As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 5/10/06  Sourcecorp Inc                    10-Q        3/31/06    5:610K                                   Merrill Corp-MD/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 10-Q        Quarterly Report Pursuant to Sections 13 or 15(D)   HTML    445K 
 2: EX-31.1     Certification per Sarbanes-Oxley Act (Section 302)  HTML     14K 
 3: EX-31.2     Certification per Sarbanes-Oxley Act (Section 302)  HTML     13K 
 4: EX-32.1     Certification per Sarbanes-Oxley Act (Section 906)  HTML      8K 
 5: EX-32.2     Certification per Sarbanes-Oxley Act (Section 906)  HTML      8K 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
		For the quarterly period ended March 31, 2006
OR
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
		For the transition period from                  to

 

Commission file number 0-27444

 

 

SOURCECORP, INCORPORATED

(Exact name of registrant as specified in its charter)

 

DELAWARE		75-2560895
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
3232 MCKINNEY AVENUE, SUITE 1000 DALLAS, TEXAS		75204
(Address of principal executive offices)		(Zip code)
REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (214) 740-6500

 

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  ý  No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check One):

 

Large Accelerated Filer o

Accelerated Filer ý

Non-Accelerated Filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No  ý

 

As of April 30, 2006, 15,684,952 shares of the registrant’s Common Stock, $.01 par value per share, were outstanding (excluding 516,599 shares of unvested restricted stock).

 

 

PART I. FINANCIAL INFORMATION

 

Item 1.                   Financial Statements

 

SOURCECORP, INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE DATA)

 

		December 31, 2005			March 31, 2006
		(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents		$	2,317		$	1,990
Accounts and notes receivable, less allowance for doubtful accounts of $10,219 and $12,680, respectively		68,444			79,741
Inventories		640			616
Deferred income taxes		7,835			7,528
Prepaid expenses and other current assets		6,921			6,356
Total current assets		86,157			96,231
PROPERTY, PLANT AND EQUIPMENT, net of accumulated depreciation of $49,292 and $51,737, respectively		39,939			37,437
GOODWILL		286,101			286,101
INTANGIBLES, net of amortization of $2,525 and $2,731, respectively		4,079			3,873
OTHER NONCURRENT ASSETS		2,360			2,343
Total assets		$	418,636		$	425,985
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued liabilities		$	48,982		$	45,874
Current maturities of long-term obligations		128			109
Income tax payable		242			2,902
Total current liabilities		49,352			48,885
LONG-TERM OBLIGATIONS, net of current maturities		37,924			40,032
DEFERRED INCOME TAXES		26,064			25,981
OTHER LONG-TERM OBLIGATIONS		935			1,023
Total liabilities		114,275			115,921
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ EQUITY:
Preferred stock, $.01 par value, 1,000,000 shares authorized, no shares issued or outstanding		—			—
Common stock, $.01 par value, 26,000,000 shares authorized, 15,659,348 and 15,720,122 shares issued and 15,622,678 and 15,683,452 shares outstanding at December 31, 2005 and March 31, 2006, respectively		157			157
Additional paid-in-capital		197,684			192,857
Retained earnings		113,023			117,551
		310,864			310,565
Less— Treasury stock, at cost, 36,670 shares		(501		)	(501		)
Less— Deferred compensation		(6,002		)	—
Total stockholders’ equity		304,361			310,064
Total liabilities and stockholders’ equity		$	418,636		$	425,985

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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SOURCECORP, INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

 

		Three Months Ended March 31,
		2005			2006
		(Unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES:
Income from continuing operations		$	7,355		$	4,637
Adjustments to reconcile income to net cash provided by (used in) operating activities:
Depreciation and amortization		3,629			3,858
Deferred income tax provision (benefit)		(1,900		)	223
Stock based compensation expense		631			961
Loss on sale of property, plant and equipment		15			210
Change in operating assets and liabilities:
Accounts and notes receivable		(8,303		)	(11,092		)
Inventories, prepaid expenses and other assets		(1,441		)	605
Accounts payable and accrued liabilities		(4,435		)	1,180
Excess tax benefit from exercise of stock options		—			(40		)
Net cash provided by (used in) operating activities from continuing operations		(4,449		)	542
Net cash provided by (used in) operating activities from discontinued operations		(171		)	—
Net cash provided by (used in) operating activities		(4,620		)	542
CASH FLOWS FROM INVESTING ACTIVITIES:
Net proceeds received from divestitures		224			45
Purchase of property, plant and equipment		(5,705		)	(2,581		)
Proceeds from disposition of property, plant and equipment		3			64
Cash paid for acquisitions, net of cash acquired		(34		)	(1,000		)
Net cash used in investing activities from continuing operations		(5,512		)	(3,472		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of common stock options		—			475
Excess tax benefit from exercise of stock options		—			40
Proceeds from long-term obligations		52,975			57,782
Principal payments on long-term obligations		(46,321		)	(55,694		)
Net cash provided by financing activities from continuing operations		6,654			2,603
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(3,478		)	(327		)
CASH AND CASH EQUIVALENTS, beginning of period		3,722			2,317
CASH AND CASH EQUIVALENTS, end of period		$	244		$	1,990
SUPPLEMENTAL DATA:
Cash paid for:
Income taxes, net of income tax refunds		$	11		$	146
Interest		$	1,209		$	521
NONCASH OPERATING AND INVESTING TRANSACTIONS:
Common stock retained and retired related to employee payroll tax obligations associated with restricted stock vesting (0 and 16,726 shares, respectively)		$	—		$	(411	)
Accrued proceeds from disposition of property, plant and equipment		$	—		$	(250	)
Accrued capital expenditures		$	—		$	(908	)

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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SOURCECORP, INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. Basis of Presentation

 

The accompanying condensed consolidated financial statements and related notes to the condensed consolidated financial statements include the accounts of SOURCECORP, Incorporated and subsidiaries (collectively, the “Company”).  All significant intercompany accounts and transactions have been eliminated in consolidation. These condensed consolidated financial statements have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “Commission”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that all disclosures are adequate to make the information presented not misleading.  These condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and the related notes thereto in the Annual Report on Form 10-K filed with the Commission on March 31, 2006 as amended by Form 10-K/A filed with the Commission on April 26, 2006.

 

In the opinion of management, all adjustments necessary to fairly present the Company’s financial position at March 31, 2006, and results of operations and cash flows for the three months ended March 31, 2006 and 2005 have been included. The results of operations for the three months ended March 31, 2006 are not necessarily indicative of the results to be expected for the full fiscal year or for any future periods.

 

The Company uses estimates and assumptions required for preparation of the financial statements. The estimates are primarily based on historical experience and business knowledge and are revised as circumstances change. However, actual results could differ from the estimates.

