Form 10K 2003

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

_________________

FORM 10-K

  (Mark One)

       X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

  For the fiscal year ended December 31, 2003 or

  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

  For the transition period from ___________to ___________

Commission File Number 000-26489

_________________

ENCORE CAPITAL GROUP, INC.
(Exact name of registrant as specified in its charter)

_________________

Delaware
(State or Other Jurisdiction of
Incorporation or Organization)
48-1090909
(I.R.S. Employer Identification No.)
5775 Roscoe Court, San Diego, CA
(Address of Principal Executive Offices)
92123
(Zip Code)

(877) 445-4581
(Registrant’s Telephone Number, Including Area Code)

_________________

Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.01 Par Value Per Share
(Title of Class)

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [   ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [    ] No [X]

The aggregate market value of the voting stock held by non-affiliates of the registrant totaling 2,136,735 shares was $18,803,268 at June 30, 2003 based on the closing price of the Common Stock of $8.80 per share on such date, as reported by the Nasdaq National Market.

The number of shares of the registrant’s Common Stock outstanding at February 10, 2004 was 22,020,016.






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TABLE OF CONTENTS

Index

PART I      3  
Item 1 - Business    3  
Item 2 - Properties    16  
Item 3 - Legal Proceedings    16  
Item 4 - Submission of Matters to a Vote of Security Holders    18  
PART II    19  
Item 5 - Market for the Registrant's Common Equity Securities and Related Stockholder Matters    19  
Item 6 - Selected Consolidated Financial Data    22  
Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations    24  
Item 7A - Quantitative and Qualitative Disclosure about Market Risk    66  
Item 8 - Consolidated Financial Statements    67  
Report of Independent Auditors    68  
Consolidated Statements of Financial Condition    69  
Consolidated Statements of Operations    70  
Consolidated Statements of Stockholders' Equity (Deficit) and Comprehensive Income (Loss)    71  
Consolidated Statements of Cash Flows    72  
Notes to Consolidated Financial Statements    74  
Item 9 - Changes in and Disagreements with Accountants    103  
Item 9A - Controls and Procedures    103  
PART III    104  
PART IV    104  
Item 15 - Exhibits, Financial Statement Schedules, and Reports on Form 8-K    104  
SIGNATURES    109  
Consent of Independent Auditors    111  
Certificate of Principal Executive Officer    113  
Certificate of Principal Financial Officer    114  





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Index

PART I

Item 1 — Business

An Overview of Our Business

Nature of Business
Encore Capital Group, Inc. (“Encore”) is a systems-driven purchaser and manager of charged-off consumer receivables portfolios. Encore acquires these portfolios at deep discounts from their face values using its proprietary valuation process that is based on the consumer attributes of the underlying accounts. Based upon the ongoing analysis of these accounts, Encore employs a dynamic mix of collection strategies to maximize its return on investment. Encore is a Delaware holding company whose principal assets are its investments in its wholly-owned subsidiaries, Midland Credit Management, Inc. (“Midland Credit”), Midland Funding 98-A Corporation (“98-A”), Midland Receivables 99-1 Corporation (“99-1”), Midland Acquisition Corporation, MRC Receivables Corporation (“MRC”), Midland Funding NCC-1 Corporation (“NCC-1”), and Midland Funding NCC-2 Corporation (“NCC-2”) (collectively referred to herein as the “Company,” “we,” “us,” or “our”). Encore also has a wholly owned subsidiary, Midland Receivables 98-1 Corporation, which is not consolidated, but is recorded as an investment in retained interest on the accompanying consolidated statements of financial condition. The receivable portfolios consist primarily of charged-off domestic consumer credit card receivables purchased from national financial institutions, major retail credit corporations, and resellers of such portfolios. Acquisitions of receivable portfolios are financed by operations and by borrowings from third parties.

We have been in the collection business for 50 years and started purchasing portfolios for our own account approximately 13 years ago. We purchase charged-off credit card receivables and, to a lesser extent, other consumer receivables, including auto loan deficiencies and general consumer loans. From our inception through December 31, 2003, we have invested over $285.4 million to acquire 7.3 million consumer accounts with a face value of approximately $12.7 billion.

In May 2000, we acquired selected assets of West Capital Financial Services Corp., which also purchased defaulted receivables portfolios. At that time, West Capital’s management team took over the operations of our business. Since then, this management team has refined our purchasing methodologies, significantly expanded and enhanced our collection strategies, improved our financial condition and returned Encore to profitability.

Since new management took over in mid-2000, we have collected $108.5 million through December 31, 2003 from the portfolios we purchased for $39.0 million in 2001; $118.5 million through December 31, 2003 from the portfolios we purchased for $62.5 million in 2002; and $59.0 million through December 31, 2003 from the portfolios we purchased for $89.8 million in 2003.




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We purchase discrete pools of consumer receivables directly from credit card originators and other lenders, as well as from a variety of resellers. We have established certain relationships that allow us to purchase portfolios directly through negotiated transactions, and we participate in the auction-style purchase processes that typify our industry. In addition, we enter into “forward flow” arrangements in which we agree to buy receivables that meet agreed upon parameters over the course of the contract term. Since mid-2000, we have purchased pools of consumer receivables from thirty credit originators and resellers.

We evaluate each portfolio for purchase using our proprietary valuation and underwriting processes developed by our in-house team of statisticians. Unlike many of our competitors which we believe often base their purchase decisions primarily on numerous aggregated portfolio-level factors, including the lender/originator, the type of receivables to be purchased, or the number of collection agencies the accounts have been placed with previously, we base our purchase decisions primarily on our analysis of the specific accounts included in a portfolio. Based upon this analysis, we determine a value for each account, which we aggregate to produce a valuation of the entire portfolio. We believe this capability allows us to perform more accurate valuations of receivables portfolios. In addition, we have successfully applied this methodology to other types of receivables, such as auto loan deficiencies and consumer loans.

Generally, our objective is to purchase portfolios at a price that allows us to recoup at least 85% of our purchase price within 12 months, and at least 2.7 times our purchase price over 54 months, for that portion we do not sell at the time of purchase. A substantial majority of our portfolios purchased since the arrival of the new management team in mid-2000 have returned more than 85% of their purchase price within a year, excluding cash generated from selected sales of accounts.

After we purchase a portfolio, we continuously refine our analysis of the accounts to determine the best strategy for collection. As with our purchase decisions, our collection strategies are based on account level criteria. Our collection strategies include:

By applying these multiple collection processes in a systematic manner, we have greatly increased our collection effectiveness and reduced our total operating expense per dollar collected. Total operating expense per dollar collected was $0.39 for the year ended December 31, 2003, an improvement from $0.43 in the year ended December 31, 2002 and $0.56 in the year ended December 31, 2001. For the year ended December 31, 2003, we collected a monthly average of $23,385 per average active employee. For the year ended December 31, 2002, we collected a monthly average of $21,656 per average active employee, as compared to a monthly average of $12,875 per average active employee for the year ended December 31, 2001.




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Investors wishing to obtain more information about Encore Capital Group, Inc. may access our Internet site (www.encorecapitalgroup.com) that allows access to relevant investor related information such as SEC filings, analyst coverage and earning estimates, press releases, featured articles, an event calendar, and frequently asked questions.

Our Industry
The receivables management industry is large and growing rapidly, driven by increasing levels of consumer debt, higher default rates, and increasing use of third-party providers by credit originators to collect their defaulted receivables. At December 31, 2003, consumer credit, which excludes mortgages, was $2.0 trillion, up 3.9% from December 31, 2002. Consumer credit grew at an 8.3% compounded annual rate between 1992 and 2002. The Federal Reserve Board estimates that consumer credit charge-offs totaled $57.2 billion during the third quarter of 2003, representing 2.9% of all consumer credit outstanding as of September 30, 2003. Consumer credit charge-offs grew at a 12.1% compounded annual rate between 1992 and 2002. Revolving credit, a subset of consumer credit, which includes credit cards, rose 2.6% to $742.5 billion in December 2003 from December 2002. Revolving credit is the fastest growing component of consumer credit, growing at an 11.0% compounded annual rate between 1992 and 2002. According to the Federal Reserve Board, for the third quarter of 2003, the credit card charge-off rate was 5.2%, down from 5.7% in the third quarter of 2002. Revolving credit charge-offs reached $44.3 billion in 2002, growing at a 14.2% compounded annual rate between 1992 and 2002.

Historically, credit originators have sought to limit credit losses either through using internal collection efforts with their own personnel or outsourcing collection activities to accounts receivable management providers. Credit originators that have outsourced the collection of defaulted receivables have typically remained committed to third-party providers as a result of the perceived economic benefit of outsourcing and the resources required to reestablish the infrastructure required to support in-house collection efforts. Credit originators’ outsourced solutions include selling their defaulted receivables for immediate cash proceeds and placing defaulted receivables with an outsourced provider on a contingent fee basis while retaining ownership of the receivables.

The accounts receivable industry is highly fragmented, with approximately 6,000 collection companies in the United States. Most of these collection companies are small, privately owned companies that collect for others for a contingent fee. We believe that there are fewer than fifteen to twenty large companies (many of which remain privately-owned) that purchase the receivables and collect on them for their own account.




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Our Strengths
Since the new management team took over in mid-2000, we have substantially refined our purchasing methodologies, expanded our collection strategies, improved our balance sheet and became consistently profitable. We believe that these results are a product of the following strengths and competitive advantages:

Empirically Based and Technology-Driven Business Processes. We have assembled a team of statisticians, business analysts and software programmers that has developed proprietary valuation models, software and other business systems that guide our portfolio purchases and collection efforts. Our information technology department has developed and continually updates sophisticated software that manages the movement of data, accounts and information throughout the company. These proprietary systems give us the flexibility, speed and control to capitalize on business opportunities.

Account-Based Portfolio Valuation. We analyze each account within a portfolio presented to us for purchase to determine the likelihood and expected amount of payment. The expectations for each account are then aggregated to arrive at a valuation for the entire portfolio. Our valuations are derived in large part from information accumulated on approximately 4.8 million accounts acquired since mid-2000.

Dynamic Collections Approach. Over the past three years, we have dramatically reduced our dependence on general outbound calling by expanding our collection strategies to include direct mail campaigns, greater use of legal actions, account sales, and a relationship with a national credit card company to provide for account balance transfers. Moreover, because the status of individual debtors changes continually, once each quarter we re-analyze all of our accounts with refreshed external data, which we supplement with information gleaned from our own collection efforts. We change our collection method for each account accordingly.

Experienced Management Team. Our management team has considerable experience in financial, banking, consumer and other industries, as well as the collections industry. We believe that the expertise of our executives obtained by managing in other industries has been critical to the enhancement of our operations. Our management team has created a culture of new ideas and progressive thinking, coupled with the increased use of technology and statistical analysis.

Ability to Hire, Develop and Retain Productive Collectors and Key Employees. We place considerable emphasis on hiring, developing and retaining effective collectors and other employees who are key to our continued growth and profitability. As a result of ongoing training, compensation incentives and our progressive corporate culture, we believe that we have been able to achieve a retention rate that is higher than typical for our industry.




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Large Database of Consumer Information. From our inception through December 31, 2003, we acquired approximately 7.3 million accounts. We utilize a significant portion of the data from these accounts in our account-level valuation techniques employed in both the acquisition and management of accounts.

Our Strategy
To enhance our position in the industry, we have implemented a business strategy that emphasizes the following elements:

Implement New and Refine Existing Collection Channels. We continually refine our collection processes, and evaluate new collection strategies, such as strategic outsourcing, to further supplement our traditional call center approach. We believe that our multiple and dynamic approach to collections increases our opportunity to achieve enhanced returns on our investments.

Leverage Expertise in New Markets. We believe that our internally developed underwriting and collection processes can be extended to a variety of charged-off consumer receivables in addition to charged-off credit card receivables. We intend to continue to leverage our valuation, underwriting and collection processes to other charged-off receivables markets, including auto loan deficiencies and general consumer loans. We believe that these markets may be less competitive, and therefore may offer more favorable pricing and higher margin opportunities. To date, our purchases of auto loan deficiencies and general consumer loans have performed to expectations.

Increase Our Negotiated Transactions. We have purchased portfolios from a number of credit originators and other sources. We believe that we have earned a reputation as a reliable purchaser and collector of defaulted consumer receivables portfolios, which helps to preserve the reputation of the credit originator. We intend to leverage our industry relationships and reputation to increase purchases through negotiated agreements, including forward flow contracts, and to reduce our reliance on auctions.

Improve Overall Cost of Funds. Recently, we have taken a number of steps to improve our balance sheet, and are now exploring new financing arrangements with the goal of continuing to improve our balance sheet, lowering our cost of funds, and thereby improving our profitability and return on equity.

Continue to Build Our Data Management and Analysis Capabilities. We are continually improving our technology platform and our pricing, underwriting and collection processes through software development, statistical analysis and experience.




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Consider Complementary Acquisitions. We intend to be opportunistic, and may pursue the acquisition of complementary companies to add to our expertise in new markets, add capacity, and provide us with additional portfolios to service.

Acquisition of Receivables
Once a portfolio purchase has been approved by our investment committee and the terms of the sale have been agreed to with the portfolio seller, the acquisition is documented in an agreement that contains customary terms and conditions. Provisions are incorporated for bankrupt, disputed, fraudulent or deceased accounts and, typically, the credit originator either agrees to repurchase these accounts or replace them with acceptable replacement accounts within certain time frames.

We maintain detailed static pool analysis on each portfolio that we have acquired, capturing collections, revenue, expense and other items for further analysis. In addition, our performance data set is continually updated and our valuation models are refined quarterly to capture the most current performance data.

As of December 31, 2003, we had two forward flow agreements under which we purchase charged-off receivables from the seller/originator on a periodic basis at a set price over a specified time period. Each of the agreements is cancelable by either party upon 60 days written notice without penalty. For the year ended December 31, 2003, we paid $32.8 million for receivables portfolios under forward flow agreements, which represented 36.6% of the $89.8 million in portfolio investments for the year. For the year ended December 31, 2002 we paid $12.4 million for receivable portfolios under forward flow agreements, which represented 19.8% of the $62.5 million in portfolio investments for the year. As part of our pre-purchase procedures, we obtain a representative test portfolio to evaluate and compare the characteristics of each portfolio to the parameters set forth in the agreement prior to purchase.







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The following table summarizes the average age since charge-off of our portfolios at time of purchase after mid-2000 when the new management team took control. This table excludes all receivables portfolios purchased prior to May 22, 2000, which as of December 31, 2003 consists of approximately 2.5 million accounts with an original face value of approximately $2.7 billion and remaining book value of approximately $2.2 million (in thousands):

Age at Purchase
Remaining
Book Value1

%2
Purchases after May 22, 2000
0-6 Months     $ 34,671    38 .4%
7-12 Months    12,629    14 .0
13-18 Months    22,284    24 .6
19-24 Months    7,677    8 .5
25-30 Months    2,588    2 .9
31-36 Months    3,484    3 .9
37+ Months    4,751    5 .2


                                          Total  $ 88,084    97 .5%


  1 Remaining book value at December 31, 2003.
  2 Percentages are calculated based on our entire portfolio of receivables, including receivables purchased prior to May 22, 2000 and our investment in the retained interest.


Collection Strategies
After we purchase a portfolio, we continuously refine our analysis to determine the most effective collection strategy to pursue. Through our proprietary internally-developed collection software we evaluate a number of variables to determine collection strategies for each account. These strategies consist of:




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°      Recovery Collectors. Prior to sending accounts to a law firm, a specialized internal group of collectors communicates our intention to have a lawyer evaluate the suitability of the account for litigation if payment arrangements cannot be established. These collectors have higher collection rates than the “core” collectors in the call center.




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Because the status of debtors changes continually, we re-analyze all of our accounts each quarter with refreshed credit bureau data, which we supplement with information gleaned from our own collection efforts. As circumstances dictate, we change our collection method for each account accordingly.  We work the accounts we deem collectible over an extended period of time to improve our return on investment.

Recruiting and Training of Collectors
As of December 31, 2003, we employed 383 experienced collectors, 124 inexperienced collector trainees, and 74 management personnel within the collection workforce. Experienced collectors include those in the collection workforce employed as of January 1, 2003 and who were not part of our Employee Development Group (EDG). Inexperienced collectors are those in the collection workforce who were part of the EDG on January 1, 2003 plus all new hires in 2003. We believe our approach to hiring, training and retaining the collector workforce is unique and is aligned with our corporate goals. We seek to hire individuals who not only can collect, but will also be flexible when the company makes changes to account workflows and support our goal of always improving our collection processes.

Prospective collectors go through an extensive interviewing process that requires them to fill out a job questionnaire, interview with professional recruiters, take a basic mathematical test, go through a criminal background screen, sit on the phone with one of our existing employees for 30 minutes and pass a behavioral test designed to predict a job fit. The behavioral test was developed in partnership with an outside psychological testing firm and targets those individuals who have characteristics similar to our established collector workforce. This test was implemented in the third quarter of 2002 and reduced attrition in the collector trainees during the first six months by almost 50%.

Once hired, all new collectors go through a thorough 4-week training process. During this period, they are taught our collection system, the Fair Debt Collection Practices Act (“FDCPA”), negotiation skills and queue management. Each collector must pass a comprehensive test on the FDCPA and other state laws before graduating.

After graduation, each individual is placed in our Employee Development Group. This group consists of inexperienced collectors, most of whom are in their first 6 months of employment. Our focus in this area is to build confidence in the new collectors and to support their growth with extensive management attention. Our manager-to-collector ratio target for this group is 1 to 10. We set up incentives to encourage personal growth through development of solid work habits and refined individual skills that will promote long-term success rather than penalize employees for not achieving quick performance levels. We believe this approach motivates the new collectors to learn and perform.




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Once collectors in the Employment Development Group are able to show consistent performance by completing the required proficiency levels, they are transferred to our general workforce, where they are organized into teams of approximately 36 people with 3 managers. The larger team environment was established specifically to ensure management coverage throughout the day and to make sure there is adequate coverage during vacations. Our general collector workforce incentive plan has three components: base pay, which ranges from $2,250 to $3,500 per month; variable individual compensation; and team bonus. Top collectors earn more than $90,000 per year, with the average collector earning approximately $40,225 per year. The variable component of the collector’s salary is based on a rolling 90-day period of time to ensure consistent performance.

Technology Platform
We believe one of our competitive advantages is the robust information management system we have developed. This system is integrated into all areas of our business and moves large amounts of data and information throughout the company as needed. In addition, it provides us with the flexibility to act upon up-to-date account information that allows us to continually enhance our business models to improve our collection efforts. We have an in-house staff of 16 programmers who create the functionality required to perform the tasks. Some examples include:

Our collection software resides on an IBM iSeries, which was upgraded in July 2003. The hardware platform currently manages our approximately 7.3 million accounts and can be expanded to manage twice this number of accounts in the future without an additional upgrade, giving us extremely high levels of reliability and scalability.




