SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------- FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 001-16123 ----------------- NEWTEK BUSINESS SERVICES, INC. -------------------- (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) NEW YORK 11-3504638 ------------------------------------- ----------------------- (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 100 QUENTIN ROOSEVELT BOULEVARD, GARDEN CITY, NY 11530 ----------------------------------------------------------- ----------- (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (516) 390-2260 - CHECK WHETHER THE REGISTRANT HAS (1) FILED ALL DOCUMENTS AND REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(D) OF THE EXCHANGE ACT 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 NINETY DAYS. YES NO [X] [ ] INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER (AS DEFINED IN RULE 12B-2 OF THE EXCHANGE ACT). YES NO [ ] [X] AS OF AUGUST 12, 2004, 33,321,253 SHARES OF COMMON STOCK WERE ISSUED AND OUTSTANDING. CONTENTS PART I - FINANCIAL INFORMATION PAGE ---- Item 1. Financial Statements (Unaudited) Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003 1 Consolidated Statements of Income for the Three and Six Month Periods Ended June 30, 2004 and 2003 2 Consolidated Statements of Cash Flows for the Six Month Periods Ended June 30, 2004 and 2003 4 Notes to Unaudited Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 18 Item 3. Quantitative and Qualitative Disclosures about Market Risk 25 Item 4. Controls and Procedures 26 PART II - OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds and Issuer Repurchase of Equity Securities 27 Item 4. Submission of Matters to a Vote of Security Holders 27 Item 6. Exhibits and Reports on Form 8-K 28 Signatures 28 Certifications 29 Exhibits 29 ITEM 1. FINANCIAL STATEMENTS NEWTEK BUSINESS SERVICES, INC., AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS JUNE 30, 2004 (UNAUDITED) AND DECEMBER 31, 2003 JUNE 30, DECEMBER 31, 2004 2003 ------------- ------------- ASSETS ------ Cash and cash equivalents $ 37,649,541 $ 33,444,611 Restricted cash 2,060,788 2,107,471 Credits in lieu of cash 70,853,664 71,294,083 SBA loans receivable, net of reserve for loan losses 38,096,972 52,050,725 Accounts receivable (net of allowances of $44,824 and $96,480, respectively) 902,157 469,768 Receivable from bank 2,002,756 2,670,353 SBA loans held for sale 2,840,714 3,619,582 Accrued interest receivable 272,596 281,072 Investments in qualified businesses - equity method investments 300,000 300,000 Investments in qualified businesses - held to maturity investments 1,255,475 1,420,179 Structured insurance product 3,135,408 3,054,705 Prepaid insurance 14,170,099 13,282,630 Prepaid expenses and other assets 3,511,002 1,907,132 Capitalized servicing assets (net of accumulated amortization of $184,448 and $24,545, respectively) 1,526,052 754,064 Furniture, fixtures and equipment (net of accumulated depreciation of $537,144 and $390,011, respectively) 815,058 670,715 Customer merchant accounts (net of accumulated amortization of $579,936 and $269,380, respectively) 2,729,191 3,024,298 Goodwill 2,201,644 1,832,621 ------------- ------------- Total assets $ 184,323,117 $ 192,184,009 ------------- ------------- LIABILITIES AND SHAREHOLDERS' EQUITY ------------------------------------ Liabilities: Accounts payable and accrued expenses $ 6,001,753 $ 6,095,440 Notes payable - certified investors 3,822,869 3,829,973 Notes payable - insurance 6,003,088 4,115,136 Notes payable - other 760,000 1,000,000 Bank notes payable 37,658,253 51,990,047 Notes payable in credits in lieu of cash 67,921,494 65,697,050 Deferred tax liability 10,905,455 10,815,790 ------------- ------------- Total liabilities 133,072,912 143,543,436 ------------- ------------- Minority interest 7,631,729 8,393,151 ------------- ------------- Commitments and contingencies Shareholders' equity: Common stock (par value $0.02 per share; authorized 39,000,000 shares, issued and outstanding 26,862,324 and 26,209,211, not including 582,980 shares held in escrow) 537,246 524,184 Additional paid-in capital 29,290,600 26,588,400 Unearned compensation (1,579,826) (2,106,588) Retained earnings 15,370,456 15,241,426 ------------- ------------- Total shareholders' equity 43,618,476 40,247,422 ------------- ------------- Total liabilities and shareholders' equity $ 184,323,117 $ 192,184,009 ------------- ------------- See accompanying notes to these unaudited consolidated financial statements. 1 NEWTEK BUSINESS SERVICES, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2004, AND 2003 THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ---------------------------- ---------------------------- 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Revenue: Income from tax credits $ 7,024,520 $ 11,470,752 $ 9,048,045 $ 21,859,334 Electronic payment processing 4,070,630 1,140,282 7,303,134 1,988,086 Servicing fee and premium income 2,141,745 353,013 3,254,112 721,460 Interest and dividend income 1,042,215 1,024,551 2,071,163 2,083,720 Other income 203,225 731,550 676,374 986,992 ------------ ------------ ------------ ------------ Total revenue 14,482,335 14,720,148 22,352,828 27,639,592 ------------ ------------ ------------ ------------ Expenses: Interest 3,478,022 3,486,235 7,242,797 7,204,087 Payroll and consulting fees 2,361,025 1,629,000 4,546,474 3,293,064 Electronic payment processing costs 2,578,749 399,811 4,679,735 1,519,753 Professional fees 1,295,050 1,725,936 2,289,659 2,641,703 Insurance 691,350 638,124 1,406,312 1,211,417 Other than temporary decline in value of investments -- 20,287 -- 1,733,701 Equity in net losses of affiliates -- 62,930 -- 117,904 Net benefit for loan losses (151,930) -- (47,249) -- Other 1,433,410 1,353,617 2,626,986 2,060,129 ------------ ------------ ------------ ------------ Total expenses 11,685,676 9,315,940 22,744,714 19,781,758 ------------ ------------ ------------ ------------ Income (loss) before minority interest, provision for income taxes and extraordinary items 2,796,659 5,404,208 (391,886) 7,857,834 Minority interest in loss (income) 310,267 (968,379) 610,581 (680,042) ------------ ------------ ------------ ------------ Income before provision for income taxes and extraordinary items 3,106,926 4,435,829 218,695 7,177,792 Provision for income taxes (1,273,839) (1,729,874) (89,665) (2,799,339) ------------ ------------ ------------ ------------ Income before extraordinary items 1,833,087 2,705,955 129,030 4,378,453 Extraordinary gain on acquisition of a business -- -- -- 186,729 ------------ ------------ ------------ ------------ Net income $ 1,833,087 $ 2,705,955 $ 129,030 $ 4,565,182 ------------ ------------ ------------ ------------ See accompanying notes to these unaudited consolidated financial statements. 2 NEWTEK BUSINESS SERVICES, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (CONTINUED) FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2004, AND 2003 THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, 2004 2003 2004 2003 ----------------- --------------- -------------- ---------------- Net income per share : Basic $ 0.07 $ 0.11 $ 0.00 $ 0.18 Diluted $ 0.07 $ 0.10 $ 0.00 $ 0.18 Income per share before extraordinary items Basic $ 0.07 $ 0.11 $ 0.00 $ 0.17 Diluted $ 0.07 $ 0.10 $ 0.00 $ 0.17 Weighted average common shares outstanding Basic 26,773,791 25,670,866 26,624,960 25,541,088 Diluted 27,227,038 26,047,237 27,158,205 25,857,904 See accompanying notes to these unaudited consolidated financial statements. 3 NEWTEK BUSINESS SERVICES, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003 2004 2003 ------------ ------------ Cash flows from operating activities: Net income $ 129,030 $ 4,565,182 Adjustments to reconcile net income to net cash used in operating activities: Other than temporary decline in value of investments -- 1,733,701 Equity in losses of affiliates -- 117,904 Extraordinary gain on acquisition of business -- (186,729) Income from tax credits (9,048,045) (21,859,334) Deferred income taxes 89,665 2,799,339 Depreciation and amortization 617,592 67,236 (Benefit) provision for loan losses (47,249) 338,800 SBA loans originated for sale (16,644,036) -- Proceeds from sale of SBA loans 17,422,904 -- Accretion of interest income (87,808) (87,808) Accretion of interest expense 5,884,294 5,912,863 Non cash compensation 750,887 134,925 Minority interest (610,581) 680,042 Changes in assets and liabilities, net of the effect of business acquisition: Prepaid insurance 363,124 1,012,631 Discount on loan originations, net 194,313 -- Prepaid expenses and other assets, accounts receivable and capitalized servicing assets (2,088,754) (924,807) Accounts payable and accrued expenses (93,687) 614,239 ------------ ------------ Net cash used in operating activities (3,168,351) (5,081,816) ------------ ------------ Cash flows from investing activities: Investments in qualified businesses - held to maturity (643,500) (710,000) Investments in qualified businesses - consolidated entities (5,372,352) (3,800,000) Return of investments - held to maturity 808,204 129,148 Return of investments - consolidated entities 1,698,165 1,977,247 Consolidation of majority owned entities 3,674,187 1,550,126 Purchase of furniture, fixtures and equipment (291,476) (128,222) SBA loans originated for investment (7,473,223) -- Proceeds from sale of SBA loans held for investment, reclassified as loans held for sale 17,022,400 Payments received on SBA loans 4,257,512 3,244,970 Other investments (215,410) (30,000) ------------ ------------ Net cash provided by investing activities 13,464,507 2,233,269 ------------ ------------ See accompanying notes to these unaudited consolidated financial statements. 