 

2. Reserves and Other Loss Contingencies

 

Self-Insurance Liabilities and Reserves.  The Company is self-insured for workmen’s compensation liabilities and a significant portion of its employee medical costs. The Company accounts for its self-insurance programs based on actuarial estimates of the amount of loss inherent in that period’s claims, including losses for which claims have not been reported. These loss estimates rely on actuarial observations of ultimate loss experience for similar historical events. The Company limits its risk by carrying stop-loss policies for significant claims incurred for both workmen’s compensation liabilities and medical costs. The Company’s exposure under the stop-loss policies for workmen’s compensation and medical costs is limited based on fixed dollar amounts.  For workman’s compensation, the fixed dollar amount of stop-loss coverage is $500,000 per occurrence.  For medical costs, the fixed dollar amount of stop-loss coverage was $100,000 per covered participant for the fiscal plan year ended June 30, 2005.  The stop-loss policy was renewed for one year, effective July 1, 2005.  The fixed dollar amount of stop-loss coverage under the new policy is $200,000 per covered participant with a lifetime limit of liability per covered participant of $1,800,000.

 

Accrual balances related to workmen’s compensation and medical costs, included in accrued liabilities in the Condensed Consolidated Balance Sheets, are as follows (in thousands):

 

		December 31, 2005			March 31, 2006
Workmen’s Compensation		$	2,288		$	2,410
Employee Medical Insurance		1,734			2,103
Total		$	4,022		$	4,513

 

Other Loss Contingencies.  The Company records liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 5, Accounting for Contingencies.  Disclosure is required when there is a reasonable possibility that the ultimate loss will exceed the recorded provision. Contingent liabilities are often resolved over long periods of time. Estimating probable losses requires analysis of multiple forecasts that often depend on judgments about potential actions by third parties such as regulators. The Company’s loss contingencies consist primarily of estimates related to the probable outcome of pending litigation.  See Note 8, Litigation.

 

3. Stockholders’ Equity and Stock-Based Compensation

 

Stock-Based Compensation

 

In 2002, the Board of Directors and Shareholders of the Company approved the SOURCECORP, Incorporated 2002 Long-Term Incentive Plan (the “2002 Plan”), which replaced the 1995 Stock Option Plan, as amended (the “1995 Plan”). The 2002 Plan

 

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authorizes awards of options to purchase common stock and may include incentive stock options (“ISOs”) and/or non-qualified stock options (“NQSOs”), stock appreciation rights, restricted stock, deferred stock, bonus stock and awards in lieu of cash obligations, dividend equivalents and other stock based awards.

 

The Board of Directors has appointed a committee (the “Committee”), which is composed of independent, non-employee directors, to administer the 2002 Plan. Persons eligible to receive awards under the plan include directors, officers, employees of the Company and its subsidiaries, and persons who provide consulting services to the Company deemed by the Committee, or the Board as a whole, to be of substantial value to the Company, persons who have been offered employment by the Company or its subsidiaries, and persons employed by an entity that the Committee reasonably expects to become a subsidiary of the Company. Awards granted under the 2002 Plan may, at the discretion of the Committee, be granted either alone or in addition to, in tandem with or in substitution for any other award granted under the 2002 Plan or any other plan of the Company, any subsidiary or any business entity to be acquired by the Company or one of its subsidiaries. The Committee determines vesting in awards granted under the 2002 Plan.

 

Prior to January 1, 2006, the Company accounted for its stock-based compensation plans under the provisions of Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees, and related interpretations and applied the disclosure-only provisions of SFAS No 123, Accounting for Stock-Based Compensation.   Accordingly, the Company recognized compensation expense related to grants of restricted stock awards, but no compensation expense was recognized for grants of stock option and warrant awards as the exercise price of the stock option and warrant awards was equal to the market price of the common stock on the date of grant.

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), Share-Based Payment, which eliminates the alternative to account for employee stock options under APB No. 25 and requires the fair value of all share-based payments to employees, including the fair value of grants of employee stock options, be recognized in the condensed consolidated statements of operations, generally over the vesting period.  The pro-forma disclosures previously permitted under SFAS No. 123 are no longer an alternative to financial statement recognition.

 

On January 1, 2006, the Company adopted SFAS No. 123(R) using the modified prospective transition method.  Under this method, the Company will, on a prospective basis, recognize compensation expense in the condensed consolidated statements of operations for (i) all stock-based awards granted prior to, but not yet vested as of January 1, 2006 based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 and (ii) all stock –based awards granted or modified subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R).  Results from prior period have not been restated.

 

During the first quarter of 2006, the Company recognized approximately $0.2 million of compensation expense, included in Selling, General and Administrative expenses in the Condensed Consolidated Statements of Operations, related to stock option and warrants awards granted prior to, but not yet vested as of January 1, 2006 as a result of adopting SFAS No. 123(R).  There were no grants or modifications to stock option or warrant awards during the three months ended March 31, 2006.

 

Prior to the adoption of SFAS No. 123(R), the Company presented all tax benefits from deductions resulting from the exercise of stock options as operating cash flows in the its Condensed Consolidated Statements of Cash Flows.  SFAS No. 123(R) requires that the portion of benefits resulting from tax deductions in excess of recognized compensation (the “excess tax benefits”) be presented as financing cash flows.  The excess tax benefits were approximately $0.04 million for the first quarter of 2006 and would have been presented as an operating cash inflow prior to the adoption of SFAS No. 123(R).  In addition, the Company previously presented deferred compensation as a separate component of Stockholders’ Equity.  In accordance with the provisions of SFAS No. 123(R), the Company reclassified the deferred compensation balance to additional paid-in-capital on its accompanying Condensed Consolidated Balance Sheets.

 

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5. Business Combinations

 

Intangibles

 

The components of intangibles are as follows (in thousands):

 

		December 31, 2005							March 31, 2006
		Gross Carrying Value				Accumulated Amortization			Gross Carrying Value			Accumulated Amortization
Customer relationships		$		4,283		$	(1,350	)	$	4,283		$	(1,417	)
Non-compete agreements		2,321				(1,175		)	2,321			(1,314		)
Total		$	6,604			$	(2,525	)	$	6,604		$	(2,731	)

 

Aggregate amortization expense related to intangibles for the three months ended March 31, 2005 and 2006 was approximately $0.2 million and $0.2 million, respectively.  Estimated amortization expense for the years ending December 31, 2006 through December 31, 2010 and thereafter is presented in the table below.

 

 

Contingent Consideration

 

Certain of the Company’s acquisitions were subject to adjustments in overall consideration and recorded goodwill based upon the achievement of specified revenue and/or earnings targets generally over one to three year periods. In certain agreements, the Company reserves the right to change the payment mix to use common stock versus cash in satisfying contingent consideration liabilities.

 

Management’s evaluation of the cumulative earnings of acquired companies indicated that an acquired company met specified earnings targets beyond a reasonable doubt.  As result, at December 31, 2004, in connection with the 2002 purchase of United Information Services, Inc. (“UIS”), approximately $5.3 million of additional consideration was accrued and classified as other current liabilities in the consolidated balance sheet.  Pursuant to the terms of the UIS purchase agreement, approximately $4.3 million of additional contingent consideration was paid in cash to the former shareholders during the second quarter of 2005 and approximately $1.0 million of additional contingent consideration was paid in cash to the former shareholders during the first quarter of 2006.