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We maintain a Microsoft Windows® 2000 based network that supports our back-office software including the human resource management application Perspectives, MAS 200® accounting software and ADP payroll system.

We use a Sun MicrosystemsTM based Concerto predictive dialing system and our analysts work with our SAS® quantitative analysis software on a Unix® server.

The application software and the network are backed up daily and kept offsite in a fireproof vault. We have a disaster recovery plan that was developed in conjunction with IBM and an agreement with Sungard Data Systems Inc. to provide equipment and facilities. In addition, we have an 850-gallon diesel generator capable of running our Phoenix facility, where the iSeries resides, in case of an extended power failure.

Competition
The consumer credit recovery industry is highly competitive and fragmented. We compete with a wide range of collection companies and financial services companies, which may have substantially greater personnel and financial resources than we do. We also compete with traditional contingency agencies and in-house recovery departments. Competitive pressures affect the availability and pricing of receivables portfolios, as well as the availability and cost of qualified recovery personnel. In addition, some of our competitors may have signed forward flow contracts under which originating institutions have agreed to transfer charged-off receivables to them in the future, which could restrict those originating institutions from selling receivables to us. We believe some of our major competitors, which include companies that focus primarily on the purchase of charged-off receivables portfolios, have continued to diversify into third party agency collections and into offering credit card and other financial services as part of their recovery strategy.

When purchasing receivables, we compete primarily on the basis of the price paid for receivables portfolios, our ability to be a reliable funder of prospective portfolios, and the quality of services that we provide. There continues to be consolidation of issuers of credit cards, which have been a principal source of receivable purchases. This consolidation has limited the sellers in the market and has correspondingly given the remaining sellers increasing market strength in the price and terms of the sale of credit card accounts.

Trade Secrets and Proprietary Information
We believe several components of our computer software are proprietary to our business. Although we have neither registered the software as copyrighted software nor attempted to obtain a patent related to the software, we believe that the software is protected as our trade secret. We have taken actions to establish the software as a trade secret, including informing employees that the software is a trade secret and making the underlying software code available only on an as needed basis. In addition, people who have access to information we consider proprietary must sign confidentiality agreements.




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Government Regulation
In a number of states we must maintain licenses to perform debt recovery services and must satisfy related bonding requirements. We believe that we have satisfied all material licensing and bonding requirements and are in compliance with all material government regulations.

The FDCPA and comparable state statutes establish specific guidelines and procedures, which debt collectors must follow when communicating with customers, including the time, place and manner of the communications. It is our policy to comply with the provisions of the FDCPA and comparable state statutes in all of our recovery activities, even though we may not be specifically subject to these laws. Our failure to comply with these laws could have a material adverse effect on us if they apply to some or all of our recovery activities. In addition to the FDCPA, significant federal laws applicable to our business include the following:

Truth-In-Lending Act; Electronic Funds Transfer Act;
Fair Credit Billing Act; U.S. Bankruptcy Code;
Equal Credit Opportunity Act; Gramm-Leach-Bliley Act; and
Fair Credit Reporting Act; Regulations that relate to these Acts

Additionally, there may be comparable statutes in those states in which customers reside or in which the originating institutions are located. State laws may also limit the interest rate and the fees that a credit card issuer may impose on its customers, and also limit the time in which we may file legal actions to enforce consumer accounts.

The relationship between a customer and a credit card issuer is extensively regulated by federal and state consumer protection and related laws and regulations. While we are not a credit card issuer, these laws affect some of our operations because the majority of our receivables were originated through credit card transactions. The laws and regulations applicable to credit card issuers, among other things, impose disclosure requirements when a credit card account is advertised, when it is applied for and when it is opened, at the end of monthly billing cycles, and at year-end. Federal law requires, among other things, that credit card issuers disclose to consumers the interest rates, fees, grace periods, and balance calculation methods associated with their credit card accounts. Some laws prohibit discriminatory practices in connection with the extension of credit. If the originating institution fails to comply with applicable statutes, rules, and regulations, it could create claims and rights for the customers that would reduce or eliminate their obligations under their receivables, and have a possible material adverse effect on us. When we acquire receivables, we generally require the originating institution to contractually indemnify us against losses caused by its failure to comply with applicable statutes, rules, and regulations relating to the receivables before they are sold to us.




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Federal statutes further provide that, in some cases, consumers cannot be held liable for, or their liability is limited with respect to, charges to the credit card account that were a result of an unauthorized use of the credit card. These laws, among others, may give consumers a legal cause of action against us, or may limit our liability to recover amounts owing with respect to the receivables, whether or not we committed any wrongful act or omission in connection with the account.

Recently enacted state and federal laws concerning identity theft, privacy, the use of automated dialing equipment and other consumer protection laws impose requirements or restrictions on collection methods or our ability to enforce and recover certain debts. These requirements or restrictions could adversely affect our ability to enforce the receivables.

The laws described above, among others, as well as any new laws, rules or regulations, may adversely affect our ability to recover amounts owing with respect to the receivables.

Legal Department
Our legal department manages corporate legal matters, including litigation management, contract preparation and review, regulatory and statutory compliance, obtaining and maintaining state licenses and bonds, and dispute and complaint resolution. As of December 31, 2003, this department consisted of three full-time attorneys and one full-time paralegal.

The legal department helps to develop guidelines and procedures for recovery personnel to follow when communicating with a customer or third party during our recovery efforts. The legal department assists our training department in providing employees with extensive training on the FDCPA and other relevant laws. In addition, the legal department researches and provides collection and recovery personnel with summaries of state statutes so that they are aware of applicable time frames and laws when attempting to recover an account. It meets with other departments to provide legal updates and to address any practical issues uncovered in its review of files referred to the department.




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Employees
As of December 31, 2003, we had 716 employees, of which 581 were involved in the collection workforce and 135 were involved in other functions. The additional 135 employees were in the following departments:

None of our employees is represented by a labor union. We believe that our relations with our employees are good.



Index

Item 2 – Properties

We service our customers from two facilities. Our larger facility is located in Phoenix, Arizona. Designed to accommodate up to 600 employees, at December 31, 2003, the facility housed 431 employees. We lease the Phoenix facility, which is approximately 62,000 square feet, for a current monthly amount of $28,000; this lease expires in 2008. We also lease a facility in San Diego, California, which contains not only additional collection operations, but also serves as our corporate headquarters. This facility is approximately 33,000 square feet and is designed to accommodate up to 325 employees. It housed 285 employees at December 31, 2003. The San Diego facility lease payment totals $45,505 per month and the lease expires in October 2004. The Company is currently in negotiations with respect to replacement facilities following the expiration of the San Diego facility lease.

Index



Item 3 — Legal Proceedings

The FDCPA and comparable state statutes may result in class action lawsuits, which can be material to our business due to the remedies available under these statutes, including punitive damages.

On May 28, 2002, a complaint was filed by plaintiff Lana Waldon in the United States District Court for the Northern District of Texas against our wholly owned subsidiary Midland Credit and two unaffiliated financial institutions. The plaintiff’s second amended complaint purported to assert claims for alleged violations of (i) the Texas Debt Collection Act and the Texas Deceptive Trade Practices Act on behalf of a putative class of Texas residents allegedly similarly situated, and (ii) the Fair Debt Collection Practices Act on behalf of a nationwide putative class of persons allegedly similarly situated. Generally, the second amended complaint alleged that mailings related to a credit card balance transfer program are deceptive and misleading. The second amended complaint sought actual, statutory and treble damages in an amount to be determined, together with pre-judgment and post-judgment interest, attorneys’ fees, and preliminary and permanent injunctions enjoining defendants from making offers or distributing materials substantially similar to the mailings that are the subject of the second amended complaint, plus certain other relief. Our co-defendants, including a large financial institution, accepted our defense in this case. This case was settled at no cost to us and dismissed on December 16, 2003 with a full release by the plaintiff of all claims and liability against Midland Credit and related entities.




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There are a number of additional lawsuits or claims pending or threatened against us. In general, these lawsuits or claims have arisen in the ordinary course of business and involve claims for actual damages arising from alleged misconduct of our employees or alleged improper reporting of credit information by the us. Although litigation is inherently uncertain, based on past experience; the information currently available; and the possible availability of insurance and/or indemnification from originating institutions in some cases, we do not believe that the currently pending and threatened litigation or claims will have a material adverse effect on our consolidated financial statements. However, future events or circumstances, currently unknown to us, may determine whether the resolution of pending or threatened litigation or claims will ultimately have a material effect on our consolidated financial statements in any future reporting periods.

We do not believe that contingencies for ordinary routine claims, litigation and administrative proceedings and investigations incidental to our business will have a material adverse effect on our consolidated financial statements.




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Index

        Item 4 — Submission of Matters to a Vote of Security Holders

On November 18, 2003, the Company held its Annual Meeting of Stockholders. At the Annual Meeting, Raymond Fleming, Carl C. Gregory, III, Neville J. Katz, Eric D. Kogan, Alexander Lemond, Richard A. Mandell, Peter W. May, Nelson Peltz and Robert M. Whyte were elected to serve as Directors.

The votes for the election of Directors is set forth below:

Name of Nominee Votes For Votes Against Votes Withheld Abstentions
Raymond Fleming 14,291,238  107,770 
Carl C. Gregory, III 14,291,238  107,770 
Neville J. Katz 14,291,238  107,770 
Eric D. Kogan 14,288,338  107,770  2,900 
Alexander Lemond 14,291,238  107,770 
Richard A. Mandell 14,291,238  107,770 
Peter W. May 14,288,338  107,770  2,900 
Nelson Peltz 14,291,238  107,770 
Robert M. Whyte 14,291,238  107,770 

At the Annual Meeting, the stockholders also approved proposal 2, ratifying the selection of the Company’s independent auditors. The votes for proposal 2 were as follows:

Votes For Votes Against Votes Withheld Abstentions
Proposal 2 14,272,388  102,770  23,850 



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Index

PART II

Item 5 — Market for the Registrant’s Common Equity Securities and Related
Stockholder Matters

Our common stock is traded on the Nasdaq Stock Market’s National Market under the symbol “ECPG.” Prior to July 21, 2003, our stock traded on the OTC Electronic Bulletin Board under the symbol “ECPG.OB” (and before February 2002, it traded under the symbol “MCMC.OB”).

While on the OTC, trading in our stock was often sporadic with a relatively low volume of shares traded. Quotations of the OTC reflect inter-trader prices, without material mark-up, markdown or commission and may not necessarily represent actual transactions.

The high and low closing sales prices of the common stock, as reported by Nasdaq Stock Market’s National Market and the OTC Electronic Bulletin Board for each quarter during our two most recent fiscal years are reported below:

Market Price
High Low
Fiscal Year 2002
First Quarter $0.80  $0.26 
Second Quarter $1.01  $0.70 
Third Quarter $1.20  $0.45 
Fourth Quarter $1.60  $0.75 


Fiscal Year 2003
First Quarter $  1.60  $  1.05 
Second Quarter $  9.70  $  1.60 
Third Quarter $14.40  $  8.99 
Fourth Quarter $15.10  $11.85 


The closing price of Encore’s common stock on February 10, 2004 was $15.49 per share and there were 142 holders of record, including 100 NASD registered broker/dealers, which hold 9,382,172 shares on behalf of their clients.

Use of Proceeds of Recent Public Offering
In October 2003, Encore completed a public offering of 3,000,000 shares of its common stock, with certain stockholders selling an additional 2,750,000 shares of Encore’s common stock. The underwriters for the offering were Jefferies & Company, Inc., Brean Murray & Co., Inc. and Roth Capital Partners, LLC. The shares of common stock sold in the offering were registered under the Securities Act of 1933, as amended, on a Registration Statement on Form S-1, Registration Number 333-108423, which was declared effective by the Securities and Exchange Commission on September 26, 2003. All of the 3,000,000 shares sold by us were issued at a price of $11.00 per share. We received net proceeds from the offering of approximately $30.1 million, after deducting approximately $2.9 million in underwriters’ fees and other offering fees and expenses. We used $7.3 million of the proceeds from the offering to repay the then outstanding $7.3 million principal amount senior note to an institutional investor (the “Senior Notes”) (see Note 6 to the consolidated financial statements). We intend to use the balance of approximately $22.8 million of such net proceeds for working capital and general corporate purposes, which may include the acquisition of complementary companies.




19





Private Securities Issuances
On February 22, 2002, certain existing stockholders and their affiliates purchased one million shares of our Series A Convertible Preferred Stock at a price of $5.00 per share for an aggregate purchase price of $5.0 million. Pursuant to an agreement between the Company and the holders of the Series A Preferred Stock, all of the preferred shares were converted into 10,000,000 shares of our common stock simultaneously with the closing of the public offering of our common stock on October 1, 2003. The holders of the Series A Preferred Stock were paid accrued dividends to the conversion date in accordance with the terms of the Series A Preferred Stock, but did not pay or receive any other consideration in connection with the conversion.

Effective February 22, 2002, in connection with the forgiveness of $5.3 million of outstanding debt, the lender agreed to reduce its warrant position by 200,000 from 428,571 to 228,571, retaining the term and exercise price of $0.01 when originally issued in January 2000 in connection with the purchase of our 12% Series No. 1 Senior Notes (the “Senior Notes”) to an institutional investor (see “Senior Notes” in Management’s Discussion and Analysis of Financial Discussion and Results of Operations). Effective October 31, 2000, we issued an additional 5,241 warrants to the institutional investor pursuant to the anti-dilution provisions of the warrants. Concurrently with the closing of our public offering on October 1, 2003, all 233,812 warrants were exercised and we received $2,338 in payment of the aggregate exercise price.

In January 2000 we issued 100,000 warrants to an affiliated party that agreed to guarantee the Senior Notes. Effective October 31, 2000, we issued an additional 1,275 warrants to the affiliated party pursuant to the anti-dilution provisions of the warrants. On September 30, 2003, all 101,275 warrants were exercised and we received $1,013 in payment of the aggregate exercise price.

In December 2000, we issued 621,576 warrants to acquire our common stock at an exercise price of $1.00 per share. The warrants were granted in conjunction with the establishment of a $75.0 million secured financial facility (the “Secured Financing Facility”) that expires on December 31, 2004. On December 8, 2003, all 621,576 warrants were exercised and we received $621,576 in payment of the aggregate exercise price.




20





From October 2000 through September 2001, we issued 250,000 warrants to acquire our common stock at an exercise price of $0.01 per share. The warrants were granted in conjunction with the establishment and extension of a $2.0 million stand-by line of credit. The stand-by line of credit expired December 31, 2001. In April 2002, all 250,000 warrants were exercised and we received $2,500 in payment of the aggregate exercise price.

No underwriters were involved in the foregoing issuances of our securities. Each of the issuances of these securities was exempt from registration under the Securities Act pursuant to Section 4(2) under the Securities Act as transactions by an issuer not involving a public offering. The recipients of the securities represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof and appropriate legends were affixed to the certificates representing such securities issued in such transactions. All recipients had access to detailed financial and operating information about us.

Dividend Policy
We have never declared or paid dividends on our common stock and we anticipate that we will retain earnings to support operations and to finance the growth and development of our business. Therefore, we do not intend to declare or pay dividends on the common stock for the foreseeable future. The declaration, payment and amount of future dividends, if any, will be subject to the discretion of our board of directors, which may review our dividend policy from time to time. We may also be subject to additional dividend restrictions under future financing facilities.

Our Series A Convertible Preferred Stock carried a cumulative dividend, payable semi-annually, of 10.0% per annum. Dividends due on August 15, 2002, February 15, 2003 and August 15, 2003 were paid in cash. On October 1, 2003, concurrent with the Company’s follow-on public offering, all the holders of the Series A Preferred Stock converted their shares into 10.0 million shares of common stock pursuant to an agreement executed between the holders of such shares and the Company. The holders of the Series A Preferred Stock were paid accrued and unpaid dividends totaling $63,889 to the conversion date in accordance with the terms of the Series A Preferred Stock, but did not pay or receive any other consideration with the conversion.





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Index

Item 6 — Selected Consolidated Financial Data

This table presents selected historical financial data of Encore. This information should be carefully considered in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this report. The selected data in this section are not intended to replace the consolidated financial statements. The selected financial data (except for “Selected Operating Data” in the table below), as of December 31, 2001, 2000, and 1999 and for the years ended December 31, 2000 and 1999, were derived from our audited consolidated financial statements not included in this report. The Selected Operating Data are derived from the books and records of Encore.