4 NEWTEK BUSINESS SERVICES, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (CONTINUED) FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003 2004 2003 ------------ ------------ Cash flows from financing activities: Proceeds from issuance of notes payable to certified investors $ 10,925,483 $ -- Cash paid for Coverage A (3,347,461) -- Principal payments of note payable-insurance (1,112,048) (578,404) Repayments of note payable - bank and other (240,000) (475,000) Proceeds from sale of preferred stock of subsidiary -- 2,000,000 Change in restricted cash 46,683 -- Net repayments on SBA bank notes payable (14,331,794) (2,698,720) Net proceeds from exercise of stock options 566,319 -- Net proceeds from issuance of common stock 1,401,592 1,456,725 ------------ ------------ Net cash used in financing activities (6,091,226) (295,399) ------------ ------------ Net increase (decrease) in cash and cash equivalents 4,204,930 (3,143,946) Cash and cash equivalents - beginning of period 33,444,611 41,171,358 ------------ ------------ Cash and cash equivalents - end of period $ 37,649,541 $ 38,027,412 ------------ ------------ SUPPLEMENTAL DISCLOSURE OF CASH FLOW ACTIVITIES: Reduction of credits in lieu of cash and notes payable in credits in lieu of cash balances due to delivery of tax credits to Certified Investors $ 9,488,464 $ 10,094,827 ------------ ------------ Issuance of notes in partial payment for insurance $ 3,000,000 $ -- ------------ ------------ Issuance of warrant in connection with purchase of Coverage A Insurance $ 250,000 $ -- ------------ ------------ Acquisition of minority interest resulting in goodwill: Newtek Business Services common stock issued $ 517,324 $ 362,388 Less: minority interest acquired 148,301 -- ------------ ------------ Goodwill recognized $ 369,023 $ 362,388 ------------ ------------ See accompanying notes to these unaudited consolidated financial statements. 5 NEWTEK BUSINESS SERVICES, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES: BASIS OF PRESENTATION AND DESCRIPTION OF BUSINESS The consolidated financial statements of Newtek Business Services, Inc. and Subsidiaries (the "Company" or "Newtek") included herein have been prepared by us pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC") and include all majority owned subsidiaries or those which Newtek is considered to be the primary beneficiary of (as defined under FASB Interpretation No. FIN 46 ("FIN 46")). All intercompany balances and transactions have been eliminated in consolidation. The financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in our Form 10-K for the fiscal year ended December 31, 2003, as amended. The unaudited consolidated financial statements of Newtek, reflect, in the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary to present fairly the financial position of Newtek at June 30, 2004, the results of operations and its cash flows for the six months ended June 30, 2004. Results of operations for the interim periods may not be representative of results to be expected for a full year. Newtek is engaged in the business of providing financial products and business services to small and medium-sized businesses through ownership and/or operation of specific primary lines of business as well as organizing certified capital companies ("Capcos") and investing funds made available under the Capco programs in small businesses. The following is a summary of each Capco or Capco fund, state of certification and date of certification: CAPCO STATE OF CERTIFICATION DATE OF CERTIFICATION ----- ---------------------- --------------------- WA New York May 1998 WP Florida December 1998 WI Wisconsin October 1999 WLA Louisiana October 1999 WA II New York April 2000 WNY III New York December 2000 WC Colorado October 2001 WAP Alabama February 2004 The State of Louisiana has four "Capco funds" which are all a part of and consolidated with the WLA Capco (the first fund). The second, Wilshire Louisiana Partners II, LLC (WLPII), and the third, Wilshire Louisiana Partners III, LLC (WLPIII), were formed in October 2001, and October 2002, respectively. The fourth, Wilshire Louisiana Partners IV, LLC (WLPIV) was formed in October 2003. 6 NOTE 1- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED): In general, the Capcos issue debt and equity instruments, generally warrants ("Certified Capital"), to insurance company investors ("Certified Investors"). The Capcos then make targeted investments ("Investments in Qualified Businesses", as defined under the respective state statutes, or, "Qualified Businesses"), with the Certified Capital raised. Such investments may be accounted for as either consolidated subsidiaries, or under the equity method or cost method of accounting, depending upon the nature of the investment and the Company's and/or the Capco's ability to control or otherwise exercise significant influence over the investee. Participation in each Capco program legally entitles the Capco to receive (or earn) tax credits from the state upon satisfying quantified, defined investment percentage thresholds and time requirements. In order for the Capcos to maintain their state-issued certifications, the Capcos must make Investments in Qualified Businesses in accordance with these requirements. These state requirements are mirrored in the limitations agreed to by each Capco in its written agreements with its Certified Investors and limit the activities of the Capcos to conducting the business of a Capco. Each Capco also has separate, legal contractual arrangements with the Certified Investors obligating the Capco to refrain from unauthorized activities, to use the proceeds from the notes only for Capco-authorized (i.e., "qualified") investments, to limit fees for professional services related to making, buying or selling investments to $200,000 per Capco annually; and to pay interest on the aforementioned debt instruments whether or not it meets the statutory requirements for Investments in Qualified Businesses. The Capco can satisfy this interest payment, at the Capco's discretion, by delivering tax credits in lieu of paying cash. The Capcos legally have the right to deliver the tax credits to the Certified Investors. The Certified Investors legally have the right to receive and use the tax credits and would, in turn, use these tax credits to reduce their respective state tax liabilities in an amount usually equal to 100% (WLA, WLPII, and WLPIII -110%) of their certified investment. The tax credits can be utilized usually over a ten-year period at a rate of 10% (WLA, WLPII, and WLPIII - 11%) per year and in some instances are transferable and can be carried forward. During February 2004, Newtek funded its twelfth Capco, Wilshire Alabama Partners LLC, for total certified capital of $11,111,111. STOCK - BASED COMPENSATION The Company has elected to continue using Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," in accounting for employee stock options. With regard to stock options, no stock-based employee compensation cost is reflected in net income (loss), as all options granted under our plan had an exercise price equal to the market value of the underlying common stock at the date of grant. Compensation expense on restricted shares granted to employees is measured at the fair market value on the date of grant and recognized in the consolidated statements of income on a pro-rata basis over the service period which approximates the vesting period. 7 NOTE 1- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED): The following table summarizes the pro forma consolidated results of operations of the Company as though the fair value based accounting method in SFAS 148 "Accounting for Stock-based Compensation-Transition and Disclosure-an amendment of SFAS 123" had been used in accounting for employee stock options. THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, -------------------------- -------------------------- 2004 2003 2004 2003 ----------- ----------- ----------- ----------- As reported: Net income $ 1,833,087 $ 2,705,955 $ 129,030 $ 4,565,182 ----------- ----------- ----------- ----------- Add: Total stock based employee compensation expense recognized, net of related tax effects 169,595 -- 312,696 -- ----------- ----------- ----------- ----------- Deduct: Total stock based employee compensation expense determined under fair value based method for all awards, net of related tax effects (192,944) (215,366) (401,206) (428,364) ----------- ----------- ----------- ----------- Pro forma net income $ 1,809,738 $ 2,490,589 $ 40,520 $ 4,136,818 ----------- ----------- ----------- ----------- Earnings per share: Basic - as reported $ 0.07 $ 0.11 $ 0.00 $ 0.18 ----------- ----------- ----------- ----------- Basic - pro forma $ 0.07 $ 0.10 $ 0.00 $ 0.16 ----------- ----------- ----------- ----------- Diluted - as reported $ 0.07 $ 0.10 $ 0.00 $ 0.18 ----------- ----------- ----------- ----------- Diluted - pro forma $ 0.07 $ 0.10 $ 0.00 $ 0.16 ----------- ----------- ----------- ----------- For the six months ended June 30, 2004 and 2003, the weighted average fair value of each option granted is estimated on the date of grant using the Black Scholes model with the following assumptions: expected volatility of 59-85%, risk-free interest rate of 1.61% to 6.15%, respectively, expected dividends of $0 and expected terms of 1-6 years. 