 

As of December 31, 2004, all periods applicable for earnout targets of past acquisitions were completed.  As of March 31, 2006, all amounts due under earnout agreements of past acquisitions have been paid and there are no further amounts due.

 

6. Segment Reporting

 

The Company aggregates its service offerings and operations into two reportable segments: (i) Information Management and

Distribution, and (ii) Healthcare, Regulatory, and Legal Compliance. The Company’s reportable segments are organized around customer types and service offerings possessing similar economic characteristics. Management evaluates segment performance based on revenue and income before income taxes. All centrally incurred corporate costs are allocated to the segments based principally on operating income of the reportable segments.  The reporting segments follow the same accounting policies used for the Company’s consolidated financial statements.

 

The identified segments are as follows:

 

Information Management and Distribution.  This segment offers Business Process Outsourcing (“BPO”) solutions that help its customers manage the Document In-flow, Workflow Processing and Statement Out-flow of their mission critical business document processes. This segment’s BPO solutions enable customers to automate their complex workflow processes by digitizing large volumes of documents, capturing information from the documents, hosting electronic documents on the Company’s Web-based repository, and preparing statements that customers mail or present electronically to their end users.

 

11

 

Healthcare, Regulatory and Legal Compliance.  This segment offers specialized knowledge-based processing and consulting services that include medical records release, record management services for healthcare institutions, temporary staffing for healthcare institutions, providing managed care compliance reviews, class action claims administration services, and professional economic research and litigation services.

 

The Company measures segment profit as income from continuing operations before income taxes. Information on the segments follows (in thousands):

 

		THREE MONTHS ENDED MARCH 31, 2006
		Information Management and Distribution			Healthcare, Regulatory and Legal Compliance			Consolidated
Revenue		$	52,996		$	52,287		$	105,283
Income (loss) from continuing operations before income taxes		3,271			4,437			7,708

 

		THREE MONTHS ENDED MARCH 31, 2005
		Information Management and Distribution			Healthcare, Regulatory and Legal Compliance			Consolidated
Revenue		$	56,295		$	49,637		$	105,932
Income from continuing operations before income taxes		5,816			6,249			12,065

 

7.  Potential Merger

 

On March 8, 2006, the Company announced that it had entered into an Agreement and Plan of Merger, dated as of March 7, 2006 (the “Merger Agreement”), among the Company, CorpSource Holdings, LLC (“Purchaser”) and CorpSource MergerSub, Inc. (“Merger Sub”). Purchaser and Merger Sub are entities affiliated with Apollo Management, L.P. (“Apollo”). The Merger Agreement contemplates that Merger Sub will be merged with and into the Company (the “Merger”) and each outstanding share of common stock of the Company will be converted into the right to receive $25.00 per share in cash, without interest. The consummation of the Merger is subject to various customary conditions, including adoption of the Merger Agreement by the Company’s stockholders, expiration of the antitrust waiting period (which has expired), the absence of a material adverse change in the Company’s business and the receipt of committed debt financing by Purchaser. No assurance can be given that such conditions will be satisfied or waived.  In the event the potential Merger closes, the Company will incur additional transaction costs and expenses related to investment banker fees, outside legal counsel fees, change of control payments and acceleration of stock-based compensation vesting.

 

The Merger Agreement contains representations and warranties by the Company, Purchaser and Merger Sub. The representations and warranties reflect negotiations between the parties to the Merger Agreement and, in certain cases, merely represent allocation decisions among the parties and may not be statements of fact. As such, the representations and warranties are solely for the benefit of the parties to the Merger Agreement and may be limited or modified by a variety of factors, including: subsequent events, information included in public filings, disclosures made during negotiations, correspondence between the parties and disclosure schedules to the Merger Agreement. Accordingly, the representations and warranties may not describe the actual state of affairs at the date they were made or at any other time and you should not rely on them as statements of fact.

 

8. Litigation

 

The Company is, from time to time, a party to litigation. The following is a description of the most significant legal matters that the Company is involved in.  In the event of an adverse outcome in one or more of the legal proceedings the Company’s business, financial condition, results of operations or cash flows could be materially adversely affected.

 

Davidco Litigation

 

On March 8, 2006, a purported class action complaint (the “Davidco Complaint”) challenging the proposed Merger with entities affiliated with Apollo was filed by a putative stockholder of the Company in an action styled Davidco Investments, on behalf of itself and all others similarly situated v. Ed H. Bowman, Jr., et al., C.A. No. 1982-N (the “Davidco Action”), pending in the Court of the Chancery of the State of Delaware, County of New Castle, against the Company, certain of its officers and directors (the “Davidco Individual Defendants”) and Apollo.  See Note 7, Potential Merger.  The Davidco Complaint alleges a claim for breach of fiduciary duties against the Davidco Individual Defendants, alleging, among other things, that the consideration to be paid to the stockholders of the Company in the Merger is unfair and inadequate and was not the result of a full and fair sale process or adequate market check.  The Davidco Complaint also asserts a claim against Apollo for allegedly aiding and abetting such purported breaches of fiduciary duties.

 

12

 

Item 2.                   Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

We were founded in September 1994, to create a national, single source provider of document and information outsourcing solutions to document and information intensive industries, including healthcare insurance, financial services, healthcare provider, transportation/logistics, federal and state government, and legal industries.  We acquired the seven founding companies (the “Founding Companies”) simultaneously with the closing of our initial public offering (the “IPO”) on January 26, 1996, and effectively began operations at that time. The consideration for the Founding Companies consisted of a combination of cash and common stock of our Company.

 

Since the IPO and through March 31, 2005, we have acquired 66 companies and divested 22 operating units by sales or closures. We evaluate candidates for acquisition and periodically for divestiture as a part of our strategic plan of providing customers a single solution for business process outsourcing and knowledge-based processing and consulting services. The criteria for evaluation include geographic need, additional technology, market growth potential, industry expertise, service expansion to broaden service offerings, expansion of our customer base, revenue and earnings growth potential, and expected sources and uses of capital.

 

During the first quarter of 2005, we completed the sale of an asset group that provides computer application software and services to the public sector.  This asset group was related to our litigation services operations and was previously reported in our Healthcare, Regulatory and Legal Compliance segment.  This asset group incurred losses, net of tax, of $0.2 million for the full year ended December 31, 2004.  See Note 4, Discontinued Operations, of Notes to Condensed Consolidated Financial Statements, for a more detailed discussion.

 

Additionally, during the first quarter of 2005, the Company entered into an agreement with one of its customers impacted by the facts relating to the subject of the internal investigation. As a result of the agreement, during the first quarter of 2005, the Company recognized remediation revenue of $4.1 million related to revenue reversals in 2004; however, such revenue did not contribute to our operating cash flow during 2005.