The selected historical financial data, except for Selected Operating Data, as of December 31, 2003 and 2002 and for the years ended December 31, 2003, 2002 and 2001, were derived from our audited consolidated financial statements included elsewhere in this report. (In thousands, except per share, percentages, and personnel data):

As Of And For The Years Ended December 31,
2003 2002 2001 2000 1999
Revenues                             
Revenue from receivables portfolios 1   $ 115,575   $ 80,961   $ 32,581   $ 15,434   $ 12,917  
Revenue from retained interest    307    5,707    9,806    11,679    7,836  
Servicing fees and related revenue    1,620    3,712    5,458    9,447    7,405  





Total revenues    117,502    90,380    47,845    36,560    28,158  





Operating expenses                           
Salaries and employee benefits    39,286    35,137    27,428    23,423    18,821  
Other operating expenses    11,335    7,934    5,708    6,211    3,479  
Cost of legal collections    15,827    11,028    5,457    129      
General and administrative expenses    6,509    6,314    5,750    5,458    3,019  
Restructuring charges                1,388      
Provision for portfolio losses        1,049        20,886 2    
Depreciation and amortization    2,023    2,453    2,481    2,154    964  





Total operating expenses    74,980    63,915    46,824    59,649    26,283  





Income (loss) before interest,                           
     other income, and income taxes    42,522    26,465    1,021    (23,089 )  1,875  
Interest expense    (20,479 )  (18,592 )  (10,945 )  (7,829 )  (2,166 )
Other income (expense), net    7,380 3  213    208    (69 )  206  





Income (loss) before income taxes    29,423    8,086    (9,716 )  (30,987 )  (85 )
(Provision for) benefit from income taxes    (11,003 )  5,703 4  (1,149 )  7,257    34  





Net income (loss)    18,420    13,789    (10,865 )  (23,730) 2  (51 )
Preferred stock dividends    (374 )  (440 )            





Net income (loss) available   $ 18,046   $ 13,349   $ (10,865 ) $ (23,730) 2 $ (51 )
     to common shareholders                           










22





As Of And For The Years Ended December 31,
2003 2002 2001 2000 1999
Earnings (loss) per common share:                           
Basic   $ 1.65   $ 1.82   $ (1.52 ) $ (3.20 ) $ (0.01 )
Diluted   $ 0.88   $ 0.84   $ (1.52 ) $ (3.20 ) $ (0.01 )
Weighted-average shares outstanding:                           
Basic    10,965    7,339    7,161    7,421    5,989  
Diluted    20,873    16,459    7,161    7,421    5,989  
Cash flow data:  
Cash flows provided by (used in):                           
Operating   $ 33,971   $ 24,690   $ 8,853   $ (15,831 ) $ (3,405 )
Investing   (19,472 )  (11,158 )  (21,773 )  12,399    (59,491 )
Financing   23,361    (14,192 )  13,444    3,968    58,590  
Selected operating data:                           
Purchases of receivables portfolios, at cost   $ 89,834   $ 62,525   $ 39,030   $ 6,911 5 $ 51,969  
Growth in purchases, at cost 6    43.7 %  60.2 %  464.8 %  (86.7 )%  109.9 %
Gross collections for the period   $ 190,519   $ 148,808   $ 83,051   $ 66,117   $ 34,877  
Gross collections growth for the period 6    28.0 %  79.2 %  25.6 %  89.6 %  118.8 %
Total active collectors at period end    507    435    419    336    NAV 7
Total active employees at period end    716    611    583    523    585  
Average active employees for the period    679    573    538    554    NAV 7
Gross collections per average active                           
     employee for the period   $ 281   $ 260   $ 154   $ 119    NAV 7
Total operating expenses per average                           
     active employee for the period   $ 110   $ 112   $ 87   $ 108 2  NAV 7
Total operating expenses to gross                           
  collections    39.4 %  43.0 %  56.4 %  90.2% 2  75.4 %
Consolidated statements                            
     of financial condition data:                           
Cash   $ 38,612   $ 752   $ 1,412   $ 888   $ 352  
Restricted cash    842    3,105    3,053    2,468    2,939  
Investment in receivables portfolios    89,136    64,168    47,001    25,969    57,473  
Investment in retained interest    1,231    8,256    17,926    31,616    30,555  
Total assets    138,285    89,974    77,711    71,101    101,540  
Accrued profit sharing arrangement    12,749    11,180    2,378          
Notes payable and other borrowings, net    41,178    47,689    69,215    53,270    47,418  
Capital lease obligations    460    344    1,236    2,233    1,262  
Total debt    41,638    48,033    70,451    55,503    48,680  
Total liabilities    66,914    70,432    80,069    61,022    68,512  
Total stockholders’ equity (deficit)    71,371    19,542    (2,358 )  10,079    33,028  



  1 Includes gains from whole portfolio sales totaling $0.3 million, $0.7 million, and $0.1 million for the years ended December 31, 2003, 2002, and 1999, respectively.
  2 Includes impairment charges of $20.9 million against the carrying value of thirty-two receivable portfolios acquired in 1999 and 2000, which increased the operating expenses per average active employee for 2000 by $38,000 and approximates 31.6% of gross collections for 2000.
  3 Reflects a non-recurring net pre-tax gain totaling $7.2 million, recognized in the first quarter of 2003 upon settlement of a lawsuit against the seller of certain accounts. This resulted in an after tax net gain of $4.4 million or $0.21 per share on a fully diluted basis.
  4 Reflects a benefit totaling $9.9 million or $0.60 per share on a fully diluted basis, recognized in 2002 resulting from our reinstatement of our net deferred tax asset.
  5 Includes $2.0 million in receivables portfolios purchased as part of the West Capital acquisition.
  6 Percentage is calculated by taking the current period amount less the prior period amount and dividing the result by the prior period amount.
  7 NAV - This information is not available.



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Index

Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations

The information in this section should be read in conjunction with our consolidated financial statements and notes to the consolidated financial statements beginning on page 67 and the Risk Factors beginning on page 58.

Results of Operations

Highlights
Our business and financial results improved significantly during 2003. Highlights of our year are as follows:

We completed a follow-on public offering of our common stock in October of 2003. We sold 3.0 million shares (certain selling stockholders sold an additional 2.75 million shares) and our net proceeds were approximately $30.1 million, increasing our total equity to approximately $63.3 million at the time of the offering.

For the year ended December 31, 2003 as compared to the same period in 2002:

Our net income has grown, despite, among other things, a 22.8% growth in contingent interest expense to $16.0 million for the year ended December 31, 2003. Contingent interest expense relates to the sharing of residual collections with our Secured Financing Facility lender who has an exclusive relationship with us to finance credit card receivables purchases through December 2004. We have made moderate purchases of defaulted auto loans as part of our strategy to expand our activities into non-credit card markets.




24





Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

The following table summarizes our collections, revenues, operating expenses, income before taxes, net income, and cash flows from operations (in thousands):

Years Ended December 31,

2003 2002 $ Change % Change




Gross collections $ 190,519 $ 148,808 $ 41,711 28.0 %
Revenue $ 117,502 $ 90,380 27,122 30.0
     as a percentage of gross collections 61.7 % 60.7 %
Operating expenses $ 74,980 $ 63,915 11,065 17.3
     as a percentage of gross collections 39.4 % 43.0 %
Income before taxes $ 29,423 $ 8,086 21,337 263.9
     as a percentage of gross collections 15.4 % 5.4 %
Net income $ 18,420 $ 13,789 4,631 33.6
     as a percentage of gross collections 9.7 % 9.3 %
Cash flows from operations $ 33,971 $ 24,690 9,281 37.6
     as a percentage of gross collections 17.8 % 16.6 %

Collections
Gross collections for the year ended December 31, 2003 were $190.5 million compared to gross collections of $148.8 million for the year ended December 31, 2002, an increase of $41.7 million or 28%. The components of gross collections for the twelve months ended December 31, 2003 and 2002 are as follows:

December 31,
2003
December 31
2002


Investment in receivable portfolios     $ 178,950   $ 124,388  
Investment in retained interest    6,819    13,929  
Gross collections for third parties    4,750    10,491  


Total gross collections   $ 190,519   $ 148,808  



The $41.7 million increase in gross collections reflects the continued leveraging of our workforce’s intellectual capital. Gross collections grew by 28.0% while the size of our average workforce grew by 18.5% during the year ended December 31, 2003 compared to the prior year. Our high collector retention rates coupled with our innovative alternative collection strategies have resulted in an increase of 8.0% in monthly average collections to $23,385 from $21,656 per average employee during years ended December 31, 2003 and 2002, respectively. Our average monthly gross collections were $15.9 million and $12.4 million during the years ended December 31, 2003 and 2002, respectively, while our total employees averaged 679 for the year ended December 31, 2003 and 573 for the year ended December 31, 2002.




25





The $41.7 million increase in gross collections is derived primarily from new portfolios purchased since December of 2000 utilizing our Secured Financing Facility. Gross collections related to portfolios utilizing our Secured Financing Facility were $156.3 million for the year ended December 31, 2003, compared to gross collections of $101.1 million for the year ended December 31, 2002, an increase of $55.2 million or 54.6%.

Proceeds from a litigation settlement were not included in gross collections for the year ended December 31, 2003 (see Note 4 to the consolidated financial statements).

Revenues
Total revenues for the year ended December 31, 2003 were $117.5 million compared to total revenues of $90.4 million for the year ended December 31, 2002, an increase of $27.1 million, or 30.0%. The increase in total revenues is primarily the result of a $41.7 million or a 28.0% increase in gross collections from $148.8 million for the year ended December 31, 2002 compared to gross collections of $190.5 million for the year ended December 31, 2003. The increase is primarily from revenue from receivable portfolios, which increased $34.6 million or 42.8%, to $115.6 million from $81.0 million for the years ended December 31, 2003 and 2002, respectively. Revenue from the retained interest in securitized receivables declined by $5.4 million, from $5.7 million for the year ended December 31, 2002 to $0.3 million for the year ended December 31, 2003. This reflects declines in cash collections since the first quarter of 2003 in the underlying portfolios and the concurrent lowering of our expected yield on the retained interest from approximately 44.4% to 7.5% per annum. The portfolios within the retained interest were purchased as long ago as 1990, and therefore age, coupled with the recent decline in collection performance led to our conclusion that a lowering of the expected yield would be appropriate. The increase in revenue from receivable portfolios was further offset by a decrease in servicing fees of $2.1 million, a 56.4% decrease, from $3.7 million for the year ended December 31, 2002 to $1.6 million for the year ended December 31, 2003.

The $34.6 million increase in revenue from receivable portfolios for the year ended December 31, 2003 compared to the prior year is primarily attributable to new portfolios purchased during intervening quarters. During the year ended December 31, 2003, we purchased additional portfolios with a face value of $3.3 billion at a cost of $89.8 million, or 2.7% of face value. The portfolios purchased during 2003 provided $27.2 million of revenue during the year ended December 31, 2003.

We service a pool of charged-off consumer accounts on behalf of an unrelated third party. Servicing fees received under this arrangement were $1.6 million and $3.7 million for the twelve months ended December 31, 2003 and 2002, respectively. In February of 2003, we elected to return all exhausted receivables to the owner. We have, however, retained the servicing rights for those receivables remaining in active work queues and those placed with our attorney network. As a result of this action, we anticipate that the stream of service fee income related to these receivables will continue to decrease.




26





Significant estimates have been made by management with respect to the timing and amount of collections of future cash flows from receivable portfolios owned and those underlying the Company’s retained interest. It is our policy, once every quarter, to evaluate each portfolio’s actual collections against the forecast. Through September 30, 2003, we had not increased the total estimated cash flow for any portfolio; however, we have reduced the total estimated remaining cash flow in certain circumstances. For those portfolios whose actual cumulative collections exceeded the forecast, such excess amounts were subtracted from the future estimated collections in order to maintain the original forecast. Conversely, we have reduced the remaining collection forecasts on those portfolios that have not met our expectations for the six most recent months.

On purchases made since mid-2000, our gross collections, in the aggregate, have exceeded expectations. We have sought to develop the statistical support to help us determine whether the better than expected performance resulted from: (i) our collecting at a more rapid rate than originally forecast; (ii) our increasing our penetration of the portfolio and thus increasing the likelihood of collecting more than the original forecast; or (iii) some combination of both faster collections and additional penetration of the portfolio. Our Unified Collection Score (“UCS”) model, recently developed to project these remaining cash flows, considers known data about the our customers’ accounts, including, among other things, our collection experience, and changes in external customer factors, in addition to all data known when we acquired the accounts.

The UCS model was implemented effective October 1, 2003. We revised the projected collections for portfolios with carrying values totaling $72.2 million as of October 1, 2003, which represented 91.9% of the aggregate carrying value of our portfolios at that date. The change in our estimate of projected collections resulting from the application of the UCS model resulted in an increase in the aggregate total remaining gross collections for these portfolios by 36.9% as of December 31, 2003. The implementation of these revised forecasts resulted in an increase in the recognition of accretion revenue of $1.3 million and an increase in the accrual for contingent interest of $1.0 million for the fourth quarter of 2003. The net impact of the change in estimate was to increase fourth quarter pretax income by $0.3 million, net income by $0.2 million, and fully diluted earnings per share by $0.01. The reforecast of collections resulted in expanding the budgeted life of these portfolios by an average of 13 months from an average remaining life of 31 months to a revised average remaining life of 44 months. The resulting ratio of revenues to collections for accruing portfolios for the year ended December 31, 2003 increased 84 basis points to 60.9% as a result of this adjustment. It further had the impact of increasing the aggregate annual effective interest rate on all accruing portfolios by 6.4 basis points to 119.7% for the quarter ended December 31, 2003.




27





Total revenue recognized related to portfolios worked is comprised of two components – those portfolios that have a book basis and which are on accrual basis, and those that have collected more than forecasted and have fully recovered their book value (“Zero basis portfolios”). The following table summarizes the revenue recognized from each of these sources for the following periods (in thousands):

For the Years Ended December 31,

Revenue component 2003 2002 $ Change % Change





Accrual basis portfolios     $ 95,851   $ 76,043   $ 19,808     26.0 %  
   Weighted average effective interest rate    140.5 %  160.9 %        
Zero Basis Portfolios   $ 19,724   $ 4,918   14,806   301.1  
Total owned portfolio revenue   $ 115,575   $ 80,961   34,614   42.8  
   Total owned portfolio revenue as a                    
     percentage of our average aggregate                    
     investment in receivable portfolios    169.4 %  171.3 %        


For accrual basis portfolios, the weighted average annualized effective interest rate is the accrual rate utilized in recognizing revenue on our accrual basis portfolios. This rate represents the monthly internal rate of return, which has been annualized utilizing the simple interest method. The monthly internal rate of return is determined based on the timing and amounts of actual cash received and the anticipated future cash flow projections for each pool.

Collections on certain of our portfolios have recovered their entire budgeted forecast and therefore have a zero basis. The total owned portfolio revenue as a percentage of our average aggregate investment in receivable portfolios of 169.4% for the year ended December 31, 2003 is slightly lower than the 171.3% for the year ended December 31, 2002.

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The following tables summarize the changes in the balance of the investment in receivable portfolios and the proportion of revenue recognized as a percentage of collections during the following periods (in thousands):

For the Year Ended December 31, 2003




Accrual
Basis
Portfolios
Cost
Recovery
Portfolios
Zero Basis
Portfolios
Total




Balance, beginning of period     $ 63,253   $ 915   $   $ 64,168  
  Purchases of receivable portfolios    88,809    1,025        89,834  
  Transfers of portfolios    (1,860 )  1,860          
  Gross collections    (157,335 )  (1,911 )  (19,704 )  (178,950 )
  Portion of Litigation                      
       Settlement proceeds                      
       applied to carrying value    (692 )          (692 )
  Adjustments    (777 )  (2 )  (20 )  (799 )
  Revenue recognized    95,851        19,724    115,575  




Balance, end of period   $ 87,249   $ 1,887   $   $ 89,136  




Revenue as a percentage of collections    60.9 %  0.0 %  100.0 %  64.6 %






For the Year Ended December 31, 2002




Accrual
Basis
Portfolios
Cost
Recovery
Portfolios
Zero Basis
Portfolios
Total




Balance, beginning of period     $ 45,671   $ 1,330   $   $ 47,001  
  Purchases of receivable portfolios    62,525            62,525  
  Transfers of portfolios    (1,490 )  1,490          
  Gross collections    (118,614 )  (856 )  (4,918 )  (124,388 )
  Adjustments    (882 )          (882 )
  Provision for portfolio losses        (1,049 )      (1,049 )
  Revenue recognized    76,043        4,918    80,961  




Balance, end of period   $ 63,253   $ 915   $   $ 64,168  




Revenue as a percentage of collections    64.1 %  0.0 %  100.0 %  65.1 %






The following table summarizes the changes in the balance of the retained interest and the proportion of revenue recognized as a percentage of collections during the following periods (in thousands):

For the Years Ended
December 31,


2003 2002


Balance, beginning of period     $ 8,256   $ 17,926  
   Gross collections    (6,819 )  (13,929 )
  Amortization of unrealized gain    (513 )  (1,448 )
  Revenue recognized    307    5,707  


Balance, end of period   $ 1,231   $ 8,256  


Revenue as a percentage of collections    4.5 %  41.0 %






29





The annualized effective interest rate for the retained interest was 7.5% for the year ended December 31, 2003 compared to 44.4% for the years ended December 31, 2002. During the first quarter of 2003, we lowered our expected yield on the retained interest based on our estimated net cash flows derived from both historical and projected collections.

Operating expenses
Total operating expenses were $75.0 million for the year ended December 31, 2003, compared to $63.9 million for the year ended December 31, 2002, an increase of $11.1 million or 17.3%. This increase is primarily volume-related, driven by a 28.0% increase in gross collections.

The largest component of total operating expenses is salaries (including bonuses) and employee benefits which increased by $4.2 million or 11.8% to $39.3 million for the year ended December 31, 2003 from $35.1 million for the year ended December 31, 2002. The 11.8% increase in salaries and benefits is the result of an increase in the average number of our employees. The average number of employees of 679 for the year ended December 31, 2003 grew by 106 or 18.5% from the 573 employees for the year ended December 31, 2002. Total salaries and benefits as a percentage of gross collections for the years ended December 31, 2003 and 2002 were 20.6% and 23.6%, respectively. Also included in salaries in the second quarter of 2002 is a $0.5 million settlement paid to a former executive officer.

We believe our success is directly related to our ability to attract and retain skilled employees. The retention rates of those experienced collectors employed at the beginning of the year and who remained employed through the end of the period were 79.0% and 81.0% for the years ended December 31, 2003 and 2002, respectively. The retention rates of inexperienced collectors (defined as those collectors in our training program at the beginning of the year, plus all new hires during the year and who remained employed through the end of the year) were 60.0% and 63.8% for the years ended December 31, 2003 and 2002, respectively.

Other operating expenses increased approximately $3.4 million, or 42.9%, to $11.3 million for the year ended December 31, 2003 from $7.9 million for the year ended December 31, 2002. The increase primarily reflects a $2.5 million increase to $4.7 million in direct mail campaign costs during the year ended December 31, 2003.

Gross collections through the legal channel amounted to $40.0 million for the year ended December 31, 2003, representing growth of 44.7% above the $27.6 million collected through this channel during the prior year. The cost of legal collections reflects those costs associated with the business channel dedicated to collecting on accounts that have been determined to be collectible, but which require tactics other than telephone or mail solicitation. The corresponding costs of legal collections amounted to $15.8 million or 39.5% of gross collections through this channel for the year ended December 31, 2003 as compared to the $11.0 million or 39.9% for the year ended December 31, 2002. The increase in the legal costs reflects an increased provision for uncollectible court costs of $2.2 million for the year ended December 31, 2003 as compared to $1.6 million for the prior year. The higher provision is based on our analysis of court costs that we have advanced, recovered, and anticipate recovering. The reserve of $3.6 million on court costs advanced of $4.9 million represents those costs that we believe will be ultimately uncollectible as of December 31, 2003.




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General and administrative expenses were $6.5 and $6.3 million for the years ended December 31, 2003 and 2002, respectively. We have maintained consistent general and administrative expenses despite the increase in gross collections discussed above.

Depreciation expense of $2.0 million and $2.5 million for the years ended December 31, 2003 and 2002, respectively, also decreased modestly due to limited expenditures for capital items.