8 NOTE 1- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED): NEW ACCOUNTING PRONOUNCEMENTS In March 2004, the EITF reached consensus on Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" regarding disclosures about unrealized losses on available-for-sale debt and equity securities accounted for under FASB Statements No. 115, "Accounting for Certain Investments in Debt and Equity Securities", and No. 124, "Accounting for Certain Investments Held by Not-for-Profit Organizations". The guidance for evaluating whether an investment is other-than-temporarily impaired should be applied in such evaluations made in reporting periods beginning after June 15, 2004. The disclosures are effective in annual financial statements for fiscal years ending after December 15, 2003, for investments accounted for under Statements 115 and 124. For all other investments within the scope of this Issue, the disclosures are effective in annual financial statements for fiscal years ending after June 15, 2004. The additional disclosures for cost method investments are effective for fiscal years ending after June 15, 2004. We do not expect that the implementation of EITF 03-1 will have a material effect on our financial statements. In March 2004, the EITF reached consensus on Issue No. 03-16, "Accounting for Investments in Limited Liability Companies." EITF 03-16 provides guidance for determining whether a non-controlling investment in a limited liability company should be accounted for using the cost method or the equity method of accounting. Companies will be required to adopt the provisions of this consensus in reporting periods beginning after June 15, 2004. We do not expect that the implementation of EITF 03-16 will have a material effect on our financial statements MAJOR ACCOUNTING POLICIES Refer to the Company's 2003 Form 10K for a description of major accounting policies. There have been no material changes to these accounting policies during 2004. RECLASSIFICATIONS Certain prior period amounts have been reclassified to conform to current period presentation. NOTE 2 - COMMON STOCK: In the six months ended June 30, 2004, Newtek sold 221,273 shares of common stock in private transactions, with proceeds totaling approximately $1,042,000. During the same period there were 158,992 stock options exercised, with proceeds totaling approximately $567,000. In connection with the funding of the Wilshire Alabama Capco, 85,500 shares of stock were issued for approximately $359,000. In connection with two employment agreements, 13,940 shares were issued in consideration for services rendered, valued at approximately $68,000. As part of the renewal of the SBA's line of credit with Deutsche Bank, 24,950 shares of common stock were issued, valued at approximately $125,000. In May 2004, Newtek issued 144,458 shares of its common stock, valued at approximately $517,000, in exchange for the minority interests in Wilshire Colorado, Wilshire Alabama Partners, Wilshire Louisiana Partners III and Wilshire Louisiana Partners IV (Note 7). In addition, 4,000 shares of common stock were issued in consideration for consulting services rendered, valued at approximately $25,000. NOTE 3 - INVESTMENTS IN QUALIFIED BUSINESSES: The following table is a summary of investments as of June 30, 2004, shown separately between their debt and equity components, and all terms of each are summarized. There are no expiration dates on any of the financial instruments, unless disclosed. 9 NOTE 3 - INVESTMENTS IN QUALIFIED BUSINESSES: (CONTINUED) The various interests that the Company acquires in its Qualified Businesses are accounted for under three methods: consolidation, equity method and cost method. The applicable accounting method is generally determined based on the Company's voting interest, or the economics of the transaction if the investee is determined to be a variable interest entity. The following are our non-consolidated investments: DEBT INVESTMENTS L&K TOP TOTAL DESIGN, SILVER TRAY, DIRECT AUTOTASK LOUISIANA DESANTIS INVESTEE CREATIONS, LLC GROUP BIDCO LOANS ENTERPRISES INVESTMENT DATE(S) SEPT-01, NOV-01 SEPT-03 VARIOUS VARIOUS MATURITY DATE(S) JUN-04 MARCH-05 VARIOUS VARIOUS INTEREST RATE LIBOR 7.75% PRIME + 1% PRIME + 1% ------------------------ --------------- ---------- ------------- -------------- ----------- Principal outstanding at December 31, 2003 $ 269,387 $ 300,000 $ 850,792 $ - $ 1,420,179 Debt issued - 2004 - - - 643,500 643,500 Return of principal - 2004 (62,495) - (102,209) (643,500) (808,204) ----------- ----------- ----------- ----------- ----------- Principal outstanding at June 30, 2004 $ 206,892 $ 300,000 $ 748,583 $ - $ 1,255,475 ----------- ----------- ----------- ----------- ----------- EQUITY INVESTMENTS DISTRIBUTION VIDEO AND AUDIO INVESTEE BUY SEASONS, INC. CORP. TOTAL INVESTMENT DATE(S) JUN-01 JUNE-00 TYPE OF INVESTMENT COMMON STOCK COMMON STOCK OWNERSHIP INTEREST AS OF DECEMBER 31, 2003 (less than) 20.00% (less than) 20.00% -------------------------- ------------------- ------------------- ----------------- Total equity investments at December 31, 2003 $100,000 $200,000 $300,000 Return of Capital Equity in income (losses) 2004 - - - -------- -------- -------- Total Equity Investments at June 30, 2004 $100,000 $200,000 $300,000 -------- -------- -------- 10 NOTE 3 - INVESTMENTS IN QUALIFIED BUSINESSES (CONTINUED): The Company has not guaranteed any obligation of these non-consolidated investees, and the Company is not otherwise committed to provide further financial support for the investees. However, from time-to-time, the Company may decide to provide such additional financial support which, as of June 30, 2004 was assessed at zero. Should the Company determine that an impairment exists upon its periodic review, and it is deemed to be other than temporary, the Company will write down the recorded value of the asset to its estimated fair value and record a corresponding charge in the Company's Consolidated Statement of Income. All companies in which the Company has made equity investments provide the Company with unaudited financial statements. For each equity method investment, Newtek management reviews the facts and circumstances that are apparent to ascertain if an adjustment is necessary to the books of the investee to make its financial statements materially correct. NOTE 4 - LOANS RECEIVABLE (NON-CAPCO): Loans receivable are generated by Newtek Small Business Finance ("NSBF") and are primarily related to entities in the Eastern region of the United States with concentrations in the restaurant and hotel and motel industries. The unpaid principal amount of loans serviced for others of approximately $146,270,000 and $123,832,000 at June 30, 2004 and December 31, 2003, respectively, are not included on the accompanying consolidated balance sheets. Below is a summary of the activity of the SBA loan receivable account, net of SBA loan loss reserves, for the six months ended June 30, 2004: Balance at December 31, 2003 $ 52,050,725 SBA loans originated for investment 7,473,223 Payments received in 2004 (4,257,512) SBA loans held for investment, reclassified as loans held for sale (17,022,400) Benefit from SBA loan losses 47,249 Discount on loan originations, net (194,313) ------------ Balance at June 30, 2004 $ 38,096,072 ============ Below is a summary of the activity of the reserve for loan losses account for the six months ended June 30, 2004: Balance at December 31, 2003 $ 1,613,613 SBA loan loss provision charged in 2004 241,031 Recoveries 50,530 Reversals on sale of invested portion (288,280) Charge-offs (82,585) ------------ Balance at June 30, 2004 $ 1,534,309 =========== 11 NOTE 4 - LOANS RECEIVABLE (NON-CAPCO): (CONTINUED) Below is a summary of the SBA loans held for sale as of June 30, 2004: Balance at December 31, 2003 $ 3,619,582 Loan originations for sale 16,644,036 SBA Loans held for investment, reclassified as loans held for sale 17,022,400 Loans sold (34,445,304) ------------- Balance at June 30, 2004 $ 2,840,714 ============ Below is a summary of the SBA capitalized servicing assets as of June 30, 2004: Balance at December 31, 2003 $ 754,064 Servicing rights capitalized 931,891 Servicing rights amortized (159,903) Valuation allowance recorded - ----------- Balance at June 30, 2004 $ 1,526,052 =========== As of June 30, 2004 and December 31, 2003, SBA loans that were not accruing interest amounted to approximately $2,889,000 and $3,201,000, respectively. As of June 30, 2004 and December 31, 2003, SBA loans due after one year that have adjustable interest rates amount to approximately $39,639,000 and $51,321,000, respectively. The Company originates loans to small businesses under the SBA program that provides a guaranty from 50% to 85% on the total amount of the loan up to a maximum guaranty of $1,500,000. The Company typically sells the guaranteed portion of each loan to a third party and retains the unguaranteed principal portion in its portfolio for investment, or possible sale in the future. Loan losses are shared pro rata between the guaranteed and unguaranteed portions. The following is a summary of SBA loans receivable at: JUNE 30, DECEMBER 31, 2004 2003 ------------ ------------ Due in one year or less $ 242,831 $ 168,292 Due between one and five years 1,456,926 2,619,618 Due after five years 38,542,058 51,292,650 ------------ ------------ Total 40,241,815 54,080,560 ------------ ------------ Less : Allowance (1,534,309) (1,613,613) Less: Discount on loan originations, net (610,534) (416,222) ------------ ------------ $ 38,096,972 $ 52,050,725 ------------ ------------ 12 NOTE 5 - EARNINGS PER SHARE: Basic earnings per share is computed based on the weighted average number of common shares outstanding during the period. The dilutive effect of common stock equivalents is included in the calculation of diluted earnings per share only when the effect of their inclusion would be dilutive. The calculations of Net Income Per Share and Income Per Share Before Extraordinary Items were: THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, --------------------------- --------------------------- 2004 2003 2004 2003 ----------- ----------- ----------- ----------- Numerator: Numerator for basic and diluted EPS - income available to common stock holders $ 1,833,087 $ 2,705,955 $ 129,030 $ 4,565,182 Numerator for basic and diluted EPS - extraordinary item - - - 186,729 ----------- ----------- ----------- ----------- Numerator for basic and diluted EPS -income before extraordinary item $ 1,833,087 $ 2,705,955 $ 129,030 $ 4,378,453 ----------- ----------- ----------- ----------- Denominator: Denominator for basic EPS - weighted average shares 26,773,791 25,670,866 26,624,960 25,541,088 Effect of dilutive securities (stock options and restricted stock units) 453,247 376,371 533,245 316,816 ----------- ----------- ----------- ----------- Denominator for diluted EPS - weighted average shares $27,227,038 $26,047,237 $27,158,205 $25,857,904 ----------- ----------- ----------- ----------- Net EPS: Basic $ 0.07 $ 0.11 $ 0.00 $ 0.18 Net EPS: Diluted $ 0.07 $ 0.10 $ 0.00 $ 0.18 Net EPS : Basic before extraordinary gain $ 0.07 $ 0.11 $ 0.00 $ 0.17 Net EPS : Diluted before extraordinary gain $ 0.07 $ 0.10 $ 0.00 $ 0.17 The amount of anti-dilutive shares/units excluded from above is as follows: THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, --------------------------- --------------------------- 2004 2003 2004 2003 ----------- ----------- ----------- ----------- Stock options 477,827 588,167 477,827 588,167 Warrants 5,516 - 5,516 - 13 NOTE 6 - SEGMENT REPORTING: Operating segments are organized internally primarily by the type of services provided and in accordance with Statement of Financial Accounting Standard No. 131, "Disclosures about Segments of an Enterprise and Related Information." The Company has aggregated similar operating segments into three reportable segments, SBA lending, electronic payment processing and Capcos and other. The SBA lending segment is NSBF, a licensed, Small Business Administration ("SBA") lender that originates, sells and services loans to qualifying small businesses, which are partially guaranteed by the SBA. As an SBA lender, NSBF generates revenues from sales of loans, servicing income for those loans retained to be serviced by NSBF (included in servicing fee and premium income on the consolidated statements of income) and interest income earned on available cash balances and the loans themselves. NSBF also generates expenses such as interest, professional fees, payroll and consulting, and provision for loan losses, all of which are included in the respective caption on the consolidated statements of income. NSBF also has expenses such as loan recovery expenses, loan processing costs, depreciation and amortization, and other expenses that are all included in the other expense caption on the consolidated statements of income. The electronic payment processing segment is a processor of credit card transactions, as well as a marketer of credit card and check approval services to the small business market. Revenue generated from electronic payment processing is included on the consolidated statements of income as a separate line item. Expenses include direct costs (included in a separate line captioned electronic payment processing costs), professional fees, payroll and consulting, and other expenses, all of which are included in the respective caption on the consolidated statements of income. The Capcos and other segment represents Newtek's activities in the certified capital company market as described in Note 1, as well as investments not included in the other two segments. Management has considered the following characteristics when making its determination of its operating and reportable segments: o the nature of the products and services, o the type or class of customer for their products and services, o the methods used to distribute their products or provide their services, and o the nature of the regulatory environment. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. 14 NOTE 6 - SEGMENT REPORTING (CONTINUED): FOR THE THREE MONTHS ENDED FOR THE SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------------------ ------------------------------- 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Revenue SBA lending $ 3,158,625 $ 1,683,434 $ 5,298,678 $ 3,005,495 Electronic payment processing 4,070,630 1,140,282 7,303,134 1,988,086 Capco and other 7,253,080 11,896,432 9,751,016 22,646,011 ------------ ------------ ------------ ------------ TOTAL $ 14,482,335 $ 14,720,148 $ 22,352,828 $ 27,639,592 ------------ ------------ ------------ ------------ Income (loss) before provision for income taxes and extraordinary items SBA lending $ 1,431,185 $ (174,374) $ 1,719,946 $ (467,206) Electronic payment processing 95,066 (218,685) 105,639 (593,776) Capco and other 1,580,675 4,828,888 (1,606,890) 8,238,774 ------------ ------------ ------------ ------------ TOTAL $ 3,106,926 $ 4,435,829 $ 218,695 $ 7,177,792 ------------ ------------ ------------ ------------ Depreciation and amortization SBA lending $ 112,183 $ 5,879 $ 191,387 $ 5,879 Electronic payment processing 172,065 12,834 340,669 49,086 Capco and other 38,180 3,496 85,536 12,271 ------------ ------------ ------------ ------------ TOTAL $ 322,428 $ 22,209 $ 617,592 $ 67,236 ------------ ------------ ------------ ------------ Intercompany revenue eliminated above SBA lending $ - $ - $ - $ - Electronic payment processing 236,365 70,349 451,297 162,993 Capco and other 488,692 242,828 905,224 619,784 ------------ ------------ ------------ ------------ TOTAL $ 725,057 $ 313,177 $ 1,356,521 $ 782,777 ------------ ------------ ------------ ------------ Intercompany expenses eliminated above SBA lending $ 161,783 $ 113,473 $ 319,896 $ 113,473 Electronic payment processing 337,882 134,975 658,538 350,541 Capco and other 225,392 64,729 378,087 318,763 ------------ ------------ ------------ ------------ TOTAL $ 725,057 $ 313,177 $ 1,356,521 $ 782,777 ------------ ------------ ------------ ------------ AT JUNE 30, AT DECEMBER 31, 2004 2003 ------------ --------------- Identifiable assets SBA lending $ 51,546,653 $ 64,738,750 Electronic payment processing 7,176,912 7,308,940 Capco and other 125,599,552 120,136,319 ------------ ------------ TOTAL $184,323,117 $192,184,009 ------------ ------------ 15 NOTE 7--GOODWILL ARISING FROM ACQUISITION OF MINORITY INTEREST: In May 2004, Newtek issued 144,458 shares of its common stock in exchange for the minority interests in Wilshire Colorado, Wilshire Alabama Partners, Wilshire Louisiana Partners III and Wilshire Louisiana Partners IV. These have been accounted for as a purchase transaction. The fair value of Newtek's common stock was determined based upon the quoted market price of Newtek's common stock, less a 55.0% discount factor due to certain restrictions on the sale of the stock. Such value exceeded the book values of the minority interests by approximately $369,000, and Newtek has recorded such amount as goodwill. NOTE 8 - NOTES PAYABLE: Effective with the Company's acquisition of Commercial Capital Corp. ("CCC"), a new line of credit was provided by Deutsche Bank to NSBF. The line of credit for $75 Million expired on June 30, 2004 at which time a twelve month extension was entered into under revised terms. These revised terms include a reduced advanced rate, minimum net worth thresholds and ratios, in addition to profitability requirements. NSBF is in compliance with all of the aforementioned covenants as of June 30, 2004. As of June 30, 2004, NSBF had $37,658,253 outstanding on the line of credit. The line of credit bears interest at the prime interest rate minus .50%, and is collateralized by the loans made by NSBF. The interest rate at June 30, 2004 was 3.50%. Interest on the line is payable monthly in arrears. In addition, this line of credit requires that a percentage of all advances made to NSBF be deposited into an account in the name of the bank. The balance in this account as of June 30, 2004 was $2,002,756 and is included in receivable from bank on the accompanying balance sheet. In June 2004, NSBF entered into a $4 Million revolving credit facility with Banco Popular Dominica Bank to finance the origination of SBA loans. The revolving credit facility bears interest at the prime interest rate and is collateralized by the loans made by NSBF. The agreement expires on December 31, 2004 and is renewable for successive twelve month periods thereafter. As of June 30, 2004, the Company has not utilized this credit facility. NOTE 9 - SALE OF LOANS AND CUSTOMER MERCHANT ACCOUNTS SALE OF LOANS In June 2004, NSBF sold to a bank approximately $17,022,000 of loans previously classified as held for investment for aggregate proceeds of approximately $17,661,000. This represented a portion of the unguaranteed piece of 180 loans. The difference of $639,000 was recorded as premium income. Also included in premium income is approximately $324,000 representing the allocated portion of the remaining discount recorded at the time of loan origination. Additionally, in connection with this sale, NSBF reversed the reserve for loan loss associated with these loans and recorded a benefit of approximately $288,000, which is included in the net benefit for loan losses caption on the accompanying unaudited consolidated statements of income. SALE OF CUSTOMER MERCHANT ACCOUNTS In June 2004, our electronic payment processing segment sold approximately 600 merchant accounts for gross and net proceeds of approximately $147,000, which is included in the electronic payment processing revenue caption on the accompanying unaudited consolidated Statements of Income. 