UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended October 31, 2005 ----------------------------------------- OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------------- ------------- Commission file number 1-11601 NATIONAL AUTO CREDIT, INC. -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Delaware 34-1816760 ------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 555 Madison Avenue, 29th Floor, New York, New York 10022 -------------------------------------------------- ----------------- (Address of principal executive offices) (Zip Code) (212) 644-1400 ---------------------------------------------------- (Registrant's telephone number, including area code) -------------------------------------------------------------------------------- (Former name, former address and former year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ( X ) No ( ) Indicate by check mark whether the registrant is an accelerated filer (as defined in rule 12b-2 of the Securities and Exchange Act). Yes ( ) No ( X ) Indicate by check mark whether the registrant is a shell company (as defined in rule 12b-2 of the Securities and Exchange Act) Yes ( ) No ( X ) Indicate the number of shares outstanding of each of the issuer's class of common stock, as of the latest practicable date: Class Outstanding at December 12, 2005 ----------------------------- -------------------------------- Common Stock, $0.05 par value 9,036,364 NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES TABLE OF CONTENTS PAGE ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Report of Independent Registered Public Accounting Firm 3 Condensed Consolidated Balance Sheets as of October 31, 2005 and January 31, 2005 4 Condensed Consolidated Statements of Operations for the Three Months and the Nine Months Ended October 31, 2005 and 2004 5 Condensed Consolidated Statement of Stockholders' Equity and Comprehensive Income (Loss) for the Nine Months Ended October 31, 2005 6 Condensed Consolidated Statements of Cash Flows for the Nine Months Ended October 31, 2005 and 2004 7 Notes to Condensed Consolidated Financial Statements 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 19 Item 3. Quantitative and Qualitative Disclosures about Market Risk 33 Item 4. Controls and Procedures 33 PART II. OTHER INFORMATION Item 1. Legal Proceedings 35 Item 1A. Risk Factors 38 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 38 Item 3. Defaults Upon Senior Securities 38 Item 4. Submission of Matters to a Vote of Security Holders 38 Item 5. Other Information 38 Item 6. Exhibits 38 Signatures 39 Certifications 40 -2- PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of National Auto Credit, Inc. and Subsidiaries New York, New York We have reviewed the accompanying condensed consolidated balance sheet of National Auto Credit, Inc. and Subsidiaries as of October 31, 2005, the related condensed consolidated statements of operations for each of the three-month and nine-month periods ended October 31, 2005 and 2004; the related condensed consolidated statement of stockholders' equity and comprehensive loss for the nine-month period ended October 31, 2005 and the condensed consolidated statements of cash flows for the nine-month periods ended October 31, 2005 and 2004. These financial statements are the responsibility of the Company's management. We conducted our reviews in accordance with standards established by the Public Company Accounting Oversight Board ("PCAOB"). A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to such condensed consolidated financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We have previously audited, in accordance with standards established by the PCAOB, the consolidated balance sheet as of January 31, 2005, and the related consolidated statements of operations, stockholders' equity and comprehensive loss, and cash flows for the year then ended (not presented herein) and in our report dated April 22, 2005, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of January 31, 2005, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. /s/ Grant Thornton LLP Cleveland, Ohio December 9, 2005 -3- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) October 31, January 31, 2005 2005 ------------ ------------ (unaudited) ASSETS Cash and cash equivalents $ 859 $ 471 Accounts receivable, net of allowance of $67 and $65, respectively (Note 1) 2,785 2,132 Income taxes refundable - 826 Prepaid expenses 303 256 Other current assets 204 494 ------------ ------------ Total current assets 4,151 4,179 Property and equipment, net of accumulated depreciation of $1,810 and $1,216, respectively (Note 1) 1,845 2,240 Investment in AFC (Note 3) 8,111 7,955 Goodwill (Note 1) 4,920 4,920 Other intangible assets, net of accumulated amortization of $1,277 and $852, respectively (Note 1) 8,205 8,630 Other assets 148 165 ------------ ------------ $ 27,380 $ 28,089 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES Current maturities of long term obligations (Note 4) $ 1,175 $ 1,612 Accounts payable 1,969 1,255 Self-insurance claims (Note 6) 235 256 Accrued income taxes 339 328 Deferred revenue (Note 1) 1,453 1,194 Other liabilities 1,092 1,392 ------------ ------------ Total current liabilities 6,263 6,037 Long term obligations (Note 4) 8,602 8,650 Convertible promissory note (Note 4) 2,825 2,825 ------------ ------------ 17,690 17,512 ------------ ------------ COMMITMENTS AND CONTINGENCIES (Notes 2 and 6) - - STOCKHOLDERS' EQUITY Preferred stock - - Common stock - $.05 par value, authorized 40,000,000 shares, issued 39,949,589 1,997 1,997 Additional paid-in capital 174,542 174,454 Retained deficit (143,607) (143,383) Deferred compensation (71) (89) Treasury stock, at cost, 31,409,475 and 29,946,975 shares, respectively (Note 2) (23,171) (22,402) ------------ ------------ Total stockholders' equity 9,690 10,577 ------------ ------------ $ 27,380 $ 28,089 ============ ============ See accompanying notes to condensed consolidated financial statements. -4- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) Three Months Ended Nine Months Ended October 31, October 31, --------------------------- --------------------------- 2005 2004 2005 2004 --------- ---------- --------- ---------- Service revenues $ 4,503 $ 2,999 $ 8,999 $ 8,680 Cost of service revenues 2,390 1,846 5,155 5,134 --------- ---------- --------- ---------- Gross profit 2,113 1,153 3,844 3,546 Selling, general and administrative 2,210 1,926 6,046 5,512 --------- ---------- --------- ---------- Loss from operations (97) (773) (2,202) (1,966) Interest income 7 - 42 - Income from AFC investment 348 165 564 354 Interest expense (161) (221) (484) (565) Other income - net (Note 2) - - 1,897 - --------- ---------- --------- ---------- Income (loss) from continuing operations before income taxes 97 (829) (183) (2,177) Provision for income taxes - - (15) - --------- ---------- --------- ---------- Income (loss) from continuing operations 97 (829) (198) (2,177) Income (loss) from discontinued operations, net of tax - - 16 (6) --------- ---------- --------- ---------- Net income (loss) $ 97 $ (829) $ (182) $ (2,183) ========= ========== ========= ========== Basic and diluted income (loss) per share Continuing operations $ .01 $ (.09) $ (.02) $ (.23) Discontinued operations - - - - ========= ========== ========= ========== Net income (loss) per share $ .01 $ (.09) $ (.02) $ (.23) ========= ========== ========= ========== Weighted average number of shares outstanding Basic and diluted 8,540 9,430 9,355 9,370 ========= ========== ========= ========== See accompanying