Interest expense
The following table summarizes our interest expense (in thousands):

For the Years Ended December 31,




2003 2002 $ Change % Change




Stated interest on debt obligations     $ 2,940   $ 3,859   $ (919 )  (23.8 )%
Amortization of loan fees and    1,516    1,685    (169 )  (10.0 )
     other loan costs  
Contingent interest    16,023    13,048    2,975    22.8  



Total interest expense   $ 20,479   $ 18,592   $ 1,887    10.1  





For the year ended December 31, 2003, total interest expense including fees and amortization of other loan costs was $20.5 million on average borrowings for the period of $41.7 million, reflecting an effective interest rate of 49.1% for the period. The interest only portion (interest on debt obligations) of this total amounted to $2.9 million. For the year ended December 31, 2002, total interest expense including fees and amortization of other loan costs was $18.6 million on average borrowings of $55.8 million, reflecting an effective interest rate of 33.3% for the period. The interest only portion (interest on debt obligations) of this total amounted to $3.9 million. The remaining portions of interest expense consists primarily of contingent interest expense related to the sharing of residual collections with our Secured Financing Facility lender as well as amortization of loan fees and other loan costs.

We expensed $16.0 million and $13.0 million related to the sharing of residual collections with our Secured Financing Facility lender for the years ended December 31, 2003 and 2002, respectively, which was a $3.0 million or 22.8% increase in contingent interest expense. The $1.9 million increase in total interest expense consisted of the $3.0 million increase in total contingent interest expense offset primarily by a reduction in interest expense reflecting the repayment in full of two securitized receivable acquisition facilities and the revolving line of credit. These three facilities had a combined debt balance that totaled $16.2 million as of December 31, 2002, and were repaid in full during the second quarter of 2003 (see Notes 6 and 8 to consolidated financial statements). The Senior Notes totaling $7.3 million were repaid in full on October 1, 2003.




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Other income and expense
For the year ended December 31, 2003, total other income was $7.4 million, compared to $0.2 million for the year ended December 31, 2002. We recorded a pretax net gain of $7.2 million in other income during the first quarter of 2003 related to a litigation settlement (see Note 4 to the consolidated financial statements).

Income taxes
For the year ended December 31, 2003, we recorded an income tax provision of $11.0 million, which is an effective rate of 37.4% of pretax income. For the year ended December 31, 2002, we recorded an income tax benefit of $5.7 million, reflecting an effective benefit of 70.5% of pretax income. During the fourth quarter of 2002, we determined that the utilization of net operating losses and other deferred tax assets was more likely than not, and therefore removed all but $0.2 million of the valuation allowance. The change in the valuation allowance resulted in the recognition of a current tax benefit in the amount of $9.9 million in the fourth quarter of 2002. This current tax benefit combined with a deferred tax expense, resulted in a net deferred tax benefit of $6.2 million for the fourth quarter of 2002 (see Note 9 to the consolidated financial statements).

Net Income
For the year ended December 31, 2003, we recognized net income of $18.4 million compared to net income of $13.8 million for the year ended December 31, 2002.





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Supplemental Financial Information

The following table is a reconciliation of generally accepted accounting principles in the United States of America (“GAAP”) income before taxes, net income and fully diluted earnings per share to income before taxes, net income and fully diluted earnings per share, excluding one-time benefits and other charges for the years presented. We believe that these non-GAAP financial measures provide useful information to investors about our results of operations because the elimination of one-time benefits and charges that are included in the GAAP financial measures results in a normalized comparison of certain key financial results between the periods presented. (in thousands, except per share amounts):

Years Ended December 31,


2003 2002


Income Before Taxes            
GAAP, as reported   $ 29,423   $ 8,086  
Gain on settlement of litigation 1    (7,210 )    
Write off of deferred costs 2    870      


Income before taxes, excluding one-time benefit and charges   $ 23,083   $ 8,086  


Percentage increase over prior period    185.5 %     

Net Income   
GAAP, as reported   $ 18,420   $ 13,789  
Gain on settlement of litigation 3    (4,376 )    
Write off of deferred costs 4    528      
Benefit from restoration of net deferred tax assets 5        (9,887 )


Net income, excluding one-time benefits and charges   $ 14,572   $ 3,902  


Percentage increase over prior period    273.4 %     

Fully Diluted Earnings Per Share   
GAAP, as reported   $ 0.88   $ 0.84  
Gain on settlement of litigation 3    (0.21 )    
Write off of deferred costs 4    0.03      
Benefit from restoration of net deferred tax assets5         (0.60 )


Fully diluted earnings per share,  
     excluding one-time benefits and charges   $ 0.70   $ 0.24  


Percentage increase over prior period    190.7 %     



  1 This is the result of a net pretax gain of $7.2 million associated with a litigation settlement during the first quarter of 2003 (see Note 4 to the consolidated financial statements).
  2 This is the result of the pretax write-off of $0.9 million in deferred loans costs and a debt discount associated with the early retirement of our Senior Notes during the fourth quarter of 2003 (see Note 8 to the consolidated financial statements).
  3 This is the result of a net after-tax gain of $4.4 million, or $0.21 per fully diluted share associated with a litigation settlement during the first quarter of 2003 (see Note 4 to the consolidated financial statements).
  4 This is the result of the after-tax write-off of $0.5 million, or $0.03 per fully diluted share in deferred loans costs and a debt discount associated with the early retirement of our Senior Notes during the fourth quarter of 2003 (see Note 8 to the consolidated financial statements).
  5 This is the result of a change in the valuation allowance associated with our net tax assets as of December 31, 2002, which resulted in the recognition of a current tax benefit in the amount of $9.9 million, or $0.60 per fully diluted share during the year ended December 31, 2002 (see Note 9 to the consolidated financial statements).




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Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

The following table summarizes our collections, revenues, operating expenses, income before taxes, net income, and cash flows from operations (in thousands):

For the Years Ended December 31,




2002 2001 $ Change % Change




Gross collections     $ 148,808   $ 83,051   $ 65,757    79.2 %
Revenues   $ 90,380   $ 47,845    42,535    88.9  
  as a percentage of gross collections    60.7 %    57.6 %            
Operating expenses   $ 63,915   $ 46,824    17,091    36.5  
  as a percentage of gross collections    43.0 %    56.4 %            
Income (loss) before taxes   $ 8,086   $ (9,716 )    17,802    183.2  
  as a percentage of gross collections    5.4 %    (11.7 )%            
Net income (loss)   $ 13,789   $ (10,865 )    24,654    226.9  
  as a percentage of gross collections    9.3 %    (13.1 )%            
Cash flows from operations   $ 24,690   $ 8,853    15,837    178.9  
  as a percentage of gross collections    16.6 %    10.7 %            


Collections
Gross collections for the twelve months ended December 31, 2002 were $148.8 million compared to gross collections of $83.0 million for the twelve months ended December 31, 2001, an increase of $65.8 million or 79.2%. The components of gross collections are as follows:

For The Years Ended December 31,


2002 2001


Investment in receivable portfolios     $ 124,388   $ 49,429  
Investment in retained interest    13,929    20,675  
Collections for third parties    10,491    12,947  


Total gross collections   $ 148,808   $ 83,051  




The $65.8 million increase in gross collections reflects the continued leveraging of our workforce’s intellectual capital. Gross collections grew 79.2% while the size of our average workforce grew 6.5% during the year ended December 31, 2002 compared to the prior year. Our high collector retention rates coupled with our innovative alternative collection strategies have resulted in an increase of 68.2% in monthly average collections of $21,656 and $12,875 per average employee during the years ended December 31, 2002 and 2001, respectively. Our average monthly gross collections were $12.4 million and $6.9 million during the years ended December 31, 2002 and 2001, respectively, while our total employees averaged 573 for the year ended December 31, 2002 and 538 for the years ended December 31, 2001.




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The increased collections are primarily derived from new portfolios purchased since December 2000 utilizing our Secured Financing Facility. Gross collections related to portfolios utilizing our Secured Financing Facility were $101.1 million for the year ended December 31, 2002, compared to gross collections of $21.3 million for the year ended December 31, 2001, an increase of $79.7 million or 375.0%.

Revenues
Total revenues for the twelve months ended December 31, 2002 were $90.4 million compared to total revenues of $47.8 million for the year ended December 31, 2001, an increase of $42.5 million or 88.9%. The increase is primarily due to revenue from receivables portfolios, which increased $48.4 million or 148.5%, to $81.0 million from $32.6 million for the twelve months ended December 31, 2002 and 2001, respectively. This increase is primarily the result of a 79.2% increase in total collections of $65.8 million from $83.0 million in 2001 to $148.8 million in 2002. Revenue from the retained interest in securitized receivables declined by $4.1 million, from $9.8 million for the year ended December 31, 2001. This reflects declines in cash collections in the underlying portfolios. The increase was further offset by a decrease in servicing fees and other related income of $1.8 million, a 32.0% decrease from $5.5 million for the year ended December 31, 2001 to $3.7 million for the year ended December 31, 2002.

The $48.4 million increase in revenue from receivables portfolios for the year ended December 31, 2002 compared to the year ended December 31, 2001 is primarily attributable to new portfolios purchased during the year ended December 31, 2002. During the year ended December 31, 2002, we acquired new portfolios with a face value of $2.8 billion at a cost of $62.5 million, which represented 2.23% of face value. The majority of these portfolios were purchased utilizing our $75.0 million Secured Financing Facility. These portfolios provided $28.0 million of revenue during 2002. In 2001, we purchased portfolios with a face value of $1.6 billion at a total cost of $39.0 million, which represented 2.51% of face value. These portfolios provided $38.1 million of revenue during 2002, which was an increase from $15.2 million of revenue during 2001. We acquired substantially all the assets of another financial services company, West Capital Financial Services Corp. (“West Capital”), in May 2000. The portfolios acquired in the West Capital transaction with a face value of $2.4 billion and a cost of $2.0 million generated $1.4 million in revenue during 2002 compared with $4.1 million in 2001, a decrease of $2.7 million. As we expected, revenues on all other portfolios decreased by $1.4 million during 2002 as compared to 2001. Furthermore, certain portfolios that were previously recorded on a cost recovery basis were returned to the accretion method and accounted for $0.9 million of the increase in revenue for the twelve months ended December 31, 2002. We also initiated whole portfolio sales during 2002. The net gain from this initiative totaled $0.7 million, which is reflected in Revenue from receivables portfolios.

We serviced a pool of charged-off consumer accounts on behalf of an unrelated third party. Servicing fees received under this arrangement were $3.7 million and $5.5 million for the years ended December 31, 2002 and 2001, respectively. In February 2003, we returned all exhausted receivables to the owner. We have, however, retained the servicing rights for those certain receivables in active work queues and those placed with our attorney network. As a result of this action, we anticipate that the stream of service fee income related to those receivables will continue to decrease.




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The following tables summarize the changes in the balance of the investment in receivables portfolios and the proportion of revenue recognized as a percentage of collections during the following periods (in thousands):

For the Year Ended December 31, 2002




Accrual
Basis
Portfolios
Cost
Recovery
Portfolios
Zero Basis
Portfolios
Total




Balance, beginning of period     $ 45,671   $ 1,330   $   $ 47,001  
  Purchases of receivables    62,525            62,525  
     portfolios                      
  Transfers of portfolios    (1,490 )  1,490          
  Gross collections    (118,614 )  (856 )  (4,918 )  (124,388 )
  Provision for portfolio losses        (1,049 )      (1,049 )
  Adjustments    (882 )          (882 )
  Revenue recognized    76,043        4,918    80,961  




Balance, end of period   $ 63,253   $ 915   $   $ 64,168  




Revenue as a percentage of    64.1 %  0.0 %  100.0 %  65.1 %
     collections                       






For the Year Ended December 31, 2001




Accrual
Basis
Portfolios
Cost
Recovery
Portfolios
Zero Basis
Portfolios
Total




Balance, beginning of period     $ 20,406   $ 5,563   $   $ 25,969  
  Purchases of receivables    39,030            39,030  
     portfolios                      
   Transfers of portfolios    1,271    (1,271 )        
   Gross collections    (41,193 )  (2,962 )  (5,274 )  (49,429 )
  Adjustments    (1,150 )          (1,150 )
  Revenue recognized    27,307        5,274    32,581  




Balance, end of period   $ 45,671   $ 1,330   $   $ 47,001  




Revenue as a percentage of    66.3 %  0.0 %  100.0 %  65.9 %
     collections                      









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Total revenue recognized related to portfolios worked is comprised of two components – those portfolios that have a book basis and which are on accrual basis and those that have collected more than forecasted and have fully recovered their book value. The table below recaps the revenue recognized from each of these sources for the following periods (in thousands):

For the Years Ended December 31,




Revenue component 2002 2001 $ Change % Change




Accrual basis portfolios $ 76,043 $ 27,307 $ 48,736 178 .5%
     Weighted average effective interest rate 160.9 % 87.3 %
Zero Basis Portfolios $ 4,918 $ 5,274 (356 ) (6 .8)
Total owned portfolio revenue $ 80,961 $ 32,581 48,380 148 .5
     Total owned portfolio revenue as a
          percentage of our average aggregate
          investment in receivable portfolios 171.3 % 105.1 %


The annualized weighted average effective interest rate for receivables portfolios on the accretion method was 160.9% for the twelve months ended December 31, 2002, compared to 87.3% for the twelve months ended December 31, 2001. The increase in the effective interest rate is primarily due to the increasing proportion of our investment in receivables portfolios purchased since mid-2000 that have a higher effective rate than those portfolios purchased prior to mid-2000. The annualized effective interest rate is the accrual rate utilized in recognizing revenue on our accrual basis portfolios. This rate represents the monthly internal rate of return, which has been annualized utilizing the simple interest method. The monthly internal rate of return is determined based on the timing and amounts of actual cash received and the anticipated future cash flow projections for each pool.




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The following table summarizes the changes in the balance of the retained interest and the proportion of revenue recognized as a percentage of collections during the following periods (in thousands):

For the Years Ended December 31,


2002 2001


Balance, beginning of period     $ 17,926   $ 31,616  
  Gross collections    (13,929 )  (20,675 )
  Amortization of unrealized gain       (1,448 )   (2,871 )
  Adjustments        50  
  Revenue recognized       5,707     9,806  


Balance, end of period   $ 8,256   $ 17,926  


Revenue as a percentage of collections       41.0 %     47.4 %  




The annualized effective interest rate for the retained interest was 47.2% for the twelve months ended December 31, 2002, compared to 39.8% for the twelve months ended December 31, 2001.

Operating Expenses
Total operating expenses were $63.9 million for the year ended December 31, 2002 compared to $46.8 million for the year ended December 31, 2001, an increase of $17.1 million or 36.5%. This increase is primarily volume-related, driven by a 79.2% increase in gross collections. The gross collections for the year ended December 31, 2002 amounted to $148.8 million, up 79.2% or $65.8 million from the $83.0 million of gross collections for the year ended December 31, 2001.

The largest component of total operating expenses is salaries (including bonuses) and employee benefits which increased by $7.7 million or 28.1% to $35.1 million for the year ended December 31, 2002 from $27.4 million for the year ended December 31, 2001. The 28.1% increase in salaries and benefits is the result of an increase in the average number of our employees. The average number of employees of 573 for the year ended December 31, 2002 grew by 35 or 6.5% from the 538 employees for the year ended December 31, 2001. Total salaries and benefits as a percentage of collections for the years ended December 31, 2002 and 2001 were 23.6% and 33.0%, respectively. Also included in salaries in the second quarter of 2002 is a $0.5 million settlement paid to a former executive officer.

We believe our success is directly related to our ability to attract and retain skilled employees. The retention rate of experienced collectors employed at the beginning of the year and who remained employed through the end of the period were 81.0% and 70.0% for the years ended December 31, 2002 and 2001, respectively. The retention rates of inexperienced collectors (defined as those collectors in our training program at the beginning of the year, plus all new hires during the period who remained employed through the end of the year) were 63.8% and 51.0% for the years ended December 31, 2002 and 2001, respectively.

Other operating expenses increased approximately $2.2 million, or 38.6%, to $7.9 million for the year ended December 31, 2002 from $5.7 million for the twelve months ended December 31, 2001. The increase was primarily a result of a $1.3 million increase in direct mail campaign costs and a $0.4 million increase in skip tracing expense during the year ended December 31, 2002.

Gross collections through the legal channel amounted to $27.6 million for the year ended December 31, 2002, representing growth of 69.2% above the $16.3 million collected during the prior year. The cost of legal collections reflects those costs associated with the business channel dedicated to collecting on accounts that have been determined to be collectible, but which require tactics other than telephone solicitation. The corresponding costs of legal collections amounted to $11.0 million or 39.9% of gross collections through this channel for the year ended December 31, 2002 as compared to the $5.5 million or 33.4% for the year ended December 31, 2001. The increase in the legal costs reflects an increased provision for uncollectible court costs of $1.6 million for the year ended December 31, 2002 as compared to $0.5 million for the prior year. The higher provision is based on our analysis of court costs that we have advanced, recovered, and anticipate recovering. The reserve of $2.1 million on court costs advanced of $3.3 million represents those costs that we believe will be ultimately uncollectible as of December 31, 2002.




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General and administrative expenses increased to $6.3 million for the twelve months ended December 31, 2002, from $5.7 million for the twelve months ended December 31, 2001. The increase was primarily a result of an increase in insurance costs, which increased $0.6 million from $0.6 million for the year ended December 31, 2001, to $1.2 million for the year ended December 31, 2002. We have been able to leverage our collections, increasing gross collections 79.2% to $148.8 million from $83.0 million during the year ended December 31, 2002 compared to the year ended December 31, 2001, while maintaining a 10.5% increase in general and administrative expenses.

Depreciation expense remained consistent at $2.5 million for the twelve months ended December 31, 2002 and 2001.

We recorded a provision for portfolio losses of $1.0 million in the year ended December 31, 2002 related to the impairment of certain receivables portfolios.

Interest Expense
The following table summarizes our interest expense (in thousands):

For the Years Ended December 31,




2002 2001 $ Change % Change




Stated interest on debt obligations     $ 3,859   $ 5,784   $ (1,925 )  (33.3 )%
Amortization of loan fees and                    
     other loan costs    1,685    2,783    (1,098 )  (39.5 )
Contingent interest    13,048    2,378    10,670    448.7



Total interest expense   $ 18,592   $ 10,945   $ 7,647    69.9





For the year ended December 31, 2002, total interest expense including fees and amortization of other loan costs was $18.6 million on average borrowings for the period of $55.8 million, reflecting an effective interest rate of 33.3% for the period. The interest only portion of this total amounted to $3.9 million. The remaining portion of interest expense consists primarily of amortization of loan fees and other loan costs, and contingent interest expense related to the sharing of residual collections with our Secured Financing Facility lender. For the year ended December 31, 2001, total interest expense including fees and amortization of other loan costs was $10.9 million on average borrowings for the period of $64.2 million, reflecting an effective interest rate of 17.0% for the period. The interest only portion of this total amounted to $5.8 million. The remaining portion of interest expense consists primarily of amortization of loan fees and other loan costs, and contingent interest expense related to the sharing of residual collections with our Secured Financing Facility lender.