16 NOTE 10 - SUBSEQUENT EVENT: On April 28, 2004, Newtek signed an agreement to acquire CrystalTech Web Hosting, Inc, one of the largest Microsoft Windows-only hosting companies in the world, with 26,000 customers, 80 percent of which are small to medium-sized businesses. This acquisition should greatly enhance the ability of Newtek to cross-market its business and financial services to a large pre-existing customer base. The acquisition was completed on July 9, for a purchase price of $10,000,000 in cash and 69,444 shares of Newtek Business Services stock. An equal number of shares of Newtek Business Services' common stock were awarded as restricted stock to employees who remain with the new company subsequent to the acquisition. In addition, there is a contingent payment of $1,250,000 in cash and 486,111 shares of common stock if CrystalTech achieves certain profitability goals. On July 2, 2004, Newtek completed a secondary public offering, issuing 6,000,000 shares of common stock at $3.60 per share. The Company received approximately $19,721,000 in net proceeds, after the underwriter's discount and other offering expenses. Subsequently, on July 13, 2004, the underwriters exercised the over-allotment option to acquire 450,000 shares and the company received additional net proceeds of approximately $1,482,000 after the underwriter's discount and other offering expenses. 17 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION: Readers are cautioned that certain statements contained herein are forward-looking statements and should be read in conjunction with the Company's disclosures under the heading "Forward Looking Statements" below. The following discussion should also be read in conjunction with the Consolidated Financial Statements of the Company and the notes thereto included elsewhere herein. CRITICAL ACCOUNTING POLICIES AND ESTIMATES: The Company's significant accounting policies are described in note 1 of the Notes to Consolidated Financial Statements included in its Form 10-K for the fiscal year ended December 31, 2003. A discussion of the Company's critical accounting policies, and the related estimates, are included in Management's Discussion and Analysis of Results of Operations and Financial Position in its Form 10-K for the fiscal year ended December 31, 2003. There have been no significant changes in the Company's existing accounting policies or estimates since its fiscal year ended December 31, 2003. NEW ACCOUNTING PRONOUNCEMENTS: In March 2004, the EITF reached consensus on Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" regarding disclosures about unrealized losses on available-for-sale debt and equity securities accounted for under FASB Statements No. 115, "Accounting for Certain Investments in Debt and Equity Securities", and No. 124, "Accounting for Certain Investments Held by Not-for-Profit Organizations". The guidance for evaluating whether an investment is other-than-temporarily impaired should be applied in such evaluations made in reporting periods beginning after June 15, 2004. The disclosures are effective in annual financial statements for fiscal years ending after December 15, 2003, for investments accounted for under Statements 115 and 124. For all other investments within the scope of this Issue, the disclosures are effective in annual financial statements for fiscal years ending after June 15, 2004. The additional disclosures for cost method investments are effective for fiscal years ending after June 15, 2004. We do not expect that the implementation of EITF 03-1 will have a material effect on our financial statements. In March 2004, the EITF reached consensus on Issue No. 03-16, "Accounting for Investments in Limited Liability Companies." EITF 03-16 provides guidance for determining whether a non-controlling investment in a limited liability company should be accounted for using the cost method or the equity method of accounting. Companies will be required to adopt the provisions of this consensus in reporting periods beginning after June 15, 2004. We do not expect that the implementation of EITF 03-16 will have a material effect on our financial statements COMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2004 AND JUNE 30, 2003 Total revenues decreased by approximately $5,287,000 to $22,353,000 for the six months ended June 30, 2004, from $27,640,000 for the six months ended June 30, 2003. The variance was due to the following segment related revenues: Income from tax credits decreased by approximately $12,811,000 from $21,859,000 for the six months ended June 30, 2003, to $9,048,000 for the six months ended June 30, 2004, due to Newtek's Capcos earning less tax credits from the various state Capco programs in 2004 compared to 2003. Electronic payment processing revenue increased by approximately $5,315,000 to $7,303,000 for the six months ended June 30, 2004, from $1,988,000 for the six months ended June 30, 2003, due to the Company's increase in electronic payment processing customers, as well as the company's acquisition of Automated Merchant Services in August, 2003. At June 30, 2004, we provided our payment services to over 5,600 small merchants across the United States, compared to approximately 1,450 customers at June 30, 2003. Gross total processing volume increased to approximately $413,059,000 from all merchant portfolios (of this amount, approximately $171,772,000 of processing volume generated revenues that were recorded net of interchange fees) for the six months ended June 30, 2004 from $69,336,000 of gross processing volume for the six months ended June 30, 2003. In addition, in June 2004, our electronic payment processing segment sold approximately 600 merchant accounts for net proceeds of approximately $147,000. 18 Servicing fee and premium income increased by approximately $2,533,000 to $3,254,000 for the six months ended June 30, 2004 from approximately $721,000 for the six months ended June 30, 2003 due to NSBF closing 72 loans for total originations of approximately $24,117,000 compared to zero loan originations for the six months ended June 30, 2003. NSBF sold 68 guaranteed loans in the six months ended June 30, 2004, aggregating approximately $17,423,000 as compared to $0 in the same period for the prior year. The premiums recognized in connection with these sales were approximately $1,503,000 during the six months ended June 30, 2004 as compared with $0 in the same period for the prior year. In addition, in June 2004, NSBF sold to a bank approximately $17,022,000 of loans previously classified as held for investment for aggregate proceeds of approximately $17,661,000. This represented a portion of the unguaranteed piece of 180 loans. The carrying value above the $17,022,000 of loans previously classified as held for investment of $639,000 was recorded as premium income. Also, in connection with this sale, included in premium income for the six months ended June 30, 2004 is approximately $324,000 representing the allocated portion of the remaining discount recorded at the time of loan origination. Interest and dividends are generated from SBA lending activities, excess cash balances that are invested in low risk, highly liquid securities (money market accounts, federal government backed mutual funds, etc.), non-cash accretions of structured insurance product and on held to maturity investments. The following table details the changes in these different forms of interest and dividend income for the six month periods ending June 30: 2004 2003 CHANGE ------ ------ -------- SBA lending activities $ 1,845,749 $1,820,218 $ 25,531 Non-cash accretions 87,808 87,808 - Qualified investments 49,428 85,687 (36,259) Low-risk highly liquid securities 88,178 90,007 (1,829) ------------- ---------- ------------- $ 2,071,163 $2,083,720 $ (12,557) ============= ========== ============= The decrease in interest income generated on qualified investments and low-risk highly liquid securities is attributable to a decline in the average outstanding balances of qualified investments and reduced short term interest rates on interest bearing cash accounts. Other income decreased by approximately $311,000 to $676,000 for the six months ended June 30, 2004 from $987,000 for the six months ended June 30, 2003. In June 2003, NSBF recovered approximately $330,000 of income from the acquired CCC loan portfolio. Changes in interest expense are summarized as follows for the six month periods ending June 30: 2004 2003 CHANGE -------- ------ -------- Capco interest expense $ 5,884,294 $ 5,912,339 $ (28,045) NSBF (SBA Lender) interest expense 1,000,117 995,872 4,245 Other interest 358,386 295,876 62,510 ------------- ------------ ------------ $ 7,242,797 $ 7,204,087 $ 38,710 ============= ============ ============ The approximately $28,000 net decrease in Capco interest expense in the six months ended 2004 was attributable to a reduction in the average outstanding individual Capco balances of the Notes payable in credits in lieu of cash from the prior period. The approximately $63,000 net increase in other interest expense was attributable to additional debt instruments associated with the financing of insurance coverage purchased for the Wilshire Alabama Partners Capco during the first quarter of 2004 and the acquisition of Automated Merchant Services during the third quarter of 2003. Payroll and consulting fees increased by approximately $1,253,000 to $4,546,000 for the six months ended June 30, 2004 from $3,293,000 for the six months ended June 30, 2003. The increase was primarily due to the stock based 19 compensation relating to the restricted stock granted in the third quarter of 2003 of approximately $528,000, the payroll and consulting fees incurred by the six additional operating entities consolidated into Newtek in the six months ended June 30, 2004 versus the same period in 2003, and the related payroll costs associated with additional employees being hired in the SBA lending and merchant processing segments in the current period. Electronic payment processing direct costs increased by approximately $3,160,000 to $4,680,000 for the six months ended June 30, 2004 from $1,520,000 for the six months ended June 30, 2003, due to the significant increase in the number of electronic payment processing customers as well as the acquisition of Automated