 

During the first quarter of 2006, the Company recognized a previously anticipated contract termination payment/settlement of $2.6 million from a large government customer relating to a contract terminated in connection with a substantial change in their operational plans.  As a part of such termination, we recognized revenue of approximately $1.5 million, which helped offset lower volumes from our mortgage and healthcare service offerings, and $1.1 million for cost recovery of actual cost incurred, which was recorded as an approximate $0.6 million reduction in Cost of Services, an approximate $0.2 million reduction in Selling, General and Administrative Expenses and an approximate $0.3 million reduction of Other (Income) Expense in the Condensed Consolidated Statements of Operations .  Our project oriented Class Action Claims Administration service offering and Legal Consulting service offering reported stronger revenues and margins.  Partially offsetting these increases during the current quarter were incremental costs related to the potential Merger and higher than expected costs associated with ongoing Sarbanes Oxley compliance and other expenses.

 

Basis for Management Discussion and Analysis

 

The following discussion and analysis focuses on the results of operations and financial condition from the Company’s continuing operations; as such, in accordance with Statement of Financial Accounting Standards No. 144, references and comparisons to prior periods exclude the impact of our discontinued operations.

 

Our revenue possesses both project and recurring characteristics.  Project revenue includes one-time projects in which the customer relationship is not expected to continue after project completion. Project revenue margins are usually higher than our average margins and the workload can be highly volatile.  Project revenue is typically based on time and material arrangements and predominately occurs within the Healthcare, Regulatory and Legal Compliance segment.  Recurring revenue is characterized by customer relationships that are generally for one year and may continue for longer.  Recurring revenue is typically based on transaction volumes sent to us by our customers at an agreed upon fixed rate per unit.  Our customers’ volumes are generally not contractually or otherwise guaranteed.  Recurring revenue typically possesses lower margins than project revenue but is usually more predictable.

 

Cost of services consists primarily of compensation and benefits to employees providing goods and services to our clients; occupancy costs; equipment costs and supplies. Our cost of services also includes, to a limited extent, the cost of products sold for micrographics supplies and equipment; computer hardware and software; and business imaging supplies and equipment.

 

Selling, general and administrative expenses (“SG&A”) consist primarily of compensation and related benefits to sales and marketing, executive management, accounting, human resources and other administrative employees; other sales and marketing costs; communications costs; insurance costs; and legal and accounting professional fees and expenses.

 

In addition, the Condensed Consolidated Financial Statements included in Item 1 “Financial Statements”, should be read in

 

16

 

conjunction with our Consolidated Financial Statements and the related notes thereto in the Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2006.

 

Business Segments

 

We aggregate our service offerings and operations into two reportable segments: (i) Information Management and Distribution, and (ii) Healthcare, Regulatory, and Legal Compliance. Service offerings are aggregated when they are similar in the following areas: economic characteristics, products and services, production processes, methods for distributing or delivering products, and type or class of customers. We evaluate segment performance based on revenue and income before income taxes. All centrally incurred corporate costs are allocated to the segments based principally on operating income of the reportable segments. The reporting segments follow the same accounting policies used for our Consolidated Financial Statements as described in the summary of critical accounting policies.

 

The identified segments are as follows:

 

Information Management and Distribution.  We offer Business Process Outsourcing (“BPO”) solutions that help our customers manage the Document In-flow, Workflow Processing and Statement Out-flow of their mission critical business document processes. Our BPO solutions enable customers to automate their complex workflow processes by digitizing extremely large volumes of documents, capturing information from the documents, hosting electronic documents on our Web-based repository, and preparing statements that customers mail or present electronically to their end users.  We offer our BPO solutions to businesses in document intensive industries, such as healthcare insurance, financial services, healthcare provider, transportation/logistics, and federal and state government.  For the three months ended March 31, 2005 and 2006, revenue in the Information Management and Distribution segment consisted of approximately $47.9 million and $47.2 million of recurring revenue, respectively, and $8.4 million and $5.8 million of project revenue, respectively.

 

Healthcare, Regulatory and Legal Compliance.  We offer specialized knowledge-based processing and consulting services that include medical records release, record management services for healthcare institutions, temporary staffing for healthcare institutions, temporary staffing for healthcare institutions, providing managed care payment compliance reviews, class action claims administration services, professional economic research and litigation services, and tax benefit services. For the three months ended March 31, 2005 and 2006, revenue in the Healthcare, Regulatory and Legal Compliance segment consisted of approximately $18.7 million and $17.8 million of recurring revenue, respectively, and $30.9 million and $34.5 million of project revenue, respectively.

 

Internal Investigation

 

During October 2004, the Company, with the oversight and approval of the Audit Committee of our Board of Directors, initiated an investigation of the financial results of one of our operating subsidiaries in the Information Management and Distribution reportable segment (the “Operating Subsidiary”). The findings of the investigation concluded that the Operating Subsidiary had incorrectly recognized revenue for certain customer arrangements and omitted certain operating expenses from its financial results which in turn resulted in overpayments and over accruals of contingent consideration amounts due under the earn-out provisions of the acquisition agreement for the Operating Subsidiary.  The overpayments and over accruals of contingent consideration amounts had been originally recognized as additional goodwill of the acquired business.

 

As described in our critical accounting policies, revenue is recognizable when each of the following conditions is met: persuasive evidence of an arrangement exists, the price is fixed or determinable, delivery has occurred or services have been rendered and collection is reasonably assured. Our investigation identified certain instances where one or more of the aforementioned revenue recognition conditions as applied to certain customer contracts were not met by the Operating Subsidiary. As a result, the revenue previously recognized that did not meet all the mentioned revenue recognition conditions was reversed, resulting in a downward adjustment to certain asset accounts or the recognition of a customer liability or deferred revenue.

 

THREE MONTHS ENDED MARCH 31, 2005 COMPARED TO THREE MONTHS ENDED MARCH 31, 2006

 

		Three Months Ended March 31,
		2005					2006
		($000’s)			% of Revenue		($000’s)			% of Revenue
Revenue		$	105,932		100.0	%	$	105,283		100.0	%
Gross Profit		43,974			41.5	%	42,866			40.7	%
SG&A		30,221			28.5	%	34,309			32.6	%
Operating income		13,546			12.8	%	8,351			7.9	%
Income from continuing operations before income taxes		12,065			11.4	%	7,708			7.3	%
Income from continuing operations		7,355			6.9	%	4,637			4.4	%

 

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$2.8 million.  The decline was primarily driven by the factors impacting SG&A discussed above offset by the gross profit increase of 2.0%.

 

Provision for income taxes

 

During the first quarter of 2006, our effective tax rate increased to 39.8% compared to 39.0% during the same quarter of the previous year.  The increase is driven by limitations of the deductibility of individual compensation expense in excess of $1.0 million.  Without this limitation, the effective tax rate for fiscal 2006 would be comparable to that of the first quarter of 2005.