As discussed in Note 8 to the consolidated financial statements, we expensed $13.0 million and $2.4 million related to the sharing of residual collections with our Secured Financing Facility lender for the years ended December 31, 2002 and 2001, respectively, resulting in an increase in contingent interest expense of $10.6 million.




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Income Taxes For the year ended December 31, 2002, we recorded an income tax benefit of $5.7 million, which is an effective benefit of 70.5% of pretax income. The provision for 2002 reflects the recognition of an income tax benefit in 2002 resulting from the restoration of a million net deferred tax asset (see Note 9 to the consolidated financial statements). For the year ended December 31, 2001, we recorded an income tax provision of $1.1 million, reflecting an effective rate of 11.8%, which represents the deferred tax impact of the decrease in the unrealized gain on the retained interest. The provision for that period excluded taxes on pre-tax income as a result of a change in the valuation reserve on our deferred tax assets, which existed at that time. For the year ended December 31, 2002, we determined that the utilization of net operating losses and other deferred tax assets was more likely than not, and therefore removed all but $0.2 million of the valuation allowance. The change in the valuation allowance resulted in the recognition of a current tax benefit in the amount of $9.9 million in the fourth quarter of 2002. This current tax benefit combined with a deferred tax expense, resulted in a net deferred tax benefit of $6.2 million. The utilization of our California net operating losses had been suspended by the state of California until 2004.

Net Income (loss) Net income for the twelve months ended December 31, 2002 was $13.8 million compared to a net loss of $10.9 million for the twelve months ended December 31, 2001.






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Supplemental Financial Information
The following table is a reconciliation of GAAP net income and fully diluted earnings per share to net income and fully diluted earnings per share, excluding one-time benefits for the years presented. We believe that these non-GAAP financial measures provide useful information to investors about our results of operations because the elimination of one-time benefits that are included in the GAAP financial measures results in a normalized comparison between the periods presented. (in thousands, except per share amounts):

Years Ended December 31,


2002 2001


Net Income            
GAAP, as reported   $ 13,789   $ (10,865 )
Benefit from restoration of net deferred tax assets 1    (9,887 )    


Net income, excluding one-time benefits   $ 3,902   $ (10,865 )


Percentage increase over prior period    135.9 %     

Fully Diluted Earnings Per Share   
GAAP, as reported   $ 0.84   $ (1.52 )
Benefit from restoration of net deferred tax assets 1    (0.60 )    


Fully diluted earnings per share, excluding one-time benefits   $ 0.24   $ (1.52 )


Percentage increase over prior period    115.8 %     


  1 This is the result of a change in the valuation allowance associated with our net tax assets as of December 31, 2002, which resulted in the recognition of a current tax benefit in the amount of $9.9 million, or $0.60 per fully diluted share during the year ended December 31, 2002 (see Note 9 to the consolidated financial statements).






41





Liquidity and Capital Resources

The following table summarizes cash and cash equivalents, notes payable, and stockholders’ equity (deficit) for the years presented (in thousands):

2003 2002 2001



Cash and cash equivalents     $ 38,612   $ 752   $ 1,412  
Notes payable    41,178    47,689    69,215  
Stockholders’ equity (deficit)    71,371    19,542    (2,358 )


Liquidity
We normally meet our operating requirements by:

For the year ended December 31, 2003, we realized net income of $18.4 million, which included the after tax effect of $4.4 million resulting from a litigation settlement (see Note 4 to the consolidated financial statements). For the twelve months ended December 31, 2002, we realized net income of $13.8 million, which included the restoration of a $6.8 million net deferred tax asset (see Note 9 to the consolidated financial statements).

On October 1, 2003, the Company and certain selling stockholders completed a follow-on public offering of 5.0 million shares of common stock at $11.00 per share. The proceeds we received from the 3.0 million shares we offered, net of the underwriters’ commissions and offering expenses of $2.9 million, totaled approximately $30.1 million. In addition, we received approximately $0.5 million in payment of the exercise price of options and warrants relating to shares offered by certain stockholders. We did not receive any of the proceeds from the 2.0 million shares offered by selling stockholders.

On October 21, 2003, the underwriters of the public offering completed the exercise in full and closed the sale of their over-allotment option to purchase an additional 750,000 shares of our common stock from selling stockholders at $11.00 per share, less the applicable underwriting discount. We received approximately $29,000 from the exercise of options relating to certain shares included in the over-allotment option. We did not receive any proceeds from the sale of the 750,000 additional shares by selling stockholders.

As a result of our follow-on public offering and our net income for the year, our stockholders’ equity increased to $71.4 million as of December 31, 2003. Our stockholders’ equity was $19.5 million as of December 31, 2002, which included the forgiveness of certain debt and the issuance of preferred stock occurring during the first quarter of 2002. This was a $21.9 million increase from the stockholders’ deficit of $2.4 million at December 31, 2001.




42





We are in compliance with all covenants under our financing arrangements. We have achieved positive cash flows from operations of $34.0 million during the year ended December 31, 2003, which was a $9.3 million increase from the $24.7 million in cash flows from operations for the year ended December 31, 2002. We had positive cash flows from operations of $8.9 million during the year ended December 31, 2001, which was an increase from the $15.8 million in cash flows used in operations during the year ended December 31, 2000. We have achieved eight consecutive quarters of positive net income.

We believe that there is sufficient liquidity, given our expectation of continued positive cash flows from operations, our cash and cash equivalents of $38.6 million as of December 31, 2003, $35.0 million in availability as of December 31, 2003 under our Secured Financing Facility (see Note 8 to the consolidated financial statements), the repayment of a securitized receivable acquisition facility entered into by 99-1 (“Securitization 99-1”) and a securitized receivable acquisition facility entered into by 98-A (the “Warehouse Facility”) (see Notes 6 and 8 to the consolidated financial statements), our recent $1.8 million secured financing arrangement (“Secured Financing”) (see Note 8 to the consolidated financial statements), and the repayment in full of our Senior Note that occurred on October 1, 2003 (see Note 8 to the consolidated financial statements) to fund operations for at least the next 12 months.

Capital Resources
Cash and Cash Equivalents. Unrestricted cash and cash equivalents as of December 31, 2003 was $38.6 million compared to $0.8 million at December 31, 2002. The follow-on public offering and the increase in cash generated from operations have permitted us to avoid borrowing for purposes other than portfolio acquisition.

Secured Financing Facility. On December 20, 2000, through a wholly owned bankruptcy-remote, special-purpose entity, we entered into the $75.0 million Secured Financing Facility, which expires on December 31, 2004. The Secured Financing Facility generally provides for a 90% advance rate with respect to each qualified receivable portfolio purchased. Interest accrues at the prime rate plus 3.0% per annum and is payable weekly. The applicable interest rate is 1.0% lower on outstanding amounts in excess of $25.0 million. Notes to be issued under the facility are collateralized by the charged-off receivables that are purchased with the proceeds from this financing arrangement. Each note has a maturity date not to exceed 27 months after the borrowing date. Once the notes are repaid and we have been repaid our investment, we share with the lender the residual collections from the receivable portfolios, net of our servicing fees. The sharing in residual cash flows continues for the entire economic life of the receivable portfolios financed using this facility, and will extend substantially beyond the expiration date of the Secured Financing Facility. New advances for portfolio purchases under the Secured Financing Facility would not be available beyond the December 31, 2004 expiration date. We are required to give the lender the opportunity to fund all of our purchases of charged-off credit card receivables with advances on the Secured Financing Facility through December 31, 2004 (see Note 8 to the consolidated financial statements).




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The assets pledged under this financing facility, together with their associated cash flows, would not be available to satisfy claims of general creditors against us. In conjunction with the Secured Financing Facility, we issued warrants to purchase up to 621,576 shares of Encore’s common stock at $1.00 per share, all of which were exercised in December 2003.

From the inception of the Secured Financing Facility through December 31, 2003, we purchased portfolios utilizing this facility at an aggregate purchase price of $183.3 million ($164.3 million of which was financed through this facility). As of December 31, 2003, there was $39.9 million outstanding under the facility (see Note 8 to the consolidated financial statements). During the year ended December 31, 2003, we repaid $59.9 million in principal, $2.2 million in interest, and $14.5 million in contingent interest pursuant to the residual collections sharing arrangement under the Secured Financing Facility. The Secured Financing Facility is collateralized by certain charged-off receivable portfolios with an aggregate carrying amount of $82.8 million at December 31, 2003. The assets pledged under this financing facility, together with their associated cash flows, would not be available to satisfy claims of our general creditors.

For the year ended December 31, 2003, we expensed $2.3 million in interest and loan fee amortization, and $16.0 million in contingent interest expense for total Secured Financing Facility related interest expense of $18.3 million, which represented an effective interest rate of 58.3% on average borrowings of $31.4 million. For the year ended December 31, 2002, we expensed $1.8 million in interest and loan fee amortization, and $13.1 million in contingent interest expense for total Secured Financing Facility related interest expense of $14.9 million, which represented an effective interest rate of 66.2% on average borrowings of $22.4 million.

We intend to replace or renegotiate this facility by the end of its term.






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The following table summarizes our repayment of debt related to our receivable purchases under the Secured Financing Facility for the following periods as of December 31, 2003 (in millions):

Period Secured
Financing
Facility
Original
Borrowings
Remaining
Balance as of
December 31,
2003
Percent of
Original
Borrowings
Remaining




   2001     $ 35.0   $ 0.0       0.0%
Q1 2002    11.7    Less than 0.1    0.0  
Q2 2002    9.4    0.1    0.6  
Q3 2002    18.1    0.3    1.6  
Q4 2002    15.1    2.8    18.7  
Q1 2003    17.0    3.8    22.7  
Q2 2003    22.0    8.5    38.8  
Q3 2003    15.8    8.2    51.9  
Q4 2003    20.2    16.2    80.3  


 Total  $ 164.3   $ 39.9    24.3  




Secured Financing. On July 25, 2003, through a wholly owned, bankruptcy-remote, special-purpose entity, we entered into a $1.8 million secured financing arrangement to finance the purchase of non-credit card debt (the “Secured Financing”). The Secured Financing provided for a 75.0% advance rate with respect to four purchased receivable portfolios of charged-off unsecured consumer loans and auto loan deficiencies. Interest accrues at 15.0% and is payable weekly. This note has a maturity date not to exceed October 25, 2005. The Secured Financing is collateralized by charged-off receivables from four receivable portfolios with an aggregate carrying value of $1.9 million as of December 31, 2003. Unlike the Secured Financing Facility, this financing arrangement does not require us to share residual collections with the lender. The assets pledged under this financing, together with their associated cash flows, would not be available to satisfy claims of general creditors of the Company.

Revolving Line of Credit. We entered into the Seventh Amended and Restated Promissory Note effective April 10, 2003, to renew our revolving line of credit. Availability under the revolving line of credit, which carried interest at the Prime Rate and matured on April 15, 2004, was reduced from $15.0 million to $5.0 million. Certain stockholders of Encore guaranteed this unsecured revolving line of credit. In connection with the guaranties, we have paid an aggregate fee of $75,000 per quarter to certain of the guarantors/stockholders. There were no amounts outstanding under the revolving line of credit at the time of termination. On October 14, 2003, we terminated this revolving line of credit, and the guarantors were released from their obligation and no further payments will be made to the guarantors.

Securitizations. In 1998, we engaged in a securitization transaction that was treated as a sale and not as a secured financing transaction. We recorded a retained interest in securitized receivables. The retained interest is collateralized by the credit card receivables that were securitized, adjusted for amounts owed to the note holders. The gross collections related to the retained interest amounted to $6.8 million for the year ended December 31, 2003; $13.9 million for the year ended December 31, 2002; and $20.7 million for the year ended December 31, 2001. The related income accrued on the retained interest amounted to $0.3 million for the year ended December 31, 2003; $5.7 million for the year ended December 31, 2002; and $9.8 million for the year ended December 31, 2001. Since repaying the note in September 2000, we have retained all collections of the underlying securitized receivables.




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On March 31, 1999, through a bankruptcy remote, special purpose subsidiary, we entered into a $35 million securitized receivables acquisition facility (the “Warehouse Facility”) that was structured as a term loan with a final payment date of December 15, 2004. The Warehouse Facility, including the deferred insurance premium, was repaid in full on April 15, 2003. As of December 31, 2002, the balance outstanding under this facility was $5.6 million (see Note 8 to the consolidated financial statements). The facility accrued interest at 1.17% plus the one-week London interbank offered rate (“LIBOR”) totaling 2.67% per annum at December 31, 2002.

On January 18, 2000, through a bankruptcy remote, special purpose subsidiary, we issued securitized non-recourse notes in the amount of $28.9 million, bearing interest at 10% per annum (“Securitization 99-1”). The Securitization 99-1, including the deferred insurance premium, was repaid in full on April 15, 2003. The outstanding balance under this facility was $6.6 million at December 31, 2002 (see Note 8 to the consolidated financial statements).

The Warehouse Facility and Securitization 99-1 were insured through a financial guaranty insurance policy. The insurance policy required the payment of a base premium on a monthly basis and an additional premium, which was due at the debt maturity. The deferred premium totaled $1.3 million and $1.9 million at December 31, 2001 and 2002, respectively, which was reflected in accounts payable and accrued liabilities.

Senior Notes. In January 2000, we obtained financing through the issuance of $10.0 million principal amount senior notes to an institutional investor. On October 1, 2003, the remaining balance of the Senior Notes was repaid in full. The notes were our unsecured obligations, but were guaranteed by Midland Credit Management and one of our stockholders. In connection with the issuance of the notes, we issued warrants to the note holders and the guaranteeing stockholder to acquire up to an aggregate of 528,571 shares of our common stock at an exercise price of $0.01 per share.

On February 22, 2002, the institutional investor forgave $5.3 million of outstanding debt, consisting of a $2.8 million reduction in the original note balance, the forgiveness of $1.9 million in Payment-in-Kind Notes, and the forgiveness of $0.6 million in interest accrued through December 31, 2001, and reduced its warrant position by 200,000 warrants (see Note 3 to the consolidated financial statements). In conjunction with the debt forgiveness, capitalized loan costs totaling $0.1 million and debt discount totaling $0.5 million were written-off. The net gain on debt forgiveness totaling $4.7 million was reflected as an adjustment to stockholders’ equity. Furthermore, the terms of the Senior Notes and Payment-in-Kind Notes were revised. The interest rate on the remaining $7.3 million in Senior Notes was 6.0% per annum until July 15, 2003 and 8.0% per annum from July 16, 2003 to October 1, 2003, when the Senior Notes were repaid in full. In addition, warrants totaling 233,812 held by the institutional investor and 101,275 held by the guaranteeing stockholder were exercised concurrent with the our follow-on public offering. The remaining debt discount and capitalized loan fees associated with the Senior Note in the amount of $0.9 million were written off and charged to income in the fourth quarter of 2003.




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Preferred Stock. In a transaction related to the forgiveness of debt discussed above, certain existing stockholders and their affiliates (the “Purchasers”) made an additional $5.0 million investment in Encore to purchase 1,000,000 shares of Series A Senior Cumulative Participating Convertible Preferred Stock. Immediately prior to such investment, the Purchasers beneficially owned in excess of 50% of our common stock on a collective basis. This debt forgiveness and sale of preferred stock increased our net worth by $9.3 million. The preferred stock was entitled to dividends and other significant rights and privileges.

On October 1, 2003, concurrent with our public offering, all the holders of the Series A Preferred Stock converted their shares into 10.0 million shares of common stock pursuant to an agreement executed between the holders of such shares and the Company. The holders of the Series A Preferred Stock were paid all accrued and unpaid dividends totaling $63,889 at the time of the conversion in accordance with the terms of the Series A Preferred Stock, but did not pay or receive any other consideration in connection with the conversion (see Note 3 to the consolidated financial statements).

Future Contractual Cash Obligations
The following table summarizes our future contractual cash obligations as of December 31, 2003 (in thousands):

2004 2005 2006 2007 2008 Total






Capital lease obligations     $ 199   $ 193   $ 68 $   $     $ 460  
Operating leases    800    390    390   390   292    2,262  
Employment agreements    604    184              788  
Secured Note    80    86    53          219  
Debt - variable principal payments                              
     (Secured Financing)    1,031                  1,031  
Debt - variable principal payments                              
     (Secured Financing Facility)    27,076    12,684    168          39,928  






Total contractual cash obligations   $ 29,790   $ 13,537   $ 679 $ 390$ 292   $ 44,688  








Repayments under our Secured Financing Facility and Secured Financing are predicated on our cash collections from the underlying secured receivables portfolios; however, repayment must be made no later than 27 months following the date of the original advance with respect to each advance under the Secured Financing Facility, and October 25, 2005 under our Secured Financing. The table reflects the repayment of the loans under these facilities based upon our expected cash collections, which reflects repayments earlier than the required due dates.




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This table does not include future interest or future contingent interest payments. For additional information on our debt, lease commitments, and other commitments see Notes 8 and 12 to our consolidated financial statements.

Cash Flows and Expenditures

Year ended December 31, 2003 compared to year ended December 31, 2002

The table below summarizes gross collections for the years indicated (in thousands):

Years Ended December 31,




2003 2002 $ Change % Change




Owned credit card portfolios     $ 172,894   $ 120,965   $ 51,929    42 .9%
Owned other consumer loans    6,056    3,423    2,633    76 .9
Retained interest    6,819    13,929    (7,110 )  (51 .0)
Serviced portfolios    4,750    10,491    (5,741 )  (54 .7)



Gross collections   $ 190,519   $ 148,808   $ 41,711    28 .0





We collected $190.5 million during the year ended December 31, 2003 from all portfolios, an increase of $41.7 million, or 28.0%, from the $148.8 million collected during the year ended December 31, 2002. The source of the improvement was approximately $51.7 million from the owned credit card portfolios, $2.9 million in collections from owned other consumer paper portfolios (charged-off unsecured consumer loans and auto loan deficiencies), offset by a decrease in collections on the retained interest of $7.1 million and decreased collections on the serviced portfolios of $5.7 million.

During 2001, we resumed purchasing charged-off unsecured consumer loans and during 2002, we began purchasing auto loan deficiencies. We purchased $6.0 million and $1.9 million in these loans for the year ended December 31, 2003 and 2002, respectively. Collections related to all portfolios of charged-off unsecured consumer loans and auto loan deficiencies amounted to $6.1 million and $3.4 million for each of years ended December 31, 2003 and 2002, respectively.