notes to condensed consolidated financial statements. -5- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS NINE MONTHS ENDED OCTOBER 31, 2005 (IN THOUSANDS, EXCEPT SHARE DATA) (UNAUDITED) Preferred Stock Common Stock --------------- ----------------------- Additional Par Par Paid-In Retained Treasury Shares Value Shares Value Capital Deficit Stock ------ ------ ---------- --------- ----------- ----------- ----------- Balance at January 31, 2005 - $ - 39,949,589 $ 1,997 $ 174,454 $ (143,383) $ (22,402) Net loss (182) Treasury stock issued for services (42) 75 Treasury stock purchased (Note 2) (844) Fair value of Eligible Shareholder warrants to be issued (ote 2) 88 Deferred compensation expense ------ ------ ---------- --------- ----------- ------------ ----------- Comprehensive income (loss) Balance at October 31, 2005 - $ - 39,949,589 $ 1,997 $ 174,542 $ (143,607) $ (23,171) ====== ====== ========== ========= =========== ============ =========== Deferred Comprehensive Compensation Income Expense Total (Loss) ------------- ---------- ------------- Balance at January 31, 2005 $ (89) $ 10,577 Net loss (182) $ (182) Treasury stock issued for services 33 Treasury stock purchased (Note 2) (844) Fair value of Eligible Shareholder warrants to be issued (Note 2) 88 Deferred compensation expense 18 18 ------------- ---------- ------------- Comprehensive income (loss) $ (182) ============= Balance at October 31, 2005 $ (71) $ 9,690 ============ ========== See accompanying notes to condensed consolidated financial statements. -6- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) Nine Months Ended October 31, --------------------------- 2005 2004 --------- --------- Cash flows from operating activities Net loss $ (182) $ (2,183) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: (Income) loss from discontinued operations (16) 6 Depreciation and amortization 1,019 996 Fair value of Eligible Shareholder warrants 88 - Changes in operating assets and liabilities, net of acquisition: Accounts receivable (653) (487) Income tax refundable 714 92 Accrued income tax 11 (7) Accounts payable and other liabilities 826 72 Deferred revenue 259 661 Other operating assets and liabilities, net (345) (548) --------- ---------- Net cash provided by (used in) operating activities 1,721 (1,398) --------- ---------- Cash flows from investing activities: Proceeds from AFC distributions 408 937 Purchase of property and equipment (199) (187) --------- ---------- Net cash provided by investing activities 209 750 --------- ---------- Cash flows from financing activities: Proceeds from issuance of promissory note - 1,000 Proceeds from sale of treasury stock - 237 Payments to acquire treasury stock (1,052) - Payments of long term debt (485) (357) --------- ---------- Net cash provided by (used in) financing activities (1,537) 880 --------- ---------- Increase in cash and cash equivalents from continuing operations 393 232 Decrease in cash and cash equivalents from discontinued operations (5) (133) Cash and cash equivalents at beginning of period 471 376 --------- ---------- Cash and cash equivalents at end of period $ 859 $ 475 ========= ========== Supplemental disclosures of cash flow information: Interest paid $ 484 $ 569 ========= ========== Income taxes paid $ 4 $ 7 ========= ========== Stock issued for services $ 33 $ - ========= ========== Fair value of Eligible Shareholder warrants $ 88 $ - ========= ========== See accompanying notes to condensed consolidated financial statements -7- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 - BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES General ------- The accompanying unaudited condensed consolidated financial statements include the accounts of National Auto Credit, Inc. and Subsidiaries ("NAC"). NAC, through its operating subsidiaries, Audience Response Systems, Inc. ("ARS") and the Campus Group Companies, Inc. ("Campus" and collectively with ARS, the "The Campus Group") and OMI Business Communications, Inc. ("OMI"), specializes in the full-service design, creative development, production, post production editing and transmission, via broadcast satellite videoconferencing, webcasting and traditional on-site presentations, of corporate communication, education and training video and other services for use at corporate events. Additionally, NAC, through its investment in the Angelika Film Center LLC ("AFC"), operates in the movie exhibition industry (see Note 3). The financial statements are unaudited, but in the opinion of management, reflect all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of NAC's consolidated financial position, results of operations, stockholders' equity and comprehensive loss, and cash flows for the periods presented. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial statements and with the rules of the Securities and Exchange Commission applicable to interim financial statements, and therefore do not include all disclosures that might normally be required for interim financial statements prepared in accordance with generally accepted accounting principles. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with NAC's consolidated financial statements, including the notes thereto, appearing in NAC's Annual Report on Form 10-K for the year ended January 31, 2005. The results of operations for the nine months ended October 31, 2005 are not necessarily indicative of the operating results for the full year. The preparation of financial statements and the accompanying notes thereto, in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the respective reporting periods. Actual results could differ from those estimates. NAC uses a January 31 year-end for financial reporting purposes. References herein to the fiscal year ended January 31, 2006 shall be the term "Fiscal 2006" and references to other "Fiscal" years shall mean the year, which ended on January 31 of the year indicated. The term the "Company" or "NAC" as used herein refers to National Auto Credit, Inc. together with its subsidiaries unless the context otherwise requires. Discontinued Operations ----------------------- Effective December 31, 2001, NAC suspended its ZoomLot operations and initiated steps to discontinue e-commerce operations. Additionally, as a consequence of NAC's decision to discontinue its ZoomLot e-commerce operations, NAC also formally exited the sub-prime used automobile consumer finance business effective December 31, 2001. As a result of these decisions, both the e-commerce and automobile finance segments have been classified as discontinued operations as of January 31, 2002. For the nine months ended October 31 2005, NAC realized income from discontinued operations of $16,000. For the nine months ended October 31, 2004, NAC incurred a loss from discontinued operations of $6,000. -8- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 - BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES - CONTINUED Service Revenues ---------------- NAC's service revenues are earned within short time periods, generally less than one week. NAC recognizes revenue from video production, video editing, meeting services and broadcast satellite or webcast services when the video is complete and delivered or all technical services have been rendered. Deposits and other prepayments are recorded as deferred revenue until revenue is recognized. NAC does not have licensing or other arrangements that result in additional revenues following the delivery of the video or a broadcast. Costs accumulated in the production of the video, meeting services or broadcasts are deferred until the sale and delivery are complete. Deferred production costs of $204,000 and $401,000, respectively, are included as a component of other current assets at October 31, 2005 and January 31, 2005, respectively. NAC recognizes revenue from website design and development when the customer accepts the completed project. Deposits and other prepayments are recorded as deferred revenue until revenue is recognized. These contracts are generally limited to the design and development of websites and the presentation of site library content developed by NAC. Clients also have the option to engage NAC to maintain and upgrade their websites. These projects are separate from the website development and design engagements, and the related revenue is recognized over the term of the agreement, which is generally up to one year. NAC recognizes revenue from developing and maintaining websites pursuant to the requirements of Statement of Position No. 97-2, "Software Revenue Recognition" ("SOP 97-2"), as amended by Statement of Position No. 98-9, "Software Revenue Recognition with Respect to Certain Arrangements." Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software. If at the outset of the customer arrangement, NAC determines that the arrangement fee is not fixed or determinable or that collectibility is not probable, NAC defers the revenue and recognizes the revenue when the arrangement fee becomes due and payable or, when collectibility is uncertain, as cash is collected. Cost of Service Revenues ------------------------ Cost of revenues consists of direct expenses specifically associated with client service revenues. The cost of revenues includes direct salaries and benefits, purchased products or services for clients, web hosting, support services, shipping and delivery costs. Accounts Receivable ------------------- Accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is NAC's best estimate of the amount of probable credit losses in NAC's existing accounts receivable. NAC determines the allowance based on analysis of historical bad debts, client concentrations, client credit-worthiness and current economic trends. NAC reviews its allowance for doubtful accounts quarterly. Past-due balances over 90 days and specified other balances are reviewed individually for collectibility. All other balances are reviewed on an aggregate basis. Account balances are written off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. NAC does not have any off-balance sheet credit exposure related to its customers. -9- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 - BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES - CONTINUED Property and Equipment ---------------------- Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from eighteen months to ten years. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful lives of the related improvements. Goodwill and Other Intangible Assets ------------------------------------ Intangible assets with indefinite lives, including goodwill, are not subject to amortization but are subject to testing for impairment at least annually or whenever there is an impairment indicator. In its acquisition of The Campus Group, NAC acquired certain intangible assets including client relationships and lists and a non-competition agreement with an initial aggregate fair value of $9.5 million. The useful lives of these intangibles are estimated to be 17 years and 9 years, respectively. The intangible assets with definite useful lives are amortized using the straight-line method over those lives. For the nine months ended October 31, 2005 and 2004, NAC charged to operations $425,000 and $426,000, respectively, for the amortization of these intangible assets. Impairment of Long-Lived Assets ------------------------------- NAC reviews the carrying value of its long-lived assets (other than goodwill) whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. If indicators of impairment exist, NAC would determine whether the estimated undiscounted sum of the future cash flows of such assets is less than its carrying amount. If less, an impairment loss would be recognized based on the excess of the carrying amount of such assets over their respective fair values. NAC would determine the fair value by using quoted market prices, if available, for such assets; or if quoted market prices are not available, NAC would discount the expected estimated future cash flows. Income Taxes ------------ Deferred income taxes are provided for all temporary differences between the book and tax basis of assets and liabilities. Deferred income taxes are adjusted to reflect new tax rates when they are enacted into law. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recognized if it is anticipated that some or all of a net deferred tax asset may not be realized. Reclassifications ----------------- Certain Fiscal 2005 amounts have been reclassified to conform with Fiscal 2006 presentations. -10- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 - BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES - CONTINUED New Accounting Pronouncements ----------------------------- In December, 2004 the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 123R (revised 2004), Share-Based Payment, which replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first interim or annual period after December 15, 2005, with early adoption encouraged. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. NAC is required to adopt SFAS 123R at the beginning of Fiscal 2007 (effective February 1, 2006). Under SFAS No. 123R, NAC must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include prospective and retrospective adoption options. Under the retrospective option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption while the retrospective methods would record compensation expense for all unvested stock options and restricted stock beginning with the first period restated. NAC has not yet determined the method of adoption or the effect of adopting SFAS 123R, and has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123. In December 2004, the FASB issued SFAS No. 153, Exchange of Nonmonetary Assets, which is an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions. The guidance in APB Opinion No. 29 is based on the principle that exchanges of nonmonetary assets should be measured based upon the fair value of the assets exchanged, with certain exemptions to that principle. SFAS No. 153 eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a consequence of the exchange. The adoption of SFAS No. 153 will be effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005. NAC expects that the adoption of SFAS No. 153 will not have a material impact NAC's consolidated financial statements. In May 2005, FASB issued Statement No. 154, Accounting Changes and Error Corrections ("SFAS 154"). SFAS 154 replaces APB No. 20, Accounting Changes, and SFAS 3, Reporting Accounting Changes in Interim Financial Statements, and establishes retrospective application as the required method for reporting a change in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 applies to all voluntary changes in accounting principles and to changes required by an accounting pronouncement in the instance that the pronouncement does not include specific transition provisions. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. NAC expects that the adoption of SFAS 154 will not have a material impact on NAC's consolidated financial position or results of operations. -11- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 2 - SHAREHOLDER COMPLAINT SETTLEMENT Shareholder Complaints ---------------------- In July and August 2001, NAC received three separate derivative complaints filed with the Court of Chancery of Delaware ("Delaware Court") by each of Academy Capital Management, Inc ("Academy Complaint")., Levy Markovich, ("Markovich Complaint") and Harbor Finance Partners ("Harbor Complaint"), all shareholders of NAC, against James J. McNamara, John A. Gleason, William S. Marshall, Henry Y.L. Toh, Donald Jasensky, Peter T. Zackaroff, Mallory Factor, and Thomas F. Carney, Jr. (the "Director Defendants") and names NAC as a nominal defendant. By order of the Delaware Court on November 12, 2001, the Academy, Markovich and Harbor Complaints were consolidated under the title "In re National Auto Credit, Inc. Shareholders Litigation," Civil Action No. 19028 NC (Delaware Court) ("Delaware Action") and the Academy Complaint were consolidated as the Delaware Action. The Delaware Action principally sought: (i) a declaration that the Director Defendants breached their fiduciary duties to NAC, (ii) a judgment voiding an employment agreement with James J. McNamara and rescinding a stock exchange agreement in which NAC acquired ZoomLot, (iii) a judgment voiding the grant of stock options and the award of director fees allegedly related thereto, (iv) an order directing the Director Defendants to account for alleged damages sustained and profits obtained by the Director Defendants as a result of the alleged various acts complained of, (v) the imposition of a constructive trust over monies or other benefits received by the Director Defendants, (vi) a judgment requiring the Director Defendants to promptly schedule an annual meeting of shareholders and (vii) an award of costs and expenses. On October 12, 2001, NAC received a derivative complaint filed by Robert Zadra, a shareholder of NAC, that had been filed with the Supreme Court of the State of New York ("New York Court") on or about October 12, 2001 against James J. McNamara, John A. Gleason, William S. Marshall, Henry Y. L. Toh, Donald Jasensky, Peter T. Zackaroff, Mallory Factor, Thomas F. Carney, Jr., and NAC as Defendants. On or about May 29, 2002 the complaint was amended to include class action allegations (the "New York Action"). The New York Action contained allegations similar to those in the Delaware Action concerning the Board's approval of the employment agreement with James McNamara, option grants and past and future compensation to the Director Defendants, and the ZoomLot transaction. The New York Action sought (i) a declaration that as a result of approving these transactions the Director Defendants breached their fiduciary duties to NAC, (ii) a judgment enjoining Director Defendants from proceeding with or exercising the option agreements, (iii) rescission of the option grants to Director Defendants, if exercised, (iv) an order directing the Director Defendants to account for alleged profits and losses obtained by the Director Defendants as a result of the alleged various acts complained of, (v) awarding compensatory damages to NAC and the class, together with prejudgment interest, and (vi) an award of costs and expenses. NAC has vigorously defended against each of the respective claims made in the Delaware Action and New York Action, as it believes that the claims have no merit. -12- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 2 - SHAREHOLDER COMPLAINT SETTLEMENT - CONTINUED The parties in the New York Action thereafter engaged in settlement negotiations and, in December 2002, the parties entered into a stipulation of settlement which was thereafter amended in November 2004 (the "New York Settlement Stipulation"). Under the terms of the New York Settlement Stipulation, NAC agreed (subject to certain terms and conditions) to, among other things, (a) adopt or implement certain corporate governance procedures or policies, (b) issue to a class of NAC shareholders who had continuously held NAC Common Stock from December 14, 2000 through December 24, 2002 ("Eligible NAC Shareholders") up to one million warrants (one warrant per 8.23 shares of Common Stock), with each warrant having a five year term and being exercisable for shares of NAC Common Stock at a price of $1.55 per share, (c) cancel 50% of certain stock options granted on December 15, 2000, and (d) make certain payments for legal fees for counsel to the plaintiffs in the New York Action. The New York Settlement Stipulation created for the benefit of NAC a Settlement Fund in the amount of $2.5 million to be funded by an insurance policy. The New York Court also subsequently approved $500,000 for legal fees for counsel to the plaintiffs in the New York Action to be paid from the proceeds from the Settlement Fund. In order to facilitate the settlement and dismissal of the separate Delaware Action as well as the New York Action, on April 22, 2005, NAC entered into a Stock Purchase Agreement ("Agreement") with Academy Capital Management, Inc., Diamond A. Partners, L.P., Diamond A. Investors, L.P., Ridglea Investor Services, Inc. and William S. Banowsky (hereinafter referred to collectively as the "Selling Stockholders"). The Selling Stockholders had also raised objections to the settlement of the New York Action. The New York Court (a) had rejected the objections raised by the Selling Stockholders and (b) had approved as fair and in the best interests of NAC and its shareholders the proposed settlement of the New York Action as set forth in the New York Settlement Stipulation. The Selling Stockholders had then filed an appeal (the "Appeal") to such determination by the New York Court. Pursuant to the terms of the Agreement, the Selling Stockholders agreed, among other things, to do the following: o enter into a stipulation (to be filed with the New York Court) pursuant to which they will (a) irrevocably withdraw, with prejudice, any objections they had asserted or might have asserted with respect to the settlement of the New York Action, (b) stipulate to the entry of an order dismissing the New York Action and (c) agree to the dismissal of the Appeal. o enter into a stipulation (to be filed with the Appellate Division, First Department, of the Supreme Court of the State of New York) providing for the dismissal of the Appeal. o enter into a stipulation (to be filed in the Delaware Court), pursuant to which they will agree to the dismissal of the Delaware Action with prejudice. The Selling Stockholders executed and delivered to NAC and NAC filed with the applicable New York Court and Delaware Court each of the stipulations referred to above. Effective May 5, 2005, the New York Court entered a Final Order and Judgment in which it approved the Stipulation of Dismissal of Objections, finding the terms set forth therein fair, reasonable and adequate, and dismissed the New York Action and the objections to the New York Settlement with prejudice. Effective May, 13, 2005, the Appellate Division, First Department, of the Supreme Court of the State of New York granted the dismissal of the Appeal. Effective May 18, 2005, the Delaware Court granted an Order and Judgment Dismissing Action with Prejudice the Delaware Action. As a consequence of each of the above actions by the respective courts, settlement of the New York Action and the Delaware Action, was deemed final in June 2005 and NAC received net proceeds of $2.0 million from NAC's insurer from the Settlement Fund in the New York Action. -13- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 2 - SHAREHOLDER COMPLAINT SETTLEMENT - CONTINUED