Merchant Services in August 2003. Professional fees decreased by approximately $352,000 to $2,290,000 for the six months ended June 30, 2004 from $2,642,000 for the six months ended June 30, 2003. This decrease is primarily due reduced legal expenses because the Company was in the process of forming two new Capcos in the prior period. Insurance expense increased by approximately $195,000 to $1,406,000 for the six months ended June 30, 2004 from $1,211,000 for the six months ended June 30, 2003. This increase is due to the additional insurance relating to the new Capco funded in 2004, Wilshire Alabama Partners, and the new Capco funded in October 2003, Wilshire Louisiana Partners IV. Recovery (benefit) of loan losses increased to approximately $47,000 for the six months ended June 30, 2004 from $0 for the six months ended June 30, 2003. This is attributable to NSBF selling loans to a bank in June 2004 that were previously classified as held for investment. In connection with this sale, NSBF reversed the reserve for loan losses associated with these loans and recorded a benefit of approximately $288,000, offset by $241,000 in loan loss provisions. There was no loan loss provision in the same period in the prior year due to NSBF not originating any loans. Other expenses increased by approximately $567,000 to $2,627,000 for the six months ended June 30, 2004 from $2,060,000 for the six months ended June 30, 2003. The increase was due primarily to expenses incurred by consolidated operating entities other than electronic payment processing direct costs as described above. Specifically, the amortization of customer merchant accounts which were acquired in August 2003 contributed approximately $264,000 to the increase in other expenses in the six months ended 2004 compared to $0 in the same period in 2003. Other than temporary decline in value of investments decreased by approximately $1,734,000 to $0 for the six months ended June 30, 2004 from $1,734,000 for the six months ended June 30, 2003, due to the Company's determination that there were no other than temporary declines in the value of investments for the period ended June 30, 2004. During the period ended June 30, 2003, the Company determined that there was an approximately $943,000 other than temporary decline in the value of its investments for Merchant Data Systems, Inc., $500,000 for 1-800 Gift Certificate, an approximate $20,000 decline for Transworld Business Brokers, and an approximate $271,000 other than temporary decline in the value of its investments for Direct Creations, LLC. For the six months ended June 30, 2004, equity in net losses of affiliates decreased by approximately $118,000 to $0. This decrease is due to investments accounted for under the equity method being written down to $0 as of December 31, 2003. The Company's results of operations decreased by approximately $4,436,000 from net income of $4,565,000 for the six months ended June 30, 2003 to net income of $129,000 for the six months ended June 30, 2004, due to the decreases in revenue of approximately $5,287,000 and the increases in overall expenses of approximately $2,963,000 discussed above, minority interest of approximately $1,291,000, offset by the decrease in the taxes of approximately $2,709,000, and the decrease in extraordinary gains of approximately $187,000. COMPARISON OF THE THREE MONTHS ENDED JUNE 30, 2004 AND JUNE 30, 2003 20 Total revenues decreased by approximately $238,000 to $14,482,000 for the three months ended June 30, 2004, from $14,720,000 for the three months ended June 30, 2003. The variance was due to the following segment related revenues: Income from tax credits decreased by approximately $4,446,000 from $11,471,000 for the three months ended June 30, 2003, to $7,025,000 for the three months ended June 30, 2004, due to Newtek's Capcos earning less tax credits from the various state Capco programs in 2004 compared to 2003. Electronic payment processing revenue increased by approximately $2,930,000 to $4,070,000 for the three months ended June 30, 2004, from $1,140,000 for the three months ended June 30, 2003, due to the Company's increase in electronic payment processing customers, as well as the company's acquisition of Automated Merchant Services in August, 2003. At June 30, 2004, we provided our payment services to over 5,600 small merchants across the United States, compared to approximately 1,450 customers at June 30, 2003. Gross total processing volume increased to approximately $215,488,000 (of this amount, approximately $80,890,000 of processing volume generated revenues that were recorded net of interchange fees) for the three months ended June 30, 2004 from $42,424,000 of gross processing volume for the three months ended June 30, 2003. In addition, in June 2004, our electronic payment processing segment sold approximately 600 merchant accounts for net proceeds of approximately $147,000. Servicing fee and premium income increased by approximately $1,789,000 to $2,142,000 for the three months ended June 30, 2004 from approximately $353,000 for the three months ended June 30, 2003 due to NSBF closing 44 loans for total originations of approximately $12,867,000 compared to zero loan originations in the same period for the prior year. We sold 39 guaranteed loans in the three months ended June 30, 2004, aggregating approximately $7,974,000 as compared to $0 in the same period for the prior year. The premiums recognized in connection with these sales were approximately $698,000 during the three months ended June 30, 2004 as compared with $0 in the same period for the prior year. In addition, in June 2004, NSBF sold to a bank approximately $17,022,000 of loans previously classified as held for investment for aggregate proceeds of approximately $17,661,000. This represented a portion of the unguaranteed piece of 180 loans. The carrying value above the $17,022,000 of loans previously classified as held for investment of $639,000 was recorded as premium income. Also, in connection with this sale, included in premium income is approximately $324,000 representing the allocated portion of the remaining discount recorded at the time of loan origination. Interest and dividends are generated from SBA lending activities, excess cash balances that are invested in low risk, highly liquid securities (money market accounts, government secured funds, etc.), non-cash accretions of structured insurance product and on held to maturity investments. The following table details the changes in these different forms of interest and dividend income: 2004 2003 CHANGE ------------- ----------- ------------ SBA lending activities $ 920,746 $ 905,042 $ 15,704 Non-cash accretions 43,904 43,904 - Qualified investments 28,599 62,712 (34,113) Low-risk highly liquid securities 48,966 12,893 36,073 ------------- ---------- ------------ $ 1,042,215 $1,024,551 $ 17,664 ============= ========== ============ The increase in interest income generated on SBA lending activities and low-risk highly liquid securities is attributable to an increase in the average outstanding balances on interest bearing cash accounts during the period. Other income decreased by approximately $528,000 to $203,000 for the three months ended June 30, 2004 from $731,000 for the three months ended June 30, 2003. In June 2003, NSBF recovered approximately $330,000 of income from the acquired CCC loan portfolio. Changes in interest expense are summarized as follows: 21 2004 2003 CHANGE -------- ------ -------- Capco interest expense $ 2,862,878 $ 2,910,796 $ (47,918) NSBF (SBA Lender) Interest Expense 498,244 491,286 6,958 Other interest 116,900 84,153 32,747 ------------- ------------ ------------ $ 3,478,022 $ 3,486,235 $ (8,213) ============= ============ ============= The approximately $48,000 net decrease in Capco interest expense in the three months ended 2004 was attributable to a reduction in the average outstanding individual Capco balances of the Notes payable in credits in lieu of cash from the prior period. The approximately $33,000 increase in other interest expense was attributable to additional debt instruments associated with the financing of insurance coverage purchased for the Wilshire Alabama Partners Capco during the first quarter of 2004 and the acquisition of Automated Merchant Services during the third quarter of 2003. Payroll and consulting fees increased by approximately $732,000 to $2,361,000 for the three months ended June 30, 2004 from $1,629,000 for the three months ended June 30, 2003. The increase was primarily due to the stock compensation related to the restricted stock granted in the third quarter of 2003, the payroll and consulting fees incurred by the six additional operating entities consolidated into Newtek in the three months ended June 30, 2004 versus the same period in 2003 and the related payroll costs associated with additional employees being hired in the SBA and electronic payment processing segments. Electronic payment processing direct costs increased by approximately $2,179,000 to $2,579,000 for the three months ended June 30, 2004 from $400,000 for the three months ended June 30, 2003, due to the significant increase in the number of electronic payment processing customers as well as the acquisition of Automated Merchant Services in August 2003. Professional fees decreased by approximately $431,000 to $1,295,000 for the three months ended June 30, 2004 from $1,726,000 for the three months ended June 30, 2003. This decrease is primarily due to reduced legal expenses because the Company was in the process of forming two new Capcos in the prior period. Insurance expense increased by approximately $53,000 to $691,000 for the three months ended June 30, 2004 from $638,000 for the three months ended June 30, 2003. This increase is due to the additional insurance