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We currently utilize various business channels for the collection of charged-off credit cards and other receivables. The following table summarizes the gross collections by collection channel (in thousands):

For the Years Ended December 31,




2003 2002 $ Change % Change




Collection sites     $ 118,431   $ 94,997   $ 23,434    24.7 %
Legal collections    39,972    27,620    12,352    44.7  
Sales    28,071    18,545    9,526    51.4  
Other    4,045    7,646    (3,601 )  (47. 1)



Gross collections   $ 190,519   $ 148,808   $ 41,711    28.0  





Cash flows from operations improved $9.3 million from $24.7 million for the year ended December 31, 2002 to $34.0 million for the year ended December 31, 2003. This reflects the 28.0% growth in gross collections, an increase of $41.7 million from the year ended December 31, 2002 to the year ended December 31, 2003 as well as the non-recurring net proceeds from the Litigation Settlement of $7.9 million in the second quarter of 2003.

Our primary investing activity to date has been the purchase of charged-off receivable portfolios. We purchase receivable portfolios directly from issuers; from resellers; and through brokers that represent various sellers. Purchases affect cash flows in two ways. In periods in which we make portfolio purchases, we generally provide ten percent of each portfolio’s purchase price (we provided 25.0% of the purchase price for certain non-credit card receivables purchased through the Secured Financing, and 100.0% of the purchase price of other non-credit card portfolios purchased during the year) as our equity contribution. In subsequent periods, recoveries on the purchased portfolios produce cash flow. We carefully evaluate portfolios and bid only on those that meet our selective targeted return profile.

We paid $89.8 million for portfolios purchased during the year ended December 31, 2003, up $27.3 million or 43.7% from the $62.5 million paid during the year ended December 31, 2002. The following table summarizes the purchases we have made by quarter, and the respective purchase prices (in thousands):

Quarter # of
Accounts
Face Value Purchase
Price
Average
Purchase
Price as a
Percentage
of Face





Q1 2002      331   $ 717,822   $ 13,145    1 .83%
Q2 2002    386    514,591    10,478    2 .04
Q3 2002    752    981,471    21,002    2 .14
Q4 2002    380    591,504    17,900    3 .03
Q1 2003    380    589,356    18,802    3 .19
Q2 2003    982    1,177,205    26,271    2 .23
Q3 2003    341    640,197    19,350    3 .02
Q4 2003    332    881,609    25,411    2 .88





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We have recovered, in excess of revenue recognized on the accretion method, $71.4 million against the combined cost basis of our portfolios and our investment in the retained interest during the year ended December 31, 2003; up 35.9% or $18.9 million from the recoveries of $52.5 million for the year ended December 31, 2002.

The following table summarizes our purchases and related collections per year of purchase, adjusted for put-backs, account recalls and replacements, purchase price rescissions, and the impact of an acquisition in 2000 (in thousands):

Year of Purchase Adjusted
Purchase
Price
Cumulative
Collections Through
December 31, 2003
Collections To Date
as a Multiple of
Purchase Price




2000     $ 6,154   $ 23,987    3.9  
2001    38,199    108,454    2.8  
2002    61,525    118,549    1.9  
2003    89,403    59,037    0.7  


Total   $ 195,281   $ 310,027    1.6  





While we have been able to exceed our targeted collections to adjusted purchase price ratio, the impact of pricing pressure may cause this multiple to decline.

The following table summarizes the concentration of our purchases by seller by year for the following periods, adjusted for put-backs, account recalls and replacements, purchase price rescissions, and the impact of an acquisition (in thousands):

Concentration of Initial Purchase Cost by Seller










2003 2002 2001 2000 Total
Cost % Cost % Cost % Cost % Cost %
 Seller 1     $ 30,420    33.9 % $ 20,223    32.3 % $ 13,222    33.9 % $     % $ 63,865    32.3 %
 Seller 2    23,614    26.3    5,214    8.3    2,463    6.3            31,291    15.8  
 Seller 3    3,862    4.3    23,463    37.5    2,292    5.9            29,617    14.9  
 Seller 4            3,780    6.1    8,871    22.7            12,651    6.4  
 Seller 5            398    0.6    8,375    21.4            8,773    4.4  
 Seller 6     4,773    5.3            1,167    3.0            5,940    3.0  
 Seller 7            1,218    2.0           1,397    20.2  2,615    1.3  
 Seller 8                            2,590    37.5    2,590    1.3  
 Seller 9                             1,078    15.6    1,078    0.5  
 Seller 10                            729    10.5    729    0.4  
 Other    27,165    30.2    8,229    13.2    2,640    6.8    1,117    16.2    39,151    19.7  










     89,834    100.0 %  62,525    100.0 %  39,030    100.0 %  6,911    100.0 %  198,300    100.0 %





Adjustments                                     
     (A)    (431 )    (1,000 )    (831 )    (757 )    (3,019 )  





 Adjusted                                     
    Cost   $ 89,403     $ 61,525     $ 38,199     $ 6,154     $ 195,281    





  (A) Adjusted for putbacks, account recalls and replacements, purchase price rescissions, and the impact of an acquisition.





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Capital expenditures for fixed assets acquired with internal cash flow were $1.0 million for the year ended December 31, 2003. During the year ended December 31, 2003, $0.3 million of additional capital expenditures were acquired through a capital lease.

Net cash arising from financing activities was $23.4 million during the year ended December 31, 2003 as compared to a use of cash in financing activities of $14.2 million during the year ended December 31, 2002. This reflected $85.5 million in repayment of principal during for the year ended December 31, 2003 and was offset by borrowings of $78.2 million during the year ended December 31, 2003 to fund new portfolio purchases. This also reflected the receipt of $30.1 million in net proceeds from our follow-on offering in the fourth quarter of 2003. The repayment of principal includes the repayment in full of Securitization 99-1 and the Warehouse Facility as discussed in Notes 4 and 8 of the consolidated financial statements. This compares to borrowings of $62.2 million for the year ended December 31, 2002 to fund new portfolio purchases and $79.7 million in repayment of principal during for the year ended December 31, 2002 under our existing portfolio financing facilities.

Year ended December 31, 2002 compared to year ended December 31, 2001

The table below summarizes gross collections for the years indicated (in thousands):

Years Ended December 31,




2002 2001 $ Change % Change




Owned credit card portfolios     $ 120,965   $ 49,178   $ 71,787    146.0 %
Owned other consumer loans    3,423    235    3,188    1,356.6  
Retained interest    13,929    20,675    (6,746 )  (32.6 )
Serviced portfolios    10,491    12,963    (2,472 )  (19.1 )




Gross collections   $ 148,808   $ 83,051   $ 65,757    79.2  





We collected $148.8 million during the year ended December 31, 2002 from all portfolios, an increase of $65.8 million, or 79.2%, from the $83.0 million collected during 2001. Collections on owned portfolios increased by approximately $67.9 million or 97% from approximately $70.1 million during the year ended December 31, 2001 to approximately $138.0 million for the year ended December 31, 2002. The source of the improvement was approximately $79.7 million from the Secured Financing Facility portfolios. Offsetting this improvement was a $2.4 million reduction in collections on the 99-1 Securitization, a $1.0 million reduction in collections on the Warehouse Facility, a $1.5 million reduction from wholly owned portfolios, and a $6.7 million reduction in the 98-1 Securitization.

The $67.9 million increase in collections on owned portfolios is offset by approximately $2.5 million in lower collections related to serviced portfolios. During the year ended December 31, 2002, we collected approximately $10.5 million on serviced portfolios compared to approximately $13.0 million during the year ended December 31, 2001. In February 2003, we returned all exhausted receivables to the owner of these portfolios; however, we have retained the servicing rights for receivables placed in the attorney network.




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During 2002 and 2001, we resumed purchasing charged-off unsecured consumer loans and auto loan deficiencies. We purchased $1.5 million and $1.0 million in unsecured consumer loans in 2002 and 2001, respectively. Collections related to the unsecured consumer loans amounted to $3.4 million in 2002 and $0.2 million in 2001. We also purchased $0.4 million in auto loan deficiencies in December 2002.

We currently utilize various business channels for the collection of charged-off credit cards and other receivables. The following table summarizes gross collections by collection channel for the years indicated (in thousands):

Years Ended December 31,




2002 2001 $ Change % Change




Collection sites     $ 94,997   $ 64,160   $ 30,837    48.1 %
Legal collections    27,620    16,325    11,295    69.2  
Sales    18,545    1,768    16,777    948.9  
Other    7,646    798    6,848    858.1  



Gross collections   $ 148,808   $ 83,051   $ 65,757    79.2  





Cash flow from operations improved $15.8 million from $8.9 million for the year ended December 31, 2001 to $24.7 million for the year ended December 31, 2002. First, this reflects the 79.2% growth in total gross collections of $65.8 million from 2001 to 2002. Additionally, we improved our ratio of total cash basis operating expenses and interest to total gross collections from 60% in 2001 to 44% in 2002. The combination of these two trends resulted in the cash from operations increasing from an 11% retention of gross collections in 2001 to a 17% retention in 2002.

Our primary investing activity is the purchase of new receivables portfolios. We purchase receivables portfolios directly from issuers and from resellers as well as from brokers that represent various issuers. Purchases affect cash flows in two ways. In periods in which we make portfolio purchases, we generally provide 10% of each portfolio’s purchase price (we provided 25% of the purchase price for certain non-credit card receivables purchased through the Secured Financing, and 100% of the purchase price of other non-credit card portfolios purchased during the year) as our equity contribution. In subsequent periods, recoveries on the purchased portfolios produce cash flow. We carefully evaluate portfolios and bid on only those that meet our selective targeted return profile.

We purchased $62.5 million in new receivables during the year ended December 31, 2002, up $23.5 million or 60.1% from the $39.0 million purchased during 2001. In addition, we recovered $51.2 million in collections against the cost basis of our portfolios and our investment in the retained interest in 2002; up $34.8 million, or 212.2%, from the recoveries of $16.4 million of recoveries during 2001.




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Capital expenditures for fixed assets and capital leases were $0.7 million for the year ended December 31, 2002 compared to $0.4 million for the year ended December 31, 2001. During the years ended December 31, 2002 and December 31, 2001, all purchases of capital expenditures were funded with internal cash flow.

Net cash used in financing activities was $14.2 million for the year ended December 31, 2002, compared to $13.4 million provided by financing activities during the year ended December 31, 2001. This reflected $79.8 million in repayment of principal in 2002 under our existing portfolio financing facilities, which was partially offset by borrowings of $62.2 million in 2002 used to fund new portfolio purchases. These compare to borrowings of $28.9 million in 2001 to fund new portfolios purchases and $14.4 million in repayment of principal in 2001 under our existing portfolio financing facilities.

In addition, we obtained net proceeds of $4.6 million from the sale of the Series A Convertible Preferred Stock during 2002.

Inflation
We believe that inflation has not had a material impact on our results of operations for the three years ended December 31, 2003, 2002 and 2001 since inflation rates generally remained at relatively low levels.

Critical Accounting Policies
Investment in Receivable Portfolios. We account for our investment in receivables portfolios on the “accrual basis” or “cost recovery method” of accounting in accordance with the provisions of the AICPA’s Practice Bulletin 6, “Amortization of Discounts on Certain Acquired Loans.” Static pools are established with accounts having similar attributes, based on the specific seller and timing of acquisition. Once a static pool is established, the receivables are permanently assigned to the pool. The discount (i.e., the difference between the cost of each static pool and the related aggregate contractual receivable balance) is not recorded because the Company expects to collect a relatively small percentage of each static pool’s contractual receivable balance. As a result, receivable portfolios are recorded at cost at the time of acquisition.

We account for each static pool as a unit for the economic life of the pool (similar to one loan) for recognition of revenue from receivables portfolios, for collections applied to principal of receivables portfolios and for provision for loss or impairment. Revenue from receivables portfolios is accrued based on the effective interest rate determined for each pool applied to each pool’s original cost basis. Each pool’s cost basis is increased for revenue earned and decreased for collections and impairments. The effective interest rate is the internal rate of return determined based on the timing and amounts of actual cash received and anticipated future cash flow projections for each pool.




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We monitor and evaluate actual and projected cash flows for each receivable portfolio on a quarterly basis. Through September 30, 2003, we had not increased the total estimated cash flows for any receivable portfolio. As a result, for those portfolios whose actual cumulative collections exceeded the forecast, such excess amounts were subtracted from the future estimated collections in order to maintain the original forecast. However, effective October 1, 2003, we implemented new collection forecasts utilizing a newly developed forecasting model, the Unified Collection Score (“UCS”) that considers known data about our customers’ accounts, including, among other things, our collection experience, and changes in external customer factors, in addition to all data known when we acquired the accounts. The effect of our change in estimated projected collections resulting from the implementation of the UCS model is discussed at Note 5 in the consolidated financial statements.

We have historically reduced the total forecasted cash flows on certain receivable portfolios where actual cumulative collections to date have not met the forecast. If the remaining forecasted cash flows are in excess of the remaining carrying value, the effective interest is reduced prospectively. If the remaining forecasted cash flows are less than the remaining carrying value, the receivable portfolio is impaired and all of the remaining collections are subsequently applied against book value. Additionally, if the amount and timing of future cash collections are not reasonably estimable, we accounts for these portfolios on the cost recovery method (“Cost Recovery Portfolios”).

Collections realized after the net book value of a portfolio has been fully recovered (“Zero Basis Portfolios”) are recorded as revenue (“Zero Basis Income”).

Contingent Interest. Under the terms of the our Secured Financing Facility, once we repay the lender for the notes for each purchased portfolio and collect sufficient amounts to recoup its initial cash investment in each purchased portfolio, then we share the residual collections (“Contingent Interest”) from the receivables portfolios, net of its servicing fees, with the lender. We make estimates with respect to the timing and amount of collections of future cash flows from these receivables portfolios. Based on these estimates, we record a portion of the estimated future profit sharing obligation as Contingent Interest Expense (see Note 8 to the consolidated financial statements).

Deferred Court Costs. We contract with a network that acts as a clearinghouse to place accounts for collection with attorneys with whom we contract in most of the 50 states. We generally refer charged-off accounts to our contracted attorneys when we believe the related debtor has sufficient assets to repay the indebtedness and has to date been unwilling to pay. In connection with our agreements with our contracted attorneys, we advance certain out-of-pocket court costs (“Deferred Court Costs”). We capitalize these costs in our consolidated financial statements and provide a reserve for those costs that we believe will be ultimately uncollectible. We determine the reserve based on our analysis of court costs that have been advanced, recovered, and anticipate recovering.




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Income Taxes. We use the liability method of accounting for income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes.” Deferred income taxes are recognized based on the differences between financial statement and income tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized (see Note 9 to the consolidated financial statements).

We utilize estimates in the calculation of our current federal and state income tax liabilities. In our industry, such estimates are subject to substantial interpretation. To the extent federal and state taxing authorities successfully challenge our estimates, we may be required to accelerate the recognition of our revenues or decelerate the recognition of certain expenses for income tax reporting purposes. As a result, we may be required to pay income taxes in periods earlier than we currently expect. Revisions to the estimates would not generally result in a material change in the income tax expense we record in our consolidated financial statements. Instead, it would increase or decrease the amount of taxes we currently are required to pay, which would result in a corresponding increase or decrease in the net deferred asset we have reflected in our consolidated statement of financial condition.

New Accounting Pronouncements

In January 2003, the AICPA issued Statement of Position 03-03 (“SOP 03-03”), “Accounting for Certain Debt Securities Acquired in a Transfer.” SOP 03-03 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. This SOP limits the yield that may be accreted (accretable yield) to the excess of the investor’s estimate of undiscounted expected principal, interest, and other cash flows (cash flows expected at acquisition to be collected) over the investor’s initial investment in the loan. This SOP requires that the excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) not be recognized as an adjustment of yield, loss accrual, or valuation allowance. This SOP prohibits investors from displaying accretable yield and nonaccretable difference in the balance sheet. Subsequent increases in cash flows expected to be collected generally would be recognized prospectively through adjustment of the loan’s yield over its remaining life. Decreases in cash flows expected to be collected would be recognized as impairment. SOP 03-03 is effective in fiscal years beginning after December 15, 2004, and accordingly, the we expect to adopt the provisions of this SOP in the first quarter of 2005. We do not believe that the implementation of SOP 03-03 will have a material effect on our consolidated financial statements.




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In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” which establishes standards for the classification and measurement of certain financial instruments with characteristics of both liability and equity. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for us on July 1, 2003. The adoption of SFAS No. 150 did not have a material effect on our consolidated financial statements.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” which amends and clarifies financial accounting and reporting for derivative instruments. The implementation of SFAS No. 149 did not have a material impact on our consolidated financial statements.

In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” The adoption of FIN 46 did not have a material impact on our consolidated financial statements.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an Amendment to SFAS No. 123.” SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method on accounting for stock-based employee compensation. We have retained our accounting for stock based employee compensation under APB No. 25 and have only adopted the pro forma disclosure requirements of SFAS No. 123. Accordingly, the implementation of SFAS No. 148 did not have a material effect on our consolidated financial statements.

In November 2002, the FASB issued Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” The interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. In general, the interpretation applies to contract or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying obligation that is related to an asset, liability or an equity security of the guaranteed party. The adoption of FIN 45 did not have a material impact on our consolidated financial statements.

Special Note on Forward-Looking Statements

This report contains “forward-looking statements” within the meaning of the federal securities laws. All statements, other than statements of historical facts, included or incorporated into this Form 10K are forward-looking statements. The words “believe,” “expect,” “anticipate,” “estimate,” “project,” and similar expressions often characterize forward-looking statements. These statements may include, but are not limited to, projections of collections, revenues, income or loss, estimates of capital expenditures, plans for future operations, products or services, and financing needs or plans, as well as assumptions relating to these matters. These statements include, among others, statements found under “Risk Factors”, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.”

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Actual results could differ materially from those contained in the forward-looking statements due to a number of factors, some of which are beyond our control. Factors that could affect our results and cause them to differ from those contained in the forward-looking statements include:

Forward-looking statements speak only as of the date the statement was made. They are inherently subject to risks and uncertainties, some of which we cannot predict or quantify. Future events and actual results could differ materially from the forward-looking statements. When considering each forward-looking statement, you should keep in mind the risk factors and cautionary statements found throughout this prospectus and specifically those found above. We are not obligated to publicly update or revise any forward looking statements, whether as a result of new information, future events, or for any other reason.

In addition, it is our policy generally not to make any specific projections as to future earnings, and we do not endorse projections regarding future performance that may be made by third parties.




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Risk Factors

We may not be able to purchase receivables at sufficiently favorable prices, terms, or quantities for us to be successful.

Our long-term success depends upon the continued availability of receivables for purchase on a cost-effective basis. The availability of receivables portfolios at favorable prices and on favorable terms depends on a number of factors, including:

To operate profitably over the long term, we must continually purchase and collect on a sufficient volume of receivables to generate cash collections and the related revenues that exceed our costs.