Pursuant to the Agreement, NAC agreed (subject to certain terms and conditions set forth in the Agreement) to purchase from the Selling Shareholders their 1,562,500 shares of Common Stock at a price of $0.6732 per share (or a total purchase price of $1,051,875) and to contribute $100,000 to cover a portion of the legal fees incurred by the Selling Shareholders. Effective June 30, 2005, NAC purchased 1,562,500 shares of Common Stock from the Selling Stockholders. As a consequence of the confirmation of the New York Settlement Stipulation, the Dismissing Action with Prejudice of the Delaware Action and the subsequent purchase by NAC of Common Stock from the Selling Shareholders, for the nine months ended October 31, 2005, NAC recorded (i) a charge to operations of $100,000 for legal fees of the Selling Shareholders, (ii) a charge to operations of $208,000 for the excess cost over the market value of the Common Stock acquired as of the date of the Agreement, April 22, 2005, (iii) a charge to other income of $88,000 for the expense of the fair value of the warrants to be issued to Eligible Shareholders and (iv) realized other income of $2.0 million for the net proceeds received by NAC from the Settlement Fund. The Eligible NAC Shareholders have until December 2005 to submit their claim for one warrant for each 8.23 shares of Common Stock owned during the eligibility period, with each warrant having a five year term and being exercisable for shares of NAC Common Stock at a price of $1.55 per share. Upon the final submission of claims by Eligible NAC Shareholders, NAC anticipates issuing the final warrants in the fourth quarter of Fiscal 2006. As acknowledged by the Selling Shareholders in the Agreement, NAC was willing to enter into the Agreement, settle the New York Action and the Delaware Action and consummate the other transactions contemplated by the Agreement in order to terminate prolonged and expensive litigation and NAC's entry into the Agreement would not constitute or be deemed to constitute or evidence any improper or illegal conduct by or on behalf of NAC (or any of its directors, officers, employees and other agents or representatives) or any other wrong doing by NAC (or any of its directors, officers, employees and other agents or representatives). The Agreement was approved by the disinterested and independent members of NAC's Board of Directors. NOTE 3 - INVESTMENT IN AFC On April 5, 2000, NAC, through its wholly owned subsidiary National Cinemas, Inc., acquired a 50% membership interest in AFC. AFC is the owner and operator of the Angelika Film Center, which is a multiplex cinema and cafe complex in the Soho District of Manhattan in New York City. AFC is currently owned 50% by NAC and 50% by Reading International, Inc. ("Reading"). The articles and bylaws of AFC provide that for all matters subject to a vote of the members, a majority is required, except that in the event of a tie vote, the Chairman of Reading shall cast the deciding vote. NAC uses the equity method to account for its investment in AFC. NAC's initial investment exceeded its share of AFC's net assets and that portion of the investment balance is accounted for in a manner similar to goodwill. AFC uses a December 31 year-end for financial reporting purposes. NAC reports on a January 31 year-end, and for its fiscal quarters ending April 30, July 31, October 31 and January 31 records its pro-rata share of AFC's earnings on the basis of AFC's fiscal quarters ending March 31, June 30, September 30, and December 31, respectively. For the three months ended October 31, 2005 and 2004, NAC recorded income of $348,000 and $165,000, respectively, representing its share of AFC's net income. For the nine months ended October 31, 2005 and 2004, NAC recorded income of $564,000 and $354,000, respectively, representing its share of AFC's net income. -14- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 3 - INVESTMENT IN AFC - CONTINUED Summarized income statement data for AFC for the three months and nine months ended September 30, 2005 and 2004, respectively, is as follows (in thousands): Three Months Ended Nine Months Ended September 30, September 30, --------------------------- ------------------------------ 2005 2004 2005 2004 ------------ ----------- ------------ ------------- Revenues $ 2,063 $ 1,478 $ 4,615 $ 4,045 Film rental 499 269 1,033 772 Operating costs 628 639 1,743 1,849 Depreciation and amortization 197 198 584 589 General and administrative expenses 43 42 127 127 ------------ ----------- ------------ ------------- 1,367 1,148 3,487 3,337 ------------ ----------- ------------ ------------- Net income $ 696 $ 330 $ 1,128 $ 708 ============ =========== ============ ============= NAC's proportionate share of net income $ 348 $ 165 $ 564 $ 354 ============ =========== ============ ============= NOTE 4 - CURRENT AND LONG TERM OBLIGATIONS On July 14, 2004, National Auto Credit, Inc. ("NAC") consummated a Loan and Security Agreement ("Loan Agreement") with a lender and issued a Promissory Note ("Note") of $1.0 million. The lender, Time Passages Corp., is an unaffiliated third party lender. The President of Time Passages Corp. was a former director of NAC who last served on NAC's board in January 2002. Pursuant to the terms of the Note (i) the outstanding principal of the Note was due July 13, 2005, (ii) NAC was required to pay interest only, monthly and in arrears, during the term and (iii) the Note accrued interest at twenty percent per annum. In January and February 2005, NAC prepaid $650,000 and $350,000, respectively and retired the Note. As a consequence of NAC's acquisition of The Campus Group effective July 31, 2003, NAC issued to Mr. Steve Campus and certain family trusts promissory notes of $9.9 million and a convertible promissory note of $2.8 million. Of the $9.9 million in promissory notes issued by NAC, $6.6 million of the promissory notes ("Base Notes") bear interest at 5% per annum and are repayable in quarterly installments according to a formula based upon the future cash flows realized from The Campus Group over a period not to exceed seven years. The remaining $3.3 million in promissory notes ("Trailing Notes") issued by NAC bear interest at 5% per annum and are repayable in quarterly installments, commencing upon the retirement of the Base Notes, according to a formula based upon the future cash flows realized from The Campus Group over a period not to exceed three years subsequent to the retirement of the Base Notes. The $2.8 million convertible promissory note (i) bears interest at 5% per annum, payable quarterly in cash or accumulating as principal at the election of NAC, (ii) requires principal payments to commence upon the retirement of the Base Notes and Trailing Notes and is then repayable in quarterly installments according to a formula based upon the future cash flows realized from The Campus Group over a period not to exceed three years and (iii) is convertible at the option of the holder into shares of NAC common stock at a base conversion price of $1.50 per share. The holder may not convert the convertible promissory note into NAC common stock prior to repayment of the Base Notes and Trailing Notes. The promissory notes are secured by the capital stock of the companies comprising The Campus Group. At October 31, 2005, NAC has outstanding obligations under the terms of the Base Notes, Trailing Notes and the Convertible Notes of $6.0 million, $3.3 million and $2.8 million, respectively. -15- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 4 - CURRENT AND LONG TERM OBLIGATIONS - CONTINUED As a consequence of NAC's acquisition of OMI effective April 1, 2003, NAC assumed $814,000 in bank debt and capital lease obligations to financial institutions and issued a promissory note payable to Mr. Dean Thompson in the amount of $153,000. During 2001, OMI obtained a $300,000 bank term loan (the "Term Loan") to finance certain capital expenditures. The Term Loan is payable in monthly installments of $6,000, comprised of principal and interest, over a five year term, expiring in July 2006. The Term Loan bears interest at the rate of 8.25% per annum. The Term Loan is collateralized by substantially all of OMI's assets and the personal guarantee of Mr. Thompson. The outstanding balance of the Term Loan at October 31, 2005 is $45,000. On April 25, 2002, OMI obtained a $402,000 loan guaranteed by the U.S. Small Business Administration (the "SBA Loan") to finance losses incurred as a result of the September 11, 2001 terrorist attacks in New York City. At October 31, 2005, the remaining balance of the SBA Loan of $367,000 is repayable in monthly installments of $3,309 with the last payment due in April 2017. The SBA Loan bears interest at the rate of 4% per annum. The SBA Loan is collateralized by substantially all of OMI's assets and the personal guarantee of Mr. Thompson. Pursuant to the terms of the Merger Agreement, NAC is seeking to obtain a release of Mr. Thompson's personal guarantee from the SBA Loan. The promissory note payable to Mr. Thompson is payable in monthly installments of principal and interest over a 36 month period expiring April 2006. The promissory note bears interest at 5% per annum. The outstanding balance of the promissory note at October 31, 2005 was $44,000. The components of long term obligations at October 31, 2005 are as follows (in thousands): Amounts --------- Term loan $ 45 SBA loan 367 Promissory note 44 Base promissory notes 6,046 Trailing promissory notes 3,275 Convertible note payable 2,825 --------- 12,602 Less current maturities (1,175) --------- Long term obligations and convertible note payable $ 11,427 ========= -16- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 4 - CURRENT AND LONG TERM OBLIGATIONS - CONTINUED NAC's current maturities and long term obligations at October 31, 2005 are as follows (in thousands): Amounts --------- 2006 $ 1,175 2007 1,143 2008 1,201 2009 1,262 2010 1,327 Thereafter 6,494 --------- $ 12,602 ========= NOTE 5 - ISSUANCE OF TREASURY STOCK In February 2005, NAC issued 100,000 shares of unregistered, restricted treasury stock as compensation for professional services rendered by an unrelated third party. Such shares issued were recorded at their then market value of $0.33 per share for an aggregate cost of $33,000. The restricted shares may not be sold or otherwise transferred without registration under the Securities and Exchange Act of 1933, as amended, or applicable state securities laws or an exemption therefrom. In the event that NAC proposes to register any of its securities under the Securities Act, whether for its own account or for the account of another shareholder, the treasury stock issued may be included in such registration. NOTE 6 - COMMITMENTS AND CONTINGENCIES Self-Insurance Reserves for Property Damage and Personal Injury Claims ---------------------------------------------------------------------- NAC, under the names Agency Rent-A-Car, Inc. ("ARAC"), Altra Auto Rental and Automate Auto Rental, previously engaged in the rental of automobiles on a short-term basis, principally to the insurance replacement market. In Fiscal 1996, NAC disposed of its rental fleet business through the sale of certain assets and through certain leases to a national car rental company. All liabilities related to the discontinued rental business, principally self-insurance claims, were retained by NAC. NAC maintained and continues to maintain self-insurance for claims relating to bodily injury or property damage from accidents involving the vehicles rented to customers by its discontinued automobile rental operations. NAC was, when required by either governing state law or the terms of its rental agreement, self-insured for the first $1.0 million per occurrence, and for losses in excess of $5.0 million per occurrence, for bodily injury and property damage resulting from accidents involving its rental vehicles. NAC was also self-insured, up to certain retained limits, for bodily injury and property damage resulting from accidents involving NAC vehicles operated by employees within the scope of their employment. In connection therewith, NAC established certain reserves in its financial statements for the estimated cost of satisfying those claims. -17- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 6 - COMMITMENTS AND CONTINGENCIES - CONTINUED NAC estimates the required self-insurance liability based upon specific identification of the known matters subject to future claims, the nature of the claim and the estimated costs to be incurred. These estimates include, but are not limited to, NAC's historical loss experience and projected loss factors. The required self-insurance liability is subject to adjustment in the future based upon changes in the nature of the remaining claims or the ultimate cost. As a consequence of NAC's sale of its automobile rental operations in 1995, NAC believes that all incurred claims have been reported to NAC and that there are no longer any incurred but not yet reported claims to be received by NAC. Because of the uncertainties related to several residual small claims and legal proceedings involving NAC's former rental operations and self-insurance claims, it is difficult to project with precision the ultimate effect the adjudication or settlement of these matters will have on NAC. At October 31, 2005 and January 31, 2005, NAC had accrued $235,000 and $256,000, respectively, to cover all outstanding self-insurance liabilities. As additional information regarding NAC's potential liabilities becomes available, NAC will revise the estimates as appropriate. Other Litigation ---------------- In the normal course of its business, NAC is periodically named as defendant in legal proceedings. It is the policy of NAC to vigorously defend litigation and/or enter into settlements of claims where management deems appropriate. In the opinion of management, the amount of ultimate liability with respect to any current actions, if any, is unlikely to materially affect our financial position, results of operations or liquidity. NOTE 7 - SUBSEQUENT EVENT On November 18, 2005, National Auto Credit, Inc. ("NAC") consummated the acquisition of 100% of the membership interest in Option Technologies Interactive LLC ("OTI") from Flexner Wheatley & Associates and MeetingNet Interactive, Inc. OTI is a technology company providing interactive software and hardware systems and services for use in live events, training and education satellite videoconferencing and corporate meeting services. OTI revenues for the year ended December 31, 2004 and the nine months ended September 30, 2005 were approximately $5.3 million and $4.3 million, respectively. OTI is headquartered in Orlando, FL with additional full service sales and service offices in Ogden, UT and Chicago, IL. OTI has approximately 22 employees. The purchase price of approximately $2.5 million was paid in a combination of cash at closing, $744,000, the issuance of 496,250 shares of NAC common stock and the issuance of two promissory notes aggregating $1.5 million. The notes are repayable according to a formula based on future cash flows realized