relating to the new Capco funded in 2004, Wilshire Alabama Partners, and the new Capco funded in October 2003, Wilshire Louisiana Partners IV. Recovery (benefit) of loan losses increased to approximately $152,000 for the three months ended June 30, 2004 from $0 for the three months ended June 30, 2003. This is attributable to NSBF selling loans to a bank in June, 2004 that were previously classified as held for investment. In connection with this sale, NSBF reversed the reserve for loan loss associated with these loans and recorded a benefit of approximately $288,000, offset by $136,000 in loan loss provisions. There was no loan loss provision in the same period in the prior year due to NSBF not originating any loans. Other expenses increased by approximately $79,000 to $1,433,000 for the three months ended June 30, 2004 from $1,354,000 for the three months ended June 30, 2003. The increase was due primarily to expenses incurred by consolidated operating entities other than electronic payment processing as described above. Other than temporary decline in value of investments decreased by approximately $20,000 to $0 for the three months ended June 30, 2004 from $20,000 for the three months ended June 30, 2003, due to the Company's determination that there were no other than temporary declines in the value of investments for the period ended June 30, 2004. During the period ended June 30, 2003, the Company determined that there was an approximately $20,000 other than temporary decline in the value of its investments for Transworld Business Brokers, LLC. For the three months ended June 30, 2004, equity in net losses of affiliates decreased by approximately $63,000 to $0. This decrease is attributable to the investments accounted for under the equity method being written down to $0 as of December 31, 2003. The Company's results of operations declined by approximately $873,000 from net income of $2,706,000 for the three months ended June 30, 2003 to $1,833,000 for the three months ended June 30, 2004, due to the decreases in revenue of approximately $238,000 and the increases in overall expenses of approximately $2,370,000 discussed above, minority interest of approximately $1,279,000, offset by the decrease in the taxes of approximately $456,000. 22 CONSOLIDATED OPERATING ENTITIES: At June 30, 2004, Newtek had twenty-two majority-owned consolidated operating entities, most of which were as a result of investments through the Capco programs. For the six months ended June 30, 2004, these companies represented approximately $497,000 in income that are consolidated in Newtek's results (net of inter-company eliminations of approximately $1,357,000 in revenues and $1,357,000 in expenses). For the six months ended June 30, 2004, revenues from consolidated operating entities, net of inter-company eliminations, amounted to $13,065,000 and were generated from the following sources: SBA lending ($5,299,000) electronic payment processing ($7,303,000), outsourced financial information systems ($146,000), and other ($317,000). For the six months ended June 30, 2004, expenses incurred by consolidated operating companies, net of inter-company eliminations, amounted to $12,568,000 and were incurred by the following sources: SBA lending ($3,579,000) electronic payment processing ($7,197,000), outsourced financial information systems ($301,000), and other ($1,491,000). At June 30, 2003, Newtek had sixteen majority-owned consolidated operating entities, most of which were as a result of investments through the Capco programs. For the six months ended June 30, 2003, these companies represented approximately $1,950,000 in losses that are consolidated in Newtek's results (net of inter-company eliminations of $783,000 in revenues and $783,000 in expenses). For the six months ended June 30, 2003, revenues from consolidated operating entities, net of inter-company eliminations, amounted to $5,481,000 and were generated from the following sources: SBA lending ($3,006,000) electronic payment processing ($1,988,000), outsourced financial information systems ($129,000), and other ($358,000). For the six months ended June 30, 2003, expenses incurred by consolidated operating companies, net of inter-company eliminations, amounted to $7,431,000 and were incurred by the following sources: SBA lending ($3,171,000) electronic payment processing ($2,582,000), outsourced financial information systems ($356,000), and other ($1,322,000). LIQUIDITY AND CAPITAL RESOURCES Newtek has funded its operations primarily through the issuance by the Capcos of notes to insurance companies through the Capco programs. Through June 30, 2004, Newtek has received approximately $184,637,000 in proceeds from the issuance of long-term debt, Capco warrants, and Newtek common stock through the Capco programs. Newtek's principal capital requirements have been to fund the purchase of Coverage A insurance related to the notes issued to the insurance companies (approximately $102,381,000), the acquisition of Coverage B Capco insurance policies ($21,255,000), the acquisition of consolidated operating entity's interests, identifying other Capco-qualified investments, and working capital needs resulting from operating and business development activities of its consolidated operating entities. Net cash used in operating activities for the six months ended June 30, 2004 of approximately $3,168,000 resulted primarily from net income of $129,000 adjusted for the non-cash interest expense of approximately $5,884,000, proceeds from the sale of SBA loans of approximately $17,423,000, and other non cash charges for stock compensation, depreciation and amortization totaling approximately $1,368,000. It was also affected by the approximately $90,000 of a deferred tax provision, $194,000 of discount on loan originations, offset by approximately $610,000 of minority interest, approximately $9,048,000 in non-cash income from tax credits, and approximately $16,644,000 in SBA loans originated for sale. In addition, Newtek had a net decrease in components of prepaid insurance, prepaid expenses and other assets, accounts receivable and capitalized servicing assets, and accounts payable and accruals of approximately $1,819,000. Net cash used in operating activities for the six months ended June 30, 2003 of approximately $5,082,000 resulted primarily from net income of approximately $4,565,000, increased by the non-cash interest expense of approximately $5,913,000. It was also affected by the approximately $1,734,000 in other than temporary decline in value of investments, approximately $680,000 in minority interest, the approximately $21,859,000 in income from tax credits, and the deferred income tax provision of $2,799,000. In addition, Newtek had an increase in components of prepaid insurance, prepaid expenses and other assets, accounts receivable and capitalized servicing assets, and accounts payable and accruals of approximately $702,000. Net cash provided by investing activities for the six months ended June 30, 2004 of approximately $13,465,000 resulted primarily from proceeds from sale of SBA loans held for investment and reclassified as held for sale of approximately $17,022,000, approximately $4,258,000 from repayment of SBA loans, and $2,506,000 from returns of 23 principal from qualified investments. This was offset by investments in qualified businesses totaling $6,016,000, SBA loans originated for investment of approximately $7,473,000, other investments of $215,000 and approximately $291,000 of purchases of furniture, fixtures and equipment. Net cash provided by investing activities for the six months ended June 30, 2003 of approximately $2,233,000 resulted primarily from returns of principal of approximately $2,106,000, offset by approximately $4,510,000 in additional qualified investments made in the period. Newtek also received approximately $3,245,000 in repayments of its SBA loan receivables and Newtek consolidated approximately $1,550,000 of cash of its majority owned partner companies. Net cash used in financing activities for the six months ended June 30, 2004 was approximately $6,091,000, primarily attributable to proceeds from the issuance of long term debt of approximately $10,925,000, approximately $1,968,000 from the private placement of common stock and exercise of stock options and a change in restricted cash of approximately $47,000. This was offset by approximately $3,348,000 in payments for insurance, including Coverage B, $1,112,000 in payments on notes payable-insurance, $240,000 in payments of notes payable-other and repayments on SBA bank notes payable of $14,332,000. Net cash used in financing activities for the six months ended June 30, 2003 was approximately $295,000, primarily attributable to approximately $1,457,000 from the private placement of common stock and exercise of stock options, and $2,000,000 in proceeds from the sale of preferred stock of a consolidated subsidiary, offset by approximately $2,699,000 in payments on loans payable, repayment of notes payable-insurance of $578,000, repayment of subordinated notes payable of $25,000 and repayment of a line of credit borrowing of $450,000. During the six months ended June 30, 2004 we and our affiliated companies generated cash flow primarily from the following sources: o private placement of common stock and exercise of stock options, netting $1,968,000; o proceeds from issuance of long-term debt and warrants of $10,925,000; o interest and dividend income of approximately $2,071,000; o other income of approximately $676,000, which represents revenue from Newtek's consolidated operating entities o proceeds from sales of SBA loans of approximately $17,423,000; o payments received on SBA loans of approximately $4,258,000; and o proceeds from sale of SBA loans held for investment, reclassified