 

LIQUIDITY AND CAPITAL RESOURCES

 

At March 31, 2006, we had $47.3 million of working capital, including $2.0 million of cash.  Working capital at December 31, 2005 was $36.8 million, including $2.3 million of cash.  For the first three months of 2006, net cash provided by operating activities from continuing operations was $0.5 million compared to cash used by operating activities from continuing operations of $4.6 million for the same period in 2005.  Factors impacting the net cash provided by operating activities from continuing operations consist of:  (i)  increased accounts receivable balances related to slower collections of approximately $6.6 million, primarily within in our Information Management and Distribution reportable segment combined with higher consolidated revenues in the current quarter, (ii) changes in compensation related accruals of approximately $6.2 million due to annual incentive compensation payments during the quarter and the timing of payroll fundings at the end of the current quarter, (iii) an approximate $4.5 million increase in accounts payable and accrued liabilities related to the timing of payments and (iv) an approximate $2.7 million increase in income taxes payable during the current quarter.

 

Days sales outstanding increased four business days during the quarter to 48 business days at March 31, 2006, compared to 44 business days at December 31, 2005.  Management expects collections of accounts receivable balances to improve during the remainder of fiscal 2006 and as a result, expects days sales outstanding to improve to 44 to 45 days.

 

For the three months ended March 31, 2006, investing activities from continuing operations consisted of acquisitions of property, plant and equipment of $2.6 million and the payment of approximately $1.0 million in contingent consideration related to the 2002 acquisition of United Information Services, Inc.  See Note 5, Business Combinations.

 

Net cash provided by financing activities from continuing operations was $2.6 million for the three months ended March 31, 2006.  Borrowings from our line of credit of $57.8 million were partially offset by payments on our line of credit of $55.7 million.  We utilize our line of credit to fund general operating requirements of the Company as well as fund significant investments such as acquisitions or capital expenditures.

 

On September 29, 2005, the Company amended its revolving credit facility. Under the amended and restated credit agreement (the “2005 Credit Agreement”), with Bank of America as agent and SunTrust Bank and JP Morgan Chase as co-agents, the Company may borrow on a revolving credit basis loans in an aggregate outstanding principal amount up to $100 million, subject to certain customary financial covenants and ratios. Additionally, the 2005 Credit Agreement contains an accordion provision for an additional $50 million.

 

The annual interest rate applicable to borrowings under the 2005 Credit Agreement is, at the Company’s option, (i)  pricing equaling the higher of (a) the Federal Funds Rate plus  ¹/₂ of 1% and (b) the prime rate as set by Bank of America or (ii) grid pricing ranging from 0.75% to 1.00% plus LIBOR based on the ratio of funded debt to earnings before interest, taxes, depreciation and amortization (“EBITDA”) (as defined in the credit agreement). The outstanding principal balance of revolving credit loans is due and payable on September 29, 2008.

 

As of March 31, 2006, we have outstanding irrevocable letters of credit totaling approximately $13.0 million. Letters of credit in the amount of approximately $8.0 million serves as security for the Company’s self-insured workmen’s compensation program. A letter of credit in the amount of $5.0 million serves as a guarantee for performance under a contract with New York State Workers Compensation Board.

 

As of March 31, 2006, the availability under the 2005 Credit Agreement was approximately $46.9 million and we are in compliance with all loan covenants.

 

Management believes that it has sufficient liquidity from its cash flow and its revolving credit facility to meet ongoing business needs.  Additionally, depending on the mix of stock and cash used in our strategic acquisition program, if any, we may need to seek further financing through the public or private sale of equity or debt securities.  However, there can be no assurance we could secure such financing if and when it is needed or with terms we deem acceptable.

 

In January 2000, we registered on Form S-4 (Registration No. 333-92981) 3,012,217 shares of common stock for issuance in connection with our acquisition program (the “Acquisition Shelf”), of which 1,359,852 shares were available as of March 31, 2006; however, such registration statement may require amendment prior to use.

 

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Critical Accounting Policies

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations are based on the related consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of the financial statements requires the use of estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses.

 

We have identified the following critical accounting policies that, as a result of the judgments, uncertainties, uniqueness and complexities of the underlying accounting standards and operations involved, could result in material changes to our financial condition or results of operations under different conditions or using different assumptions. We apply a consistent methodology at the end of each quarter to determine our account balances that require judgmental analysis.

 

Revenue Recognition.   Revenue is recognized as it becomes realized or realizable and earned according to the criteria provided by Staff Accounting Bulletin 104, Revenue Recognition. Revenue recognition occurs once persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the sales price is fixed or otherwise determinable, and collection is reasonably assured. Our revenue-earnings activities possess project and recurring customer relationships.

 

Project revenue includes one-time projects in which the customer relationship is not expected to continue after project completion. Project revenue is typically based on time and material arrangements. Revenue recognition occurs at the contractual rates as the labor hours and direct expenses are incurred.

 

Recurring revenue is characterized by customer relationships that are generally for one year and may continue for longer. Recurring revenue is typically based on the transaction volumes provided by our customers at an agreed upon fixed rate per unit. Our customer’s volumes are typically not contractual or otherwise guaranteed. Revenue recognition occurs once work is completed and delivery has occurred or services have been rendered.

 

Revenue recognition policies related to offerings within our Information Management and Distribution segment are based upon objective criteria that do not require significant estimates or uncertainties. For example, business process outsourcing services are recognized proportionally as services are rendered, based on specific, objective criteria under the contracts for the number of accounts or transactions processed. Accordingly, revenues recognized under these methods do not require the use of significant estimates that are susceptible to change.

 

Revenue recognition policies within our Healthcare, Regulatory, and Legal Compliance segment are based upon objective criteria that do not require significant estimates or uncertainties.  For example, transaction volumes and time and costs under time and material and cost reimbursable arrangements are based on specific, objective criteria under the contracts.  The following outlines specific revenue recognition policies related to certain offerings within this segment:

 

Medical records release services — revenue is recognized upon completion of the processing of the requested medical records.  Revenue recognition for this service is based on an agreed upon and in some cases, a regulated rate applied to the number of records processed.  When a fee is paid to the hospital, the revenue related to that fee is reported on a net basis in accordance with Emerging Issues Task Force (“EITF”) 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, due to the fact that: (a) the primary obligation in the arrangement is borne partially by both SOURCECORP and the hospital; (b) SOURCECORP has no discretion with respect to the supplier of the medical record; and (c) SOURCECORP is not involved in the determination of product or service specifications.

 

Record management services — revenue is recognized as storage services are provided based linear feet of documents stored times a monthly rate for shelf storage and based on a monthly per image rate for images stored electronically.  We recognize fees for processing, retrieval, delivery and return to storage as revenue upon completion of the service at the agreed upon rate applied to the unit count of items serviced.

