inc. and
Newcastle Special Opportunity Fund I, Ltd. and Newcastle
Special Opportunity Fund II, L.P. (incorporated by
reference to Exhibit 10.2 to the registrant's Current
Report on Form 8-K filed February 2, 2006).
31(a) Certification of Chief Executive Officer required by
Rule 13a-14(a) or Rule 15d-14(a).
31(b) Certification of Chief Financial Officer required by
Rule 13a-14(a) or Rule 15d-14(a).
32(a) Certification of Chief Executive Officer Pursuant to
18 U.S.C. 1350.
32(b) Certification of Chief Financial Officer Pursuant to
18 U.S.C. 1350.
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant has
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
Date: May 15, 2006 /s/ Mark E. Schwarz
---------------------------------------------
Mark E. Schwarz, Chairman
(Chief Executive Officer)
Date: May 15, 2006 /s/ Mark J. Morrison
---------------------------------------------
Mark J. Morrison, President
(Chief Operating Officer and
Chief Financial Officer)