from operations of OTI and bear interest at the rate of five percent per annum until repaid. The purchase price is subject to an upward and downward adjustment not to exceed $412,500 based upon OTI meeting, or failing to meet, certain minimum financial performance criterion and an upward or downward adjustment to the extent the book value of OTI at closing exceeded, or was less than, a certain agreed amount. -18- ITEM 2. NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL National Auto Credit, Inc. ("the Company" or "NAC") began operations in 1969 and was incorporated in Delaware in 1971. NAC is a multi-dimensional corporate communications and entertainment company. NAC, through its operating subsidiaries, Audience Response Systems, Inc. ("ARS") and the Campus Group Companies, Inc. ("Campus" and collectively with ARS, the "The Campus Group") and OMI Business Communications, Inc. ("OMI"), specializes in the full-service design, creative development, production, post production editing and transmission, via broadcast satellite videoconferencing, webcasting and traditional on-site presentations, of corporate communication, education and training video and other services for use at corporate events. Additionally, NAC, through its investment in the Angelika Film Center LLC ("AFC"), operates in the movie exhibition industry. Significant Developments ------------------------ Acquisition ----------- On November 18, 2005, National Auto Credit, Inc. ("NAC") consummated the acquisition of 100% of the membership interest in Option Technologies Interactive LLC ("OTI") from Flexner Wheatley & Associates and MeetingNet Interactive, Inc. OTI is a technology company providing interactive software and hardware systems and services for use in live events, training and education satellite videoconferencing and corporate meeting services. OTI revenues for the year ended December 31, 2004 and the nine months ended September 30, 2005 were approximately $5.3 million and $4.3 million, respectively. OTI is headquartered in Orlando, FL with additional full service sales and service offices in Ogden, UT and Chicago, IL. OTI has approximately 22 employees. The purchase price of approximately $2.5 million was paid in a combination of cash at closing, $744,000, the issuance of 496,250 shares of NAC common stock and the issuance of two promissory notes aggregating $1.5 million. The notes are repayable according to a formula based on future cash flows realized from operations of OTI and bear interest at the rate of five percent per annum until repaid. The purchase price is subject to an upward and downward adjustment not to exceed $412,500 based upon OTI meeting, or failing to meet, certain minimum financial performance criterion and an upward or downward adjustment to the extent the book value of OTI at closing exceeded, or was less than, a certain agreed amount. Settlement of Shareholder Litigation ------------------------------------ In order to settle a derivative and class action entitled Robert Zadra, et al v, James A. McNamara, et al (Index. No. 01-604859) (hereinafter referred to as the "New York Action") that was commenced against NAC and certain of its directors in the Supreme Court of the State of New York, New York County (the "New York Court"), NAC entered into a November 2004 Amended Stipulation of Settlement (the "New York Settlement Stipulation"). Under the terms of the New York Settlement Stipulation, NAC agreed (subject to certain terms and conditions) to, among other things, (a) adopt or implement certain corporate governance procedures or policies, (b) issue to a class of NAC shareholders who had continuously held NAC Common Stock from December 14, 2000 through December 24, 2002 ("Eligible NAC Shareholders") up to one million warrants (one warrant per 8.23 shares of Common Stock), with each warrant having a five year term and being exercisable for shares of NAC Common Stock at a price -19- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED of $1.55 per share, (c) cancel 50% of certain stock options granted on December 15, 2000, and (d) make certain payments for legal fees for counsel to the plaintiffs in the New York Action. In addition, the New York Settlement Stipulation created for the benefit of NAC a Settlement Fund in the amount of $2.5 million which has been funded by an insurance policy. The New York Court also subsequently approved $500,000 for legal fees for counsel to the plaintiffs in the New York Action to be paid from the proceeds from the Settlement Fund. In order to facilitate the settlement and dismissal of a separate derivative action entitled In re National Auto Credit, Inc, Shareholders Litigation (Index No. 19028 NC) (hereinafter referred to as the "Delaware Action"), which had been commenced in the Chancery Court for the State of Delaware (the "Delaware Court") against NAC, as well as the New York Action, on April 22, 2005, NAC entered into a Stock Purchase Agreement ("Agreement") with Academy Capital Management, Inc., Diamond A. Partners, L.P., Diamond A. Investors, L.P., Ridglea Investor Services, Inc. and William S. Banowsky (hereinafter referred to collectively as the "Selling Stockholders"). The Selling Stockholders had also raised objections to the settlement of the New York Action. The New York Court (a) rejected the objections raised by the Selling Stockholders and (b) approved as fair and in the best interests of NAC and its shareholders the proposed settlement of the New York Action as set forth in the New York Settlement Stipulation. The Selling Stockholders then filed an appeal (the "Appeal") to such determination by the New York Court. Pursuant to the terms of the Agreement, the Selling Stockholders agreed, among other things, to do the following: o enter into a stipulation (to be filed with the New York Court) pursuant to which they will (a) irrevocably withdraw, with prejudice, any objections they had asserted or might have asserted with respect to the settlement of the New York Action, (b) stipulate to the entry of an order dismissing the New York Action and (c) agree to the dismissal of the Appeal. o enter into a stipulation (to be filed with the Appellate Division, First Department, of the Supreme Court of the State of New York) providing for the dismissal of the Appeal. o enter into a stipulation (to be filed in the Delaware Court), pursuant to which they will agree to the dismissal of the Delaware Action with prejudice. The Selling Stockholders executed and delivered to NAC and NAC has filed with the applicable New York Court and Delaware Court each of the stipulations referred to above. Effective May 5, 2005, the New York Court entered a Final Order and Judgment in which it approved the Stipulation of Dismissal of Objections, finding the terms set forth therein fair, reasonable and adequate, and dismissed the New York Action and the objections to the New York Settlement with prejudice. Effective May, 13, 2005, the Appellate Division, First Department, of the Supreme Court of the State of New York granted the dismissal of the Appeal. Effective May 18, 2005, the Delaware Court granted an Order and Judgment Dismissing Action with Prejudice the Delaware Action. As a consequence of each of the above actions by the respective courts, settlement of the New York Action and the Delaware Action, the settlement was deemed final in June 2005 and NAC received net proceeds of $2.0 million from the Settlement Fund in the New York Action. -20- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Pursuant to the Agreement, NAC agreed (subject to certain terms and