as held for sale of approximately $17,022,000. The cash was primarily used to: o originate approximately $24,117,000 in SBA loans held for investment and for sale; o invest in qualified businesses of approximately $6,016,000 o repay SBA bank notes payable of approximately $14,332,000 o repay note payable-insurance of approximately $1,112,000; and o purchase of Coverage A insurance of approximately $3,348,000. During the six months ended June 30, 2003 we generated cash flow primarily from the following sources: o private placement of common stock, netting $1,456,000; 24 o returns of principal from qualified businesses of approximately $2,106,000; o interest and dividend income of approximately $2,084,000; o proceeds from the sale of subsidiary preferred stock of $2,000,000; o other income of approximately $987,000, which represents revenue from consolidated operating entities; and o cash received repayments on SBA loans of approximately $3,245,000. The cash was primarily used to: o invest approximately $4,510,000 in small or early stage businesses; o repay SBA bank notes and note payable-other of approximately $3,174,000; o repay notes-payable- insurance of approximately $ 578,000; and o purchase property, plant and equipment of approximately $128,000. FORWARD-LOOKING STATEMENTS This Quarterly Report on Form 10Q contains forward-looking statements. Additional written or oral forward-looking statements may be made by Newtek from time to time in filings with the Securities and Exchange Commission or otherwise. The words "believe," "expect," "seek," and "intend" and similar expressions identify forward-looking statements, which speak only as of the date the statement is made. Such forward-looking statements are within the meaning of that term in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements may include, but are not limited to, projections of income or loss, expenditures, acquisitions, plans for future operations, financing needs or plans relating to our services, as well as assumptions relating to the foregoing. Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Future events and actual results could differ materially from those set forth in, contemplated by or underlying the forward-looking statements. Newtek does not undertake, and specifically disclaims, any obligation to publicly release the results of revisions which may be made to forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after such statements. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK: All of our business activities contain elements of risk. We consider the principal types of risk to be fluctuations in interest rates and loan portfolio valuations in the SBA loans receivable. We consider the management of risk essential to conducting our businesses. Accordingly, risk management systems and procedures are designed to identify and analyze our risks, to set appropriate policies and limits and to continually monitor these risks and limits by means of reliable administrative and information systems and other policies and programs. We transact business with merchants exclusively in the United States and receive payment for our services exclusively in United States dollars. As a result, our financial results are unlikely to be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Our interest expense is sensitive to changes in the general level of interest rates in the United States, because a majority of our indebtedness is at variable rates. At June 30, 2004, $37.7 million of our outstanding indebtedness was at variable interest rates based on the prime rate. A rise in the prime rate of one percentage point would result in additional interest expense of approximately $407,000. However, our interest income would also increase by approximately the same amount, due to the variability of the interest rates on our SBA loans receivable. Although management believes that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in credit quality, size and composition of the assets on the balance sheet, and other business developments that could affect net 25 increase (decrease) in assets. Accordingly, no assurances can be given that actual results would not differ materially from the potential outcome simulated by this estimate. The increase in the borrower's interest rate however, does increase the risk of default. We do not hold derivative financial or commodity instruments, nor engage in any foreign currency denominated transactions, and all of our cash and cash equivalents are held in money market and checking funds. ITEM 4. CONTROLS AND PROCEDURES: As of June 30, 2004, Newtek Business Services, Inc. carried out an evaluation, under the supervision and with the participation of Newtek's management, including Newtek's Chief Executive Officer and Newtek's Chief Financial Officer, of the effectiveness of the design and operation of Newtek's disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, Newtek's Chief Executive Officer and Newtek's Chief Financial Officer concluded that Newtek's disclosure controls and procedures are effective in alerting them in a timely manner to material information relating to Newtek (including its consolidated subsidiaries) required to be included in Newtek's periodic SEC filings. There has been no change in the Company's internal control over financial reporting identified in connection with the evaluation performed above that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. Disclosure controls and procedures are designed to ensure that information required to be disclosed in reports filed by Newtek under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to Newtek's management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. Disclosure controls include internal controls that are designed to provide reasonable assurance that transactions are properly authorized, assets are safeguarded against unauthorized or improper use and transactions are properly recorded and reported. Any control system, no matter how well conceived and operated, can provide only reasonable assurance that its objectives are achieved. The design of a control system inherently has limitations, including the controls' cost relative to their benefits. Additionally, controls can be circumvented. No cost-effective control system can provide absolute assurance that all control issues and instances of fraud, if any, will be detected. PART II - OTHER INFORMATION 26 ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS We entered into the following transaction during the three months ended June 30, 2004 in connection with the sale of our common stock. The transaction was a direct sale by us to the purchaser for cash and was done in reliance on Section 4(2) of the Securities Act of 1933, as amended. -------------------------------------------------------------------- ---------- ----------- ------- Name Date Shares Price -------------------------------------------------------------------- ---------- ----------- ------- Jeffrey Cohen 4/2/04 20,000 $5.00 -------------------------------------------------------------------- ---------- ----------- ------- American International Specialty Lines Insurance Company 5/15/04 144,458 $5.06 -------------------------------------------------------------------- ---------- ----------- ------- ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (a) On July 9, 2004 we held our annual meeting of shareholders, at which there were present in person or by proxy 16,863,209, or 62.3%, of the outstanding shares of common stock. (b) All seven of the incumbent directors were reelected for one year terms with votes as follows: FOR WITHHOLD --- -------- David Beck 16,727,262 135,947 (One-year term) Christopher G. Payan 16,855,539 7,670 (One-year term) Jeffrey G. Rubin 16,727,262 135,947 (One-year term) Steven A. Shenfeld 16,855,539 7,670 (One-year term) Jeffrey M. Schottenstein 16,727,262 135,947 (One-year term) Barry Sloane 16,855,539 7,670 (One-year term) Brian A. Wasserman 16,855,539 7,670 (One-year term) (c) In addition to the election of directors, shareholders voted upon and approved the adoption of the Company's proposed 2003 Incentive Stock Plan. The vote was For: 16,171,699 votes Withheld: 689,235 votes There were no abstentions or non-voting broker votes. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits attached to this Quarterly Report on Form 10-Q are: 27 Exhibits 31.1 and 31.2, Certifications of the Chief Executive Officer and the Chief Financial Officer. Exhibit 31.1, Certification pursuant to 18 USC (Section) 1350. (b) During the quarter ended June 30, 2004 we filed the following Current Reports on Form 8-K: April 30, 2004: Announcement of the execution of Asset Purchase Agreement with CrystalTech Web Hosting, Inc., with audited financial statements for CrystalTech for the periods ending December 31, 2003 and 2002. May 5, 2004: Announcement of results of operations for the three months ended March 31, 2004. June 25, 2004: Announcement of the execution by Newtek Small Business Finance, Inc. of a one year extension of its warehouse line of credit used as a principal source of funding for the company's SBA lending program; a secondary line of credit with Banco Popular Dominica was also announced. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NEWTEK BUSINESS SERVICES, INC. Date: August 12, 2004 /s/ Barry Sloane ----------------------------------------------------------- Barry Sloane Chairman of the Board, Chief Executive Officer and Secretary Date: August 12, 2004 /s/ Brian A. Wasserman ---------------------------------------------------------- Brian A. Wasserman Treasurer, Chief Financial Officer and Director Date: August 12, 2004 /s/ Giuseppe Soccodato ---------------------------------------------------------- Giuseppe Soccodato Controller and Chief Accounting Officer 28