We depend on a combination of individual portfolio purchases and forward-flow purchase agreements to provide the raw material (charged off receivables) for our collections. Forward-flow purchase contracts have recently begun to represent an increasing proportion of our budgeted purchases. Our current forward-flow contracts are terminable by either the Company or the seller of the receivables on 60 days notice without penalty. There can be no assurance that we will be able to maintain or replace such agreements. In that case, we would be forced to seek alternative sources of charged off receivables, which could take time, be lower quality, cost more, or any combination of these factors, any of which could adversely affect our financial performance.

We may not be able to collect sufficient amounts on our receivables portfolios to recover our costs and fund our operations.

We acquire and service receivables that the obligors have failed to pay and the sellers have deemed uncollectible and written off. The originating institutions generally make numerous attempts to recover on their non-performing receivables, often using a combination of their in-house collection and legal departments as well as third party collection agencies. These receivables are difficult to collect and we may not be successful in collecting amounts sufficient to cover the costs associated with purchasing the receivables and funding our operations.

In addition, our ability to recover on our receivables and produce sufficient returns can be negatively impacted by the quality of the purchased receivables, as well as economic and other conditions outside of our control. Certain receivables we purchase fail to comply with certain terms of the purchase agreements under which they were acquired. Although we seek to return these receivables to the sellers and recover our cost, we are not always successful. We cannot guarantee that such sellers will be able to meet their payment obligations to us. Yields may also be affected by general economic conditions and other events not in our control.

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Our industry is highly competitive, and we may be unable to continue to successfully compete with businesses that may have greater resources than we have.

We face competition from a wide range of collection companies and financial services companies which may have substantially greater financial, personnel and other resources, greater adaptability to changing market needs and more established relationships in our industry than we currently have. We also compete with traditional contingency collection agencies and in-house recovery departments. Competitive pressures adversely affect the availability and pricing of charged-off receivables portfolios, as well as the availability and cost of qualified recovery personnel. As there are few significant barriers to entry for new purchasers of charged-off receivables portfolios, we cannot assure you that additional competitors with greater resources than ours will not enter our market. If we are unable to develop and expand our business or adapt to changing market needs as well as our current or future competitors are able to do, we may experience reduced access to charged-off receivables portfolios at appropriate prices and reduced profitability.

Moreover, we cannot assure you that we will be able to continue to offer competitive bids for charged-off receivable portfolios. We face bidding competition in our acquisition of charged-off receivable portfolios. In our industry, successful bids generally are awarded on a combination of price, service, and relationships with the debt sellers. Some of our current and future competitors may have more effective pricing and collection models, greater adaptability to changing market needs, and more established relationships in our industry. They may also pay prices for portfolios that we determine are not reasonable. There can be no assurance that we will continue to offer competitive bids for charged-off consumer receivables portfolios. In addition, there continues to be consolidation of issuers of credit cards, which have been a principal source of receivable purchases. This consolidation has limited the number of sellers in the market and has correspondingly given the remaining sellers increasing market strength in the price and terms of the sale of credit card accounts.




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Our failure to purchase sufficient quantities of receivables portfolios may necessitate workforce reductions, which may harm our business.

Because fixed costs, such as certain personnel salaries and lease or other facilities costs, constitute a significant portion of our overhead, if we do not continually augment the receivables portfolios we service with additional receivables portfolios or collect sufficient amounts on receivables owned or serviced by us, we may be required to reduce the number of employees in our collection operations. These practices could lead to:

High financing costs currently have an adverse effect on our earnings.

In December 2000, we entered into a $75.0 million Secured Financing Facility to fund portfolio purchases. It provides the lender with interest at a stated rate plus participation in the profits from acquired portfolios. For the year ended December 31, 2003, this arrangement resulted in an effective borrowing rate of 58.3% on portfolio purchases. The facility extends to December 31, 2004 and we cannot terminate it without the lender’s approval. Pursuant to an agreement with this lender, we are required to offer this lender the opportunity to finance all purchases of credit card receivables portfolios using this facility. Each note has a maturity date not to exceed 27 months after the borrowing date. This facility limits the earning potential for portfolios we own that are or were financed under it by increasing our costs of borrowing. The sharing in residual cash flows continues for the entire economic life of the receivables portfolios financed using this facility, and will extend substantially beyond the expiration date of the Secured Financing Facility, which is December 31, 2004.

We may be unable to meet our future liquidity requirements.

We depend on both internal and external sources of financing to fund our purchases of receivables portfolios and our operations. Our need for additional financing and capital resources increases dramatically as our business grows. Our inability to obtain financing and capital as needed or on terms acceptable to us would limit our ability to acquire additional receivables portfolios and to operate our business. In particular, we will need to obtain additional financing when our current Secured Financing Facility expires on December 31, 2004. Additional financing, additional capital or sales of certain receivables for cash may also be needed if we are removed as servicer of receivables that are part of our outstanding financings.




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We may not be able to continue to satisfy the restrictive covenants in our debt agreements.

Our debt agreements impose a number of restrictive covenants. Failure to satisfy any one of these covenants could result in all or any of the following adverse results:

We use estimates in our accounting and our earnings will be reduced if actual results are less than estimated.

We utilize the interest method to determine revenue recognized on substantially all of our receivables portfolios. Under this method, each pool of receivables is modeled upon its projected cash flows. A yield is then established which, when applied to the outstanding balance of the receivables, results in the recognition of revenue at a constant yield relative to the remaining balance in the receivables portfolio. The actual amount recovered by us on portfolios may substantially differ from our projections and may be lower than initially projected. If differences are material, then we may reduce our yield, which would negatively affect our earnings, or take a write off on all or a portion of our investment.

Recently, we revised the model we use to forecast collections, which is expected to result in an increase in revenue in future periods. However, we cannot assure that we will achieve the collections forecasted by this model.

We will be required to change how we account for underperforming receivables portfolios, which would have an adverse effect on our earnings.

The American Institute of Certified Public Accountants has issued a Statement of Position (“SOP”) 03-03, “Accounting for Loans and Certain Debt Securities Acquired in a Transfer,” that revises the accounting standard that governs underperforming receivables portfolios. This SOP is effective for us beginning in the first quarter of 2005. Under the standard, material decreases in expected cash flows would result in an impairment charge to our earnings while the yield we recognize on the receivables portfolio would remain unchanged. However, material increases in expected cash flows will continue to result in a prospective increase in the yield we recognize on a receivables portfolio.




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The estimates we use to calculate our income tax may be challenged resulting in our paying more income taxes.

We utilize estimates in the calculation of our current federal and state income tax liabilities. In our industry, such estimates are subject to substantial interpretation. To the extent federal and state taxing authorities successfully challenge our estimates, we may be required to accelerate the recognition of our revenues or decelerate the recognition of certain of our expenses for income tax reporting purposes. As a result, we may be required to use our financial resources to pay income taxes in periods earlier than we currently expect, which will reduce the funds that would otherwise be available to invest in new receivables portfolios or for other corporate purposes.

We will begin to pay substantial amounts in income taxes as a result of our full utilization of our federal net operating loss carry-forward in 2003.

We have not had to pay Federal income taxes for several years as we have utilized our net operating loss carry-forward to offset our Federal tax liability. As of December 31, 2002, we had an approximate $13.3 million Federal net operating loss carry-forward. In 2003, we fully utilized this carry-forward to partially offset our 2003 Federal tax obligation. As a result, we have begun to pay Federal income taxes at a 34% rate on taxable income requiring us to use a portion of our financial resources to pay Federal income taxes, which will reduce the funds we have available to invest in new receivables portfolios or for other corporate purposes.

We may not be successful at acquiring and collecting on portfolios consisting of new types of receivables.

We may pursue the acquisition of portfolios consisting of assets with which we have little collection experience. We may not be successful in completing any of these acquisitions. Our lack of experience with new types of receivables may cause us to pay too much for these portfolios, which may also result in reduced profitability. Our limited experience in collection of these new types of receivables may result in reduced profitability.

Government regulation may limit our ability to recover and enforce the collection of receivables.

Federal and state laws may limit our ability to recover and enforce receivables regardless of any act or omission on our part. Some laws and regulations applicable to credit card issuers may preclude us from collecting on receivables we purchase where the card issuer failed to comply with applicable federal or state laws in generating or servicing the receivables that we have acquired.

Laws relating to debt collections also directly apply to our business. Additional consumer protection or privacy laws and regulations may be enacted that impose additional restrictions on the collection of receivables. Such new laws may adversely affect our ability to collect on our receivables, which could adversely affect our earnings. Our failure or the failure of the originators of our receivables to comply with existing or new laws, rules or regulations could limit our ability to recover on receivables, which could reduce our revenues and harm our business.




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Because our receivables are generally originated and serviced nationwide, we cannot assure you that the originating lenders have complied with applicable laws and regulations. While receivables acquisition contracts typically contain provisions indemnifying us for losses due to the originating institution’s failure to comply with applicable laws and other events, we cannot assure you that any indemnities received from originating institutions will be adequate to protect us from losses on the receivables or liabilities to customers.

We are subject to ongoing risks of litigation, including potential class actions under securities, consumer credit, collections and other laws.

We operate in an extremely litigious climate and may be named as defendants in litigation, including in class actions under securities laws as well as consumer credit, collections and various other consumer-oriented laws.

If our future quarterly operating results are below the expectations of securities analysts or investors, the price of our common stock may decline. Stock price fluctuations may be exaggerated if the trading volume of our common stock continues to be low. In the past, securities class action litigation has often been filed against a company after a period of volatility in the market price of its stock.

Defending a lawsuit, regardless of its merit, could be costly and could divert management’s attention from the operation of our business. The use of certain collection strategies could be restricted if class action plaintiffs were to prevail in their claims. In addition, insurance costs continue to increase significantly and policy deductibles have also increased. All of these factors could have an adverse effect on our consolidated financial condition and results of operations.

We may make acquisitions that prove unsuccessful or strain or divert our resources.

From time to time, we consider acquisitions of other companies in our industry that could complement our business, including the acquisition of entities in diverse geographic regions and entities offering greater access to businesses and markets that we do not currently serve. We may not be able to successfully acquire other businesses or, if we do, we may not be able to successfully integrate these businesses with our own. Further, acquisitions may place additional constraints on our resources such as diverting the attention of our management from other business concerns. Through acquisitions, we may enter markets in which we have limited or no experience. Moreover, any acquisition may result in a potentially dilutive issuance of equity securities, incurrence of additional debt and amortization of identifiable intangible assets, all of which could reduce our profitability.




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Recent legislative actions and proposed regulations will require corporate governance initiatives, which may be difficult and expensive to implement.

To implement required corporate governance initiatives mandated by the Sarbanes-Oxley Act, the Securities and Exchange Commission and the recently adopted Nasdaq rules, we may be required to enhance our internal controls, hire additional personnel and utilize additional outside legal, accounting and advisory services, all of which would cause our general and administrative expenses to substantially increase. We also expect that the premiums we pay for directors’ and officers’ insurance policies will increase in the future as a result of higher claim rates incurred by insurers on other insured companies in recent years. These increased costs will adversely affect our operating results.

We may not be able to manage our growth or effectively obtain the resources necessary to achieve additional growth.

We have expanded significantly in recent years and we intend to maintain our growth strategy. However, expanding our operations places great demands on our management, employees, finances and other resources. To successfully manage our growth, we may need to expand and enhance our administrative infrastructure, further improve our management, financial and information systems and controls, and more effectively recruit, train, manage and retain our employees. We cannot assure you that our infrastructure, facilities and personnel will be adequate to support our future operations or to effectively adapt to future growth. If we are unable to effectively manage our growth, it may adversely affect our financial results.

In addition, we believe that the extent of the training we provide to our collections employees makes them attractive targets to our competitors, who may try to solicit them to change jobs.

We may not be able to hire and retain enough sufficiently trained employees to support our operations, and/or we may experience high rates of personnel turnover.

Our industry is very labor intensive. We generally compete for qualified personnel with companies in our business and in the collection agency, tele-services and telemarketing industries. We will not be able to service our receivables effectively, continue our growth and operate profitably if we cannot hire and retain qualified collection personnel. Further, high turnover rate among our employees increases our recruiting and training costs and may limit the number of experienced collection personnel available to service our receivables. Our newer employees tend to be less productive and generally produce the greatest rate of personnel turnover. If the turnover rate among our employees increases, we will have fewer experienced employees available to service our receivables, which will affect our ability to maintain profitable operations.

We depend on our key personnel, the loss of any of whom would adversely affect our operations.

Our performance is substantially dependent on the performance of our senior management and other key personnel. The loss of the services of one or more of our executive officers or key employees, or the inability to hire new management as needed, could disrupt our operations. Although we have employment agreements with two of our senior executives, there can be no assurances that these agreements will assure the continued services of these officers, nor can we assure you that the non-competition provisions of these agreements will be enforceable.




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The failure of our technology and phone systems could have an adverse effect on our operations.

Our success depends in large part on sophisticated telecommunications and computer systems. The temporary or permanent loss of our computer and telecommunications equipment and software systems, through casualty, operating malfunction or service provider failure, could disrupt our operations. In the normal course of our business, we must record and process significant amounts of data quickly and accurately to properly bid on prospective acquisitions of receivables portfolios and to access, maintain and expand the databases we use for our collection activities. Any simultaneous failure of both of our information systems and their backup systems would interrupt our business operations.

Our business depends heavily on service provided by various local and long distance telephone companies. A significant increase in telephone service costs or any significant interruption in telephone services could reduce our profitability or disrupt our operations.

We may not be able to successfully anticipate, invest in or adopt technological advances within our industry.

Our business relies on computer and telecommunications technologies and our ability to integrate new technologies into our business is essential to our competitive position and our success. We may not be successful in anticipating, managing, or adopting technological changes on a timely basis. Computer and telecommunications technologies are evolving rapidly and are characterized by short product life cycles.

While we believe that our existing information systems are sufficient to meet our current and foreseeable demands and continued expansion, our future growth may require additional investment in these systems. We depend on having the capital resources necessary to invest in new technologies to acquire and service receivables. We cannot assure you that adequate capital resources will be available to us.

We may not be able to adequately protect the intellectual property rights upon which we rely.

We rely on proprietary software programs and valuation and collection processes and techniques and we believe that these assets provide us with a competitive advantage. We consider our proprietary software, processes and techniques to be trade secrets. We may not be able to adequately protect our technology and data resources.




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Our quarterly operating results may fluctuate and cause our stock price to decrease.

Because of the nature of our business, our quarterly operating results may fluctuate in the future, which may adversely affect the market price of our common stock. The reasons our results may fluctuate include:

We may not be able to find adequate new facilities in San Diego.

We are currently in the process of searching for a new facility for our San Diego collection site and corporate headquarters. The lease for our current facility expires in October of 2004. We have identified a new building and are in the process of negotiating a lease for this space. There can be no assurance that we can secure a replacement facility at acceptable terms prior to the expiration of our current lease.

Index

Item 7A – Quantitative and Qualitative Disclosure About Market Risk

Our exposure to market risk relates to interest rate risk associated with our variable rate borrowings. As of December 31, 2003, we had total variable rate borrowings of $39.9 million, all of which consisted of our Secured Financing Facility (see Note 8 to the consolidated financial statements).

Changes in short-term interest rates also affect our earnings as a result of our borrowings under variable rate borrowing agreements. If the market interest rates for our variable rate agreements increase at an average of 10.0%, interest expense would increase, and income before income taxes would decrease by approximately $0.3 million, on an annualized basis, based on the amount of related outstanding borrowings as of December 31, 2003 of $39.9 million. Conversely, if market interest rates decreased an average of 10.0%, our interest expense would decrease, thereby increasing income before income taxes by approximately $0.3 million, on an annualized basis, based on borrowings as of December 31, 2003.




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Index

Item 8 - Consolidated Financial Statements

Encore Capital Group, Inc. Consolidated Financial Statements Years ended December 31, 2003, 2002 and 2001

Contents

Report of Independent Auditors      68  
Audited Financial Statements  
Consolidated Statements of Financial Condition    69  
Consolidated Statements of Operations    70  
Consolidated Statements of Stockholders' Equity (Deficit) and Comprehensive Income (Loss)    71  
Consolidated Statements of Cash Flows    72  
Notes to Consolidated Financial Statements    74  







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Index

Report of Independent Auditors

The Board of Directors and Stockholders
Encore Capital Group, Inc.

We have audited the accompanying consolidated statements of financial condition of Encore Capital Group, Inc., previously known as MCM Capital Group, Inc., and its subsidiaries (the “Company”) as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity (deficit) and comprehensive income (loss), and cash flows for each of the years in the three year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Encore Capital Group, Inc. and its subsidiaries as of December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the years in the three year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.

/s/ BDO Seidman, LLP

Costa Mesa, California
February 6, 2004





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Index

Encore Capital Group, Inc.
Consolidated Statements of Financial Condition

(In Thousands, Except Par Value Amounts)

December 31,
2003
December 31,
2002


Assets            
Cash and cash equivalents   $ 38,612   $ 752  
Restricted cash    842    3,105  
Investment in receivable portfolios, net (Notes 5, 6 and 8)     89,136    64,168  
Investment in retained interest (Note 6)     1,231    8,256  
Property and equipment, net (Note 7)     2,786    3,541  
Deferred tax asset, net (Note 9)     1,358    6,813  
Other assets    4,320    3,339  


Total assets   $ 138,285   $ 89,974  


Liabilities and stockholders' equity   
Accounts payable and accrued liabilities (Note 8)    $ 11,644   $ 10,688  
Accrued profit sharing arrangement (Note 8)     12,749    11,180  
Income tax payable (Note 9)     883    531  
Notes payable and other borrowings, net of discount of zero and  
       $742 as of December 31, 2003 and 2002, respectively (Note 8)     41,178    47,689  
Capital lease obligations (Note 12)     460    344  


Total liabilities    66,914    70,432  


Commitments and contingencies (Note 12)   
Stockholders' equity (Notes 10 and 11):   
Convertible preferred stock, $.01 par value, 5,000 shares  
       authorized, zero shares and 1,000 shares issued and  
       outstanding  
       as of December 31, 2003 and 2002, respectively (Note 3)         10  
Common stock, $.01 par value, 50,000 shares authorized,  
       and 22,003 shares and 7,411 shares issued and outstanding  
       as of December 31, 2003 and 2002, respectively (Notes 2 and 3)   
     220    74  
Additional paid-in capital    65,387    31,479  
Accumulated earnings (deficit)    5,658    (12,388 )
Accumulated other comprehensive income    106    367  


Total stockholders' equity    71,371    19,542  


Total liabilities and stockholders' equity   $ 138,285   $ 89,974  



See accompanying notes to consolidated financial statements.