 

Additional healthcare and compliance services — revenue is recognized for document and data conversion services as the services are provided based upon an agreed upon rate per patient file applied to the number of files processed.  Storage and archiving fees are recognized as revenue as the services are provided based upon an agreed upon monthly rate per file stored or otherwise archived.  Revenue related to coding and abstracting of medical records and staffing services is recognized as the services are provided based on an agreed upon rate applied to the billable hours worked and eligible out-of-pocket expenses defined by the service agreement.  The out-of-pocket expense component is recognized as revenue and cost of services on a gross basis in accordance with EITF Issue 01-14, Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred.  Revenue related to compliance reviews is based primarily on an agreed upon percentage (or commission) of amounts identified and recovered from the third party payers as a fee for services provided.  Revenue is recognized upon successful recovery of underpayments to our clients by their managed care and commercial payers at the agreed upon percentage (or commission).

 

Class action claims administration services — revenue is recognized as these services are provided based on the agreed upon

 

20

 

rate applied to the number of hours spent providing services related to administering the legal settlements and expenses incurred.  The out-of-pocket expense component is recognized as revenue and cost of services on a gross basis in accordance with EITF Issue 01-14, Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred.  In addition, revenue related to the design and implementation of comprehensive notification plans is based on an agreed upon percentage (i.e., commission) of the cost to place the media communication.  Revenue is recognized at the time of public delivery of the notification through the various media outlets at the agreed upon percentage (or commission).

 

Professional economic research and litigation services — revenue is recognized as these services are provided based on consulting hours worked at agreed upon rates at the time services are rendered and expenses are incurred.  The out-of-pocket expense component is recognized as revenue and cost of services on a gross basis in accordance with EITF Issue 01-14, Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred.

 

As a part of providing services to our customers, we incurs incidental expenses commonly referred to as “out-of-pocket” expenses. These expenses include items such as airfare, hotels, mileage, etc. and are often reimbursable by our customers. When reimbursable, we record both revenue and direct cost of services in accordance with the provisions of EITF Issue 01-14, Income Statement Characterization of Reimbursements Received for “Out-of-Pocket’ Expenses Incurred.

 

Unearned income, included in other current liabilities, represents payments from the Company’s customers in advance of services being provided. Advanced payments are deferred as unearned income when received and recognized as revenue as services are rendered.

 

Allowance for Doubtful Accounts.  The allowance for doubtful accounts is established and maintained based on our estimate of accounts receivable collectibility. Management estimates collectibility by specifically analyzing accounts receivable aging and other historical factors that affect collections. Such factors include the historical trends of write-offs and recovery of previously written-off accounts, the financial strength of the customer and projected economic and market conditions. The evaluation of these factors involves subjective judgments and changes in these factors may significantly impact our consolidated financial statements.

 

Long-Lived Asset and Other Intangible Asset Impairment.  As required by SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, management continually evaluates whether events and circumstances indicate that the carrying value of long-lived assets and intangible assets may not be recoverable. When events require, management performs the valuation by comparing the estimated undiscounted future cash flows over the remaining life of the long-lived assets and intangible assets to the carrying amount of the asset being evaluated. An impairment loss is recognized if the carrying amount of assets being evaluated exceeds the expected future undiscounted cash flow based on the difference between the carrying value and fair value..

 

Goodwill Impairment.  On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets. This statement states that goodwill and intangible assets that have indefinite useful lives will not be amortized but rather will be tested at least annually for impairment. Our annual impairment test is performed as of October 31^st each year.  The impairment test is based on fair value rather than undiscounted cash flows. Additionally, goodwill is tested at a reporting unit level rather than the individual operating unit level. A reporting unit is either at the operating segment level or one reporting level below and could consist of several service offerings aggregated into a single reporting unit. Service offerings are aggregated when they are similar in the following areas: economic characteristics, products and services, production processes, methods for distributing or delivering products, and type or class of customers. Valuation methods used in determining fair value include an analysis of the cash flows that the reporting units can be expected to generate in the future (Income Approach) and the fair value of a reporting unit as compared to similar publicly traded companies (Market Approach). In preparing these valuations, management utilizes estimates to determine fair value of the reporting units. These estimates include future cash flows, growth rates, capital needs, and projected earning margins among other factors. Estimates utilized in future calculations could differ from estimates used in the current period. Future years’ estimates that are unfavorable compared to current estimates could cause an impairment of goodwill and other intangible assets. Due to the fact that we are primarily a services company, our business acquisitions typically result in significant amounts of goodwill and other intangible assets. Therefore, an impairment charge resulting from goodwill or other intangible assets could result in a material adverse impact on our financial statements during the period incurred.

 

Self-Insurance Liabilities and Reserves. We are self-insured for workmen’s compensation liabilities and a significant portion of our employee medical costs. We account for our self-insurance programs based on actuarial estimates of the amount of loss inherent in that period’s claims, including losses for which claims have not been reported. These loss estimates rely on actuarial observations of ultimate loss experience for similar historical events. We limit our risk by carrying stop-loss policies for significant claims incurred for both workmen’s compensation liabilities and medical costs.

 

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Other Loss Contingencies.  We record liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable in accordance with SFAS No. 5, Accounting for Contingencies. Disclosure is required when there is a reasonable possibility that the ultimate loss will exceed the recorded provision. Contingent liabilities are often resolved over long periods of time. Estimating probable losses requires analysis of multiple forecasts that often depend on judgments about potential actions by third parties such as regulators. Our loss contingencies consist primarily of estimates related to the probable outcome of current litigation.

 

Recent Accounting Pronouncements

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), Share-Based Payment, which eliminates the alternative to account for employee stock options under APB Opinion 25 and requires the fair value of all share-based payments to employees, including the fair value of grants of employee stock options, be recognized in the income statement, generally over the vesting period.

 

In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No. 107, which provides additional implementation guidance for SFAS 123(R). Among other things, SAB 107 provides guidance on share-based payment valuations, income statement classification and presentation, capitalization of costs and related income tax accounting.

 

SFAS 123(R) provides for adoption using either the modified prospective or modified retrospective transition method. The Company adopted SFAS 123(R) on January 1, 2006 using the modified prospective transition method in which compensation cost is recognized beginning January 1, 2006 for all share-based payments granted on or after that date and for all awards granted to employees prior to January 1, 2006 that remain unvested on that date. The Company will continue to use the Black-Scholes option pricing model to determine the fair value of stock option awards.

 

Adoption of SFAS 123(R)’s fair value method will have an effect on results of operations, although it will not have a material impact on the Company’s overall financial position. Had SFAS 123(R) been adopted in prior periods, the effect would have approximated the SFAS 123 pro forma net income and earnings per share disclosures as shown above.  See Note 3, Stockholders’ Equity and Stock-Based Compensation.

 

In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, to clarify that the term conditional asset retirement obligation as used in FASB Statement No. 143 is a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that the enterprise may or may not have control over. This Interpretation requires recognition of a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably determined. This Interpretation is effective no later than the end of the fiscal years ending after December 15, 2005. The adoption of this Interpretation did not have a material impact on the Company’s consolidated financial statements.

 

RISKS ASSOCIATED WITH FORWARD-LOOKING STATEMENTS

 

This Report contains certain forward-looking statements such as our intentions, hopes, beliefs, expectations, strategies, predictions or any other variation thereof or comparable phraseology of our future activities or other future events or conditions within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Act”), and Section 21E of the Securities Exchange Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. Investors are cautioned that all forward-looking statements involve risks and uncertainty, including, without limitation, the actual final costs of our internal investigation, the Company’s ongoing SEC investigation, the potential impairment of our ability to enter into government contracts as a result of the conduct that was the subject of our investigation, remediation costs relating to our investigation, the potential customer impact of the results of the SEC investigation, the effect of our investigation and financial statement restatement on the trading price of our stock, the integration our operating companies, the management of our growth, the timing and magnitude of technological advances, the occurrences of future events that could diminish our customers’ needs for our services, a change in the degree to which companies continue to outsource business processes, the adverse outcome in any given legal proceeding or claim, the denial of insurance on a particular claim or of a party obligated to provide indemnification being financially unable to do so, as well as such other risks set forth under the heading Risk Factors included in our most recent annual report on Form 10-K.

 

Although we believe that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and, therefore, there can be no assurance that the forward-looking statements included in this Report will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. Further, we disclaim any obligation to update any such forward-looking statements, except as required by law.

 

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Item 3.                Quantitative and Qualitative Disclosures about Market Risk

 

We are subject to interest rate risk on our term loans and revolving credit facility.  A 100 basis point increase in short-term interest rates would result in approximately $0.4 million of additional expense in 2006 based on our expected average balance outstanding under the credit facility during 2006.  Interest rates are fixed on the capitalized lease obligations.

 

Item 4.           Controls and Procedures

 

(a) Evaluation of disclosure controls and procedures.

 

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosure. The Company periodically reviews the design and effectiveness of its disclosure controls and internal control over financial reporting. The Company makes modifications to improve the design and effectiveness of its disclosure controls and internal control over financial reporting, and may take other corrective action, if its reviews identify a need for such modifications or actions.

 

There are inherent limitations to the effectiveness of any system of disclosure controls and internal control over financial reporting, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and internal control over financial reporting can only provide reasonable assurance of achieving their control objectives.

 

In connection with the preparation of the Company’s 2005 Annual Report on Form 10-K as filed with the SEC on March 31, 2006, as of December 31, 2005, an evaluation was performed under the supervision and with the participation of the Company’s management, including the CEO and CFO, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in the Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Management concluded that control deficiencies in its internal control over financial reporting as of December 31, 2005 constituted material weaknesses within the meaning of the Public Company Accounting Oversight Board’s Auditing Standard No. 2, “An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements.” The material weaknesses identified by management were disclosed in Item 9A of the Form 10-K. Based on that evaluation, management concluded that the Company’s system of internal control over financial reporting was not effective as of December 31, 2005. As part of its evaluation of the effectiveness of the design and operation of the Company’s internal control over financial reporting as of the end of the period covered by this report, management has (i) identified no material weaknesses other than those described in the Form 10-K and (ii) evaluated whether the material weakness described above continue to exist. Although the Company believes that progress has been made to address these material weakness, management has concluded that the material weakness disclosed in the Company’s Form 10-K continues to exist as of March 31, 2006. Therefore, management has also concluded that the Company’s disclosure controls and procedures were not effective as of March 31, 2006. In light of the material weakness which continues to exist as of March 31, 2006, management performed additional analysis and other post-closing procedures to ensure its condensed consolidated financial statements are prepared in accordance with generally accepted accounting principles.

 

The required certifications of our principal executive officer and principal financial officer are included as exhibits to this Quarterly Report on Form 10-Q. The disclosures set forth in this Item 4 contain information concerning the evaluation of our disclosure controls and procedures and changes in internal control over financial reporting referred to in those certifications. Those certifications should be read in conjunction with this Item 4 and Item 9A of the Company’s Form 10-K for a more complete understanding of the matters covered by the certifications.

 

Management, with oversight from the Audit Committee, continues to focus on timely addressing the material weaknesses disclosed in its Form 10-K and is committed to remediate the material weaknesses as expeditiously as possible.  Although the Company’s remediation efforts are underway, control weaknesses will not be considered remediated until new internal controls over financial reporting: (i) are implemented and operational for a period of time; (ii) are tested; and (iii) management concludes that these controls are operating effectively.

 

(b) Changes in internal controls.

 

Other than improvements described in our remediation plan described in Item 9A of the Company’s Form 10-K, there have been no changes in our internal control over financial reporting during the quarter ended March 31, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on our findings that our disclosure controls and procedures and our internal controls over financial reporting were not effective, we continue to take steps to improve our internal controls and procedures

 

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PART II. OTHER INFORMATION

 

Item 1.                     Legal Proceedings

 

We are, from time to time, a party to litigation. The following is a description of the most significant legal matters that we are involved in.  In the event of an adverse outcome in one or more of our legal proceedings our business, financial condition, results of operations or cash flows could be materially adversely affected.

 

Davidco Litigation

 

On March 8, 2006, a purported class action complaint (the “Davidco Complaint”) challenging the proposed Merger with entities affiliated with Apollo was filed by a putative stockholder of the Company in an action styled Davidco Investments, on behalf of itself and all others similarly situated v. Ed H. Bowman, Jr., et al., C.A. No. 1982-N (the “Davidco Action”), pending in the Court of the Chancery of the State of Delaware, County of New Castle, against the Company, certain of our officers and directors (the “Davidco Individual Defendants”) and Apollo.  See Note 7, Potential Merger.  The Davidco Complaint alleges a claim for breach of fiduciary duties against the Davidco Individual Defendants, alleging, among other things, that the consideration to be paid to the stockholders of the Company in the Merger is unfair and inadequate and was not the result of a full and fair sale process or adequate market check.  The Davidco Complaint also asserts a claim against Apollo for allegedly aiding and abetting such purported breaches of fiduciary duties.

 

The Davidco Complaint seeks, among other relief, class certification, an injunction preventing completion of the Merger (or rescinding the Merger if it is completed prior to the receipt of such relief), compensatory and/or rescissory damages to the class, attorneys’ fees and expenses, and such other relief as the court might find just and proper.  Defendants have moved to dismiss the Davidco Complaint and the motion is still being briefed by the parties.

 

This matter has been settled in principle.  See Settlement of Litigation, below.