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Index

Encore Capital Group, Inc.
Consolidated Statements of Operations

(In Thousands, Except Per Share Amounts)

Years ended December 31,



2003 2002 2001



Revenues:                
   Revenue from receivable portfolios (Note5)    $ 115,575   $ 80,961   $ 32,581  
   Revenue from retained interest (Note 6)     307    5,707    9,806  
   Servicing fees and other related revenue (Note 12)     1,620    3,712    5,458  



Total revenues    117,502    90,380    47,845  



Operating expenses:  
   Salaries and employee benefits    39,286    35,137    27,428  
   Other operating expenses    11,335    7,934    5,708  
   Cost of legal collections    15,827    11,028    5,457  
   General and administrative expenses    6,509    6,314    5,750  
   Provision for portfolio losses (Note 5)         1,049      
   Depreciation and amortization (Note 7)     2,023    2,453    2,481  



Total operating expenses    74,980    63,915    46,824  



Income before other income (expense)  
    and income taxes    42,522    26,465    1,021  
Other income (expense):  
   Interest expense (Notes 8)     (20,479 )  (18,592 )  (10,945 )
   Other income (Note 4)     7,380    213    208  



Total other expense    (13,099 )  (18,379 )  (10,737 )



Income (loss) before income taxes    29,423    8,086    (9,716 )
(Provision for) benefit from income  
    taxes (Note 9)     (11,003 )  5,703    (1,149 )



Net income (loss)    18,420    13,789    (10,865 )
Preferred stock dividends (Note 3)     (374 )  (440 )    



Net income (loss) available to common stockholders   $ 18,046   $ 13,349   $ (10,865 )



Weighted average shares outstanding    10,965    7,339    7,161  
Incremental shares from assumed conversion of  
    warrants, options, and preferred stock    9,908    9,120      



Adjusted weighted average shares outstanding    20,873    16,459    7,161  



Earnings (loss) per share – Basic   $ 1.65   $ 1.82   $ (1.52 )



Earnings (loss) per share – Diluted   $ 0.88   $ 0.84   $ (1.52 )




See accompanying notes to consolidated financial statements.




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Index

Encore Capital Group, Inc.
Consolidated Statements of Stockholders' Equity (Deficit) and Comprehensive Income (Loss)

(In Thousands)

Common Stock
Treasury Stock
Preferred Stock
Additional
Paid-In
Accumulated
Earnings
Accumulated
Other
Comprehensive
Shares Par Shares Cost Shares Cost Capital (Deficit) Income Total










Balance at December 31, 2000      7,591   $ 76    430   $ (128 )     $   $ 22,082   $ (14,872 ) $ 2,921   $ 10,079  
   Net loss                                (10,865 )      (10,865 )
   Other comprehensive loss - decrease in unrealized gain
        on investment in retained interest, net of tax                                    (1,725 )  (1,725 )

   Comprehensive loss                                        (12,590 )
   Issuance of common stock warrants (Note 11)                             153            153  
   Treasury stock cancellation    (430 )  (4 )  (430 )  128            (124 )            










Balance at December 31, 2001     7,161    72                    22,111    (25,737 )  1,196    (2,358 )
   Net income                                13,789        13,789  
   Other comprehensive income - unrealized gain on  
        non-qualified deferred compensation plan assets                                    39    39  
   Other comprehensive loss - decrease in unrealized gain 
        on investment in retained interest, net of tax                                    (868 )  (868 )

   Comprehensive income                                        12,960  
   Net proceeds from issuance of Preferred Stock (Note 3)                  1,000    10    4,578            4,588  
   Preferred dividends                                (440 )      (440 )
   Forgiveness of debt, net (Note 3)                             4,665            4,665  
   Issuance of common stock warrants (Note 11)                             125            125  
   Exercise of common stock warrants (Note 11)     250    2                                2  










Balance at December 31, 2002     7,411    74            1,000    10    31,479    (12,388 )  367    19,542  
   Net income                                18,420        18,420  
   Other comprehensive income - unrealized gain on  
        non-qualified deferred compensation plan assets                                    46    46  
   Other comprehensive loss - decrease in unrealized gain 
        on investment in retained interest, net of tax                                    (307 )  (307 )

   Comprehensive income                                                 18,159  
   Preferred dividends                                (374 )      (374 )
   Preferred stock converted to common stock (Note 3)     10,000    100            (1,000 )  (10 )  (90 )            
   Net proceeds from issuance of common stock (Note 2)    3,000    30                    30,101            30,131  
   Exercise of common stock warrants (Note 11)     957    10                    615            625  
   Exercise of stock options (Note 10)     635    6                    608            614  
   Excess tax benefits related to stock options (Note 9)                             2,546            2,546  
   Amortization of stock options issued at below market  
     (Note 10)                             128            128  










 Balance at December 31, 2003     22,003   $ 220       $       $   $ 65,387   $ 5,658   $ 106   $ 71,371  











See accompanying notes to consolidated financial statements.




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Index

Encore Capital Group, Inc.
Consolidated Statements of Cash Flows

(In Thousands)

Years ended December 31,



2003 2002 2001



Operating activities                
Gross Collections   $ 190,519   $ 148,808   $ 83,051  
Proceeds from litigation settlement (Note 4)     11,100          
Less:  
   Amounts collected on behalf of third parties    (4,750 )  (10,494 )  (12,963 )
   Amounts applied to principal on receivable portfolios    (63,374 )  (43,423 )  (16,398 )
   Amounts applied to principal of securitization 98-1    (6,512 )  (7,808 )    
Litigation settlement proceeds applied to principal of receivable portfolios   (692 )        
   Legal and other costs related to litigation settlement    (3,198 )        
Servicing fees    1,620    3,712    5,398  
Operating Expenses  
   Salaries and employee benefits    (38,431 )  (32,909 )  (27,315 )
   Other operating expenses    (11,044 )  (7,800 )  (6,096 )
   Cost of legal collections    (15,827 )  (11,028 )  (5,457 )
   General and administrative    (6,303 )  (6,707 )  (6,162 )
   Interest payments    (5,222 )  (4,146 )  (4,817 )
   Contingent interest payments    (14,455 )  (4,246 )    
   Other income    295    211    197  
   Decrease (Increase) in restricted cash    2,263    (52 )  (585 )
   Income taxes    (2,018 )  572      



Net cash provided by operating activities    33,971    24,690    8,853  



Investing activities   
Purchases of receivable portfolios    (89,834 )  (62,525 )  (39,030 )
Collections applied to principal of receivable portfolios    63,374    43,423    16,398  
Litigation settlement proceeds applied to principal of receivable portfolios   692          
Collections applied to principal of securitization 98-1    6,512    7,808      
Proceeds from put-backs of receivable portfolios    799    882    1,150  
Proceeds from the sale of property and equipment        3    137  
Purchases of property and equipment    (1,015 )  (749 )  (428 )



Net cash used in investing activities    (19,472 )  (11,158 )  (21,773 )



Financing activities   
Proceeds from notes payable and other borrowings    78,226    62,183    28,936  
Repayment of notes payable and other borrowings    (85,478 )  (79,669 )  (14,440 )
Capitalized loan costs relating to financing arrangement    (245 )  (154 )  (55 )
Proceeds from sale of common stock, net (Note 2)     30,131          
Proceeds from exercise of common stock options (Note 10)     614          
Proceeds from exercise of common stock warrants (Notes 2 and 11)     625    2      
Proceeds from sale of preferred stock (Note 3)         4,588      
Payments of preferred dividends    (374 )  (250 )    
Repayment of capital lease obligations    (138 )  (892 )  (997 )



Net cash provided by (used in) financing activities    23,361    (14,192 )  13,444  



Net increase (decrease) in cash    37,860    (660 )  524  
Cash and cash equivalents, beginning of year    752    1,412    888  



Cash and cash equivalents, end of year   $ 38,612   $ 752   $ 1,412  




See accompanying notes to consolidated financial statements.




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Encore Capital Group, Inc.
Consolidated Statements of Cash Flows (continued)
Reconciliation of Net Income (Loss) to Net Cash Provided by Operating Activities

(In Thousands)

Years ended December 31,



2003 2002 2001



Net income (loss)     $ 18,420   $ 13,789   $ (10,865 )
Adjustments to reconcile net income (loss) to net cash  
   provided by operating activities:  
     Depreciation and amortization    2,023    2,452    2,481  
     Amortization of loan costs    603    661    1,457  
     Amortization of debt discount    742    112    146  
     Amortization of stock based compensation    128          
     Gain on sales of property and equipment            (11 )
     Deferred income tax expense (benefit)    5,456    (6,234 )  1,149  
     Excess tax benefits from stock options    2,722          
     Increase in income on retained interest        414    10,816  
     Increase in income on receivable portfolios            450  
     Provision for portfolio losses        1,049      
Changes in operating assets and liabilities  
     (Increase) decrease in restricted cash    2,263    (52 )  (585 )
     Increase in other assets    (1,339 )  (783 )  (1,593 )
     Note payable issued in lieu of interest payment            1,308  
     Increase in accrued profit sharing arrangement    1,569    8,802    2,378  
     Increase in accounts payable and accrued  
       liabilities    1,384    4,480    1,722  



Net cash provided by operating activities   $ 33,971   $ 24,690   $ 8,853  



Supplemental schedules of non-cash investing activities:  
     Property and equipment acquired under capital leases   $ 253   $   $  



Supplemental schedules of non-cash financing activities:  
     Issuance of common stock warrants in connection with  
       debt agreements   $   $ 125   $ 153  



     Recordation of equity in connection with debt forgiveness   $   $ 4,665   $  




See accompanying notes to consolidated financial statements.




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Index

Note 1: Summary of Significant Accounting Policies

Ownership and Description of Business
Encore Capital Group, Inc. (“Encore”) is a systems-driven purchaser and manager of charged-off consumer receivables portfolios. Encore acquires these portfolios at deep discounts from their face values using its proprietary valuation process that is based on the consumer attributes of the underlying accounts. Based upon Encore’s ongoing analysis of these accounts, it employs a dynamic mix of collection strategies to maximize its return on investment. Encore is a Delaware holding company whose principal assets are its investments in its wholly-owned subsidiaries, Midland Credit Management, Inc. (“Midland Credit”), Midland Funding 98-A Corporation (“98-A”), Midland Receivables 99-1 Corporation (“99-1”), Midland Acquisition Corporation (“MAC”), MRC Receivables Corporation (“MRC”), Midland Funding NCC-1 Corporation (“NCC-1”), and Midland Funding NCC-2 Corporation (“NCC-2”) (collectively referred to herein as the “Company”). Encore also has a wholly owned subsidiary, Midland Receivables 98-1 Corporation, which is not consolidated, but is recorded as an investment in retained interest on the accompanying consolidated statements of financial condition. The receivable portfolios consist primarily of charged-off domestic consumer credit card receivables purchased from national financial institutions, major retail credit corporations, and resellers of such portfolios. Acquisitions of receivable portfolios are financed by operations and by borrowings from third parties (see Note 8).

Cash and Cash Equivalents
Cash equivalents consist of highly liquid investments with a maturity of three months or less at the date of purchase. The Company invests its excess cash in bank deposits, money market, and short term commercial debt and auction rate preferred stock and debt securities, which are afforded the highest ratings by nationally recognized rating firms. The carrying amount reported in the balance sheet for cash and cash equivalents approximates its fair value.

Restricted Cash
Restricted cash represents undistributed collections held on behalf of principals. In 2002, restricted cash also included reserve accounts pledged to the Warehouse Securitization and Securitization 99-1 (see Notes 6, 8, and 12).

Investment in Receivable Portfolios
The Company accounts for its investment in receivables portfolios on the “accrual basis” or “cost recovery method” of accounting in accordance with the provisions of the AICPA’s Practice Bulletin 6, “Amortization of Discounts on Certain Acquired Loans.” Static pools are established with accounts having similar attributes, based on the specific seller and timing of acquisition. Once a static pool is established, the receivables are permanently assigned to the pool. The discount (i.e., the difference between the cost of each static pool and the related aggregate contractual receivable balance) is not recorded because the Company expects to collect a relatively small percentage of each static pool’s contractual receivable balance. As a result, receivables portfolios are recorded at cost at the time of acquisition.




74





The Company accounts for each static pool as a unit for the economic life of the pool (similar to one loan) for recognition of revenue from receivables portfolios, for collections applied to principal of receivables portfolios and for provision for loss or impairment. Revenue from receivables portfolios is accrued based on the effective interest rate determined for each pool applied to each pool’s original cost basis. Each pool’s cost basis is increased for revenue earned and decreased for collections and impairments. The effective interest rate is the internal rate of return determined based on the timing and amounts of actual cash received and anticipated future cash flow projections for each pool.

The Company monitors and evaluates actual and projected cash flows for each receivable portfolio on a quarterly basis. Through September 30, 2003, the Company had not increased the total estimated cash flows for any receivable portfolio. As a result, for those portfolios whose actual cumulative collections exceeded the forecast, such excess amounts were subtracted from the future estimated collections in order to maintain the original forecast. However, effective October 1, 2003, the Company implemented new collection forecasts utilizing a newly developed forecasting model, the Unified Collection Score (“UCS”) that considers known data about the Company’s customers’ accounts, including, among other things, its collection experience, and changes in external customer factors, in addition to all data known when it acquired the accounts. The effect of the Company’s change in estimated projected collections resulting from the implementation of the UCS model is discussed at Note 5.

The Company has historically reduced the total forecasted cash flows on certain receivable portfolios where actual cumulative collections to date have not met the forecast. If the remaining forecasted cash flows are in excess of the remaining carrying value, the effective interest is reduced prospectively. If the remaining forecasted cash flows are less than the remaining carrying value, the receivable portfolio is impaired and all of the remaining collections are subsequently applied against book value. Additionally, if the amount and timing of future cash collections are not reasonably estimable, the Company accounts for these portfolios on the cost recovery method (“Cost Recovery Portfolios”).

Collections realized after the net book value of a portfolio has been fully recovered (“Zero Basis Portfolios”) are recorded as revenue (“Zero Basis Income”).

Securitization Accounting
In September 2000, the FASB issued SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” that replaces, in its entirety, SFAS No. 125. The accounting treatment prescribed by this pronouncement was effective for fiscal years ending after December 15, 2000 for disclosure purposes. The adoption of this pronouncement did not have a significant impact on the Company’s consolidated financial statements.




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Retained Interest in Securitized Receivables
From inception in 1999, the Company’s investment in retained interest in securitized receivables was treated as a debt security similar to an available-for-sale security and was carried at fair value. At the time of securitization, the retained interest was initially recorded at the basis allocated in accordance with SFAS No. 125. This original cost basis was adjusted to fair value, which was based on the discounted anticipated future cash flows on a “cash out” basis, with such adjustment (net of related deferred income taxes) recorded as a component of other comprehensive income. The cash out method was used to project cash collections to be received only after all amounts owed to investors had been remitted.

Income on the retained interest was accrued based on the effective interest rate applied to its original cost basis, adjusted for accrued interest and principal pay downs. The effective interest rate was the internal rate of return determined based on the timing and amounts of actual cash received and anticipated future cash flow projections for the underlying pool of securitized receivables.

In January 2001, the Emerging Issues Task Force reached a consensus on EITF 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets.” EITF 99-20 requires companies to account for all changes in forecasted revenues for retained beneficial interests prospectively through a change in the effective interest rate. The Company adopted EITF 99-20 on its effective date, April 1, 2001. Pursuant to EITF 99-20, the retained interest is carried at cost, increased by interest accretion based on estimated future cash receipts and decreased by actual cash collections. The retained interest is estimated to yield a monthly return based on estimated net cash flows derived from historical cash flows. The unrealized gain reflected as a component of stockholders’ equity net of tax is recognized in income utilizing the effective interest method (See Note 6).

The Company monitors impairment of the retained interest based on discounted anticipated future cash flows of the underlying receivables compared to the original cost basis of the retained interest, adjusted for unpaid accrued interest and principal pay downs. The discount rate is based on a rate of return, adjusted for specific risk factors that would be expected by an unrelated investor in a similar stream of cash flows. The retained interest is evaluated for impairment by management quarterly based on current market and cash flow assumptions applied to the underlying receivables. Provisions for losses would be charged to earnings when it is determined that the retained interest’s original cost basis, adjusted for unpaid accrued interest and principal pay downs, is greater than the present value of expected future cash flows. No provision for impairment has ever been recorded for the retained interest.

The retained interest is held by Midland Credit and the related receivable portfolios are held by a wholly-owned, bankruptcy remote, special purpose subsidiary of the Company, Midland Receivables 98-1 Corporation.




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Property and Equipment
Property and equipment are recorded at cost, less accumulated depreciation and amortization. The provision for depreciation and amortization is computed using the straight-line or an accelerated method over the estimated useful lives of the assets as follows:

Leasehold improvements     Lesser of lease term or useful life    
Furniture and fixtures   5 to 7 years  
Computer hardware and software   3 to 5 years  
Vehicles   5 years  


Maintenance and repairs are charged to expense in the year incurred. Expenditures for major renewals that extend the useful lives of fixed assets are capitalized and depreciated over the useful lives of such assets.

Long-Lived Assets
The Company reviews the carrying amount of its long-lived assets and identifiable intangible assets for possible impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.

Contingent Interest
Under the terms of the Company’s Secured Financing Facility, once the Company repays the lender for the notes for each purchased portfolio and collects sufficient amounts to recoup its initial cash investment in each purchased portfolio, the Company shares the residual collections (“Contingent Interest”) from the receivables portfolios, net of its servicing fees, with the lender. The Company makes estimates with respect to the timing and amount of collections of future cash flows from these receivables portfolios. Based on these estimates, the Company records a portion of the estimated future profit sharing obligation as Contingent Interest Expense (see Note 8).

Deferred Court Costs
The Company contracts with a network that acts as a clearinghouse to place accounts for collection with attorneys with whom it contracts in most of the 50 states. The Company generally refers charged-off accounts to its contracted attorneys when it believes the related debtor has sufficient assets to repay the indebtedness and has to date been unwilling to pay. In connection with the Company’s agreement with the contracted attorneys, it advances certain out-of-pocket court costs (“Deferred Court Costs”). The Company capitalizes these costs in its consolidated financial statements and provides a reserve for those costs that it believes will be ultimately uncollectible. The Company determines the reserve based on its analysis of court costs that have been advanced, recovered, and anticipate recovering. Deferred Court Costs, net of the valuation reserves, were $1.3 million and $1.2 million as of December 31, 2003 and 2002, respectively.




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Income Taxes
The Company uses the liability method of accounting for income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes.” Deferred income taxes are recognized based on the differences between financial statement and income tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized (see Note 9).

Stock-Based Compensation
The Company has elected to follow Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, and related interpretations in accounting for its employee