 

Kabota Litigation

 

A purported stockholder derivative action was filed on December 28, 2004, in an action styled Howard Kabota, Derivatively on Behalf of Sourcecorp, Incorporated v. Thomas c. Walker, et al., Cause No. 04-12854, pending in the District Court of the State of Texas, County of Dallas, 14^th Judicial District, against certain of our current and former officers and directors as individual defendants and the Company as a nominal defendant (the “Kabota I Action”).  In an amended petition (the “Kabota I Petition”), plaintiff alleges breach of fiduciary duty, abuse of control, gross mismanagement, waste of assets and unjust enrichment related to the allegations underlying a separate securities fraud action styled In re SOURCECORP, Inc. Securities Litigation, Case No. 3:04-CV-2351-N, pending in the United States District Court for the Northern District of Texas, Dallas Division (the “Securities Litigation”) (further discussed below).  All of these claims are asserted derivatively on behalf of the Company and seek unspecified damages against those individuals.

 

Upon motion by the defendants, the court entered an order staying the case dated September 27, 2005, which stays all proceedings in the action for successive sixty day periods while the special committee of the board of directors (discussed below) considers the allegations raised in the Kabota I Petition.  At the end of each successive sixty day period, any party may file a motion requesting that the court review the continued necessity of the stay.

 

In addition, on March 8, 2006, a shareholder derivative petition for breach of fiduciary duty (the “Kabota II Petition”) was filed by a putative stockholder of the Company in an action styled Howard Kabota, Derivatively On Behalf of Sourcecorp, Incorporated v. Thomas C. Walker, et al., Cause No. 06-02446 (the “Kabota II Action”) pending in the District Court of the State of Texas, County of Dallas, D-95^th Judicial District, against the Company and certain of its officers and directors (the “Kabota Individual Defendants”).  The Kabota II Petition alleges, among other things, that the consideration contemplated under the Merger Agreement to be paid to the Company’s stockholders is unfair and inadequate.  See Note 7, Potential Merger.  In addition, the Kabota II Petition alleges a claim for breach of fiduciary duties against the Kabota Individual Defendants, asserting, among other things, that the Kabota Individual Defendants failed to properly value the Company, ignored or did not protect against purported conflicts of interest of certain Kabota Individual Defendants in connection with the Merger, and agreed to the Merger in a wrongful attempt to insulate themselves from potential personal liability alleged in the Kabota I Action (discussed above).

 

The Kabota II Petition seeks, among other relief, an injunction preventing completion of the Merger (or rescinding the Merger if it is completed prior to the receipt of such relief), a direction that the Kabota Individual Defendants exercise their fiduciary duties to obtain a transaction in the best interests of the Company and its stockholders, restitution to the Company of any wrongful profits, benefits or other compensation obtained by the Kabota Individual Defendants, attorneys’ fees and expenses, and such other relief as the court might find just and proper.  The time for all the defendants to answer, move or otherwise respond to the Petition has not yet run.

 

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Item 2.           Unregistered Sales of Equity Securities and Use of Proceeds

 

Items 2(a) and (b) are inapplicable.

 

(c) STOCK REPURCHASES

 

Period		(a) Total Number of Shares Purchased		(b) Average Price Paid per Share				(c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		(d) Maximum Number of Shares (or Approximate Dollar Value of Shares) that May Yet Be Purchased Under the Plans or Programs
Jan 1, 2006 – Jan 31, 2006		—		$		—		—		$	17,415,551
Feb 1, 2006 – Feb 28, 2006		—		$	—			—		$	17,415,551
Mar 1, 2006 – Mar 31, 2006		—		$	—			—		$	17,415,551

 

Item 6.           Exhibits

 

(a) Exhibits

 

Exhibit Number		Description
2.1		Agreement and Plan of Merger among SOURCECORP, Incorporated, Corpsource Holdings, LLC and Corpsource Mergersub, Inc. dated as of March 7, 2006 (Incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed March 8, 2006)
2.2		Amendment No. 1 to Agreement and Plan of Merger (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed May 4, 2006)
3.1		Restated Certificate of Incorporation of SOURCECORP, Incorporated (Incorporated by reference to Exhibit 99.3 to Amendment No.1 to the Company’s Registration Statement on Form 8-A filed on February 15, 2002)
3.2		Amended and Restated By-Laws of SOURCECORP, Incorporated (Incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K filed on June 27, 2005)
4.1		Specimen certificate for the Common Stock, par value $.01 per share, of the Registrant. (Incorporated by reference to Exhibit 99.1 to Amendment No. 1 to the Company’s Registration Statement on Form 8-A filed on February 15, 2002)
4.2		Form of Rights Agreement, dated as of June 24, 2005, between SOURCECORP, Incorporated and American Stock Transfer & Trust Company which includes as Exhibit A the form of Certificate of Designations of Series A Participating Preferred Stock, as Exhibit B the form of Right Certificate and as Exhibit C the Summary of Rights to Purchase Series A Participating Preferred Stock (incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form 8-A filed on June 27, 2005)
4.3		Amendment to Rights Agreement dated as of March 7, 2006 (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed March 8, 2006)
31.1		Certification Pursuant to section 302 of Sarbanes-Oxley Act.
31.2		Certification Pursuant to section 302 of Sarbanes-Oxley Act.
32.1		Certification Pursuant to section 906 of Sarbanes-Oxley Act.
32.2		Certification Pursuant to section 906 of Sarbanes-Oxley Act.

 

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INDEX TO EXHIBITS

 

Exhibit Number		Description
2.1		Agreement and Plan of Merger among SOURCECORP, Incorporated, Corpsource Holdings, LLC and Corpsource Mergersub, Inc. dated as of March 7, 2006 (Incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed March 8, 2006)
2.2		Amendment No. 1 to Agreement and Plan of Merger (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed May 4, 2006)
3.1		Restated Certificate of Incorporation of SOURCECORP, Incorporated (Incorporated by reference to Exhibit 99.3 to Amendment No.1 to the Company’s Registration Statement on Form 8-A filed on February 15, 2002)
3.2		Amended and Restated By-Laws of SOURCECORP, Incorporated (Incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K filed on June 27, 2005)
4.1		Specimen certificate for the Common Stock, par value $.01 per share, of the Registrant. (Incorporated by reference to Exhibit 99.1 to Amendment No. 1 to the Company’s Registration Statement on Form 8-A filed on February 15, 2002)
4.2		Form of Rights Agreement, dated as of June 24, 2005, between SOURCECORP, Incorporated and American Stock Transfer & Trust Company which includes as Exhibit A the form of Certificate of Designations of Series A Participating Preferred Stock, as Exhibit B the form of Right Certificate and as Exhibit C the Summary of Rights to Purchase Series A Participating Preferred Stock (incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form 8-A filed on June 27, 2005)
4.3		Amendment to Rights Agreement dated as of March 7, 2006 (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed March 8, 2006)
31.1		Certification Pursuant to section 302 of Sarbanes-Oxley Act.
31.2		Certification Pursuant to section 302 of Sarbanes-Oxley Act.
32.1		Certification Pursuant to section 906 of Sarbanes-Oxley Act.
32.2		Certification Pursuant to section 906 of Sarbanes-Oxley Act.

 

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