conditions set forth in the Agreement) to purchase from the Selling Shareholders their 1,562,500 shares of NAC Common Stock at a price of $0.6732 per share (or a total purchase price of $1,051,875) and to contribute $100,000 to cover a portion of the legal fees incurred by the Selling Shareholders. Effective June 30, 2005, NAC purchased 1,562,500 shares of Common Stock from the Selling Shareholders. As a consequence of the confirmation of the New York Settlement Stipulation, the Dismissing Action with Prejudice of the Delaware Action and the purchase of Common Stock from the Selling Shareholders, for the nine months ended October 31, 2005, NAC recorded (i) a charge to operations of $100,000 for legal fees of the Selling Shareholders, (ii) a charge to operations of $208,000 for the excess cost over the market value of the Common Stock acquired as of the date of the Agreement, April 22, 2005, (iii) a charge to other income of $88,000 for the expense of the fair value of the warrants to be issued to Eligible Shareholders and (iv) realized other income of $2.0 million for the net proceeds received by NAC from the Settlement Fund. The Eligible NAC Shareholders have until December 2005 to submit their claim for one warrant for each 8.23 shares of Common Stock owned during the eligibility period, with each warrant having a five year term and being exercisable for shares of NAC Common Stock at a price of $1.55 per share. Upon the final submission of claims by Eligible NAC Shareholders, NAC anticipates issuing the final warrants in the fourth quarter of Fiscal 2006. As acknowledged by the Selling Shareholders in the Agreement, NAC was willing to enter into the Agreement, settle the New York Action and the Delaware Action and consummate the other transactions contemplated by the Agreement in order to terminate prolonged and expensive litigation and NAC's entry into the Agreement would not constitute or be deemed to constitute or evidence any improper or illegal conduct by or on behalf of NAC (or any of its directors, officers, employees and other agents or representatives) or any other wrong doing by NAC (or any of its directors, officers, employees and other agents or representatives). The Agreement was approved by the disinterested and independent members of NAC's Board of Directors. Management believes that settlement of the New York Action and the Delaware Action, as provided for in the Agreement and the New York Settlement Stipulation, will allow management to concentrate its efforts on NAC's business and will allow NAC to avoid the costs and distractions of prolonged litigation. CRITICAL ACCOUNTING POLICIES NAC's consolidated financial statements are prepared in accordance with generally accepted accounting principles, which require NAC to make estimates and assumptions. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses of NAC. Certain accounting policies are deemed "critical", as they require management's highest degree of judgment, estimates and assumptions. These accounting estimates and disclosures have been discussed with the Audit Committee of NAC's Board of Directors. A discussion of NAC's critical accounting policies, the judgments and uncertainties affecting their application, and the likelihood that materially different amounts would be reported under different conditions or using different assumptions are as follows: -21- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Service Revenues: NAC's service revenues are earned within short time periods, generally less than one week. NAC recognizes revenue from video production, video editing, meeting services and broadcast satellite or webcast services when the video is complete and delivered or all technical services have been rendered. Deposits and other prepayments are recorded as deferred revenue until revenue is recognized. NAC does not have licensing or other arrangements that result in additional revenues following the delivery of the video or a broadcast. Costs accumulated in the production of the video, meeting services or broadcasts are deferred until the sale and delivery are complete. Deferred production costs of $204,000 and $401,000, respectively, are included as a component of other current assets at October 31, 2005 and January 31, 2005. NAC recognizes revenue from website design and development when the customer accepts the completed project. Deposits and other prepayments are recorded as deferred revenue until revenue is recognized. These contracts are generally limited to the design and development of websites and the presentation of site library content developed by NAC. Clients also have the option to engage NAC to maintain and upgrade their websites. These projects are separate from the website development and design engagements, and the related revenue is recognized over the term of the agreement, which is generally up to one year. NAC recognizes revenue from developing and maintaining websites pursuant to the requirements of Statement of Position No. 97-2, "Software Revenue Recognition" ("SOP 97-2"), as amended by Statement of Position No. 98-9, "Software Revenue Recognition with Respect to Certain Arrangements." Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software. If at the outset of the customer arrangement, NAC determines that the arrangement fee is not fixed or determinable or that collectibility is not probable, NAC defers the revenue and recognizes the revenue when the arrangement fee becomes due and payable or, when collectibility is uncertain, as cash is collected. Cost of Service Revenues: Cost of revenues consists of direct expenses specifically associated with client service revenues. The cost of revenues includes direct salaries and benefits, purchased products or services for clients, web hosting, support services, shipping and delivery costs. Accounts Receivable: NAC extends credit to clients in the normal course of business. NAC continuously monitors collections and payments from clients and maintains an allowance for doubtful accounts based upon historical experience and any specific client collection issues that have been identified. Since accounts receivable are concentrated in a relatively few number of clients, a significant change in the liquidity or financial position of any of these clients could have a material adverse impact on the collectibility of the accounts receivable and future operating results. NAC does not have any off-balance sheet credit exposure related to its customers. -22- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Valuation of Long-lived Assets and Goodwill: NAC reviews the carrying value of its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be fully recoverable and it annually assesses whether goodwill has been impaired by comparing the carrying amount of the goodwill to its fair value. When it is determined that the carrying amount of long-lived assets or goodwill is impaired, impairment is measured by comparing an asset's estimated fair value to its carrying value. The determination of fair value is based on quoted market prices in active markets, if available, or independent appraisals; sales price negotiations; or projected future cash flows discounted at a rate determined by management to be commensurate with our business risk. The estimation of fair value utilizing discounted forecasted cash flows includes significant judgments regarding assumptions of revenue, operating and marketing costs; selling and administrative expenses; interest rates; property and equipment additions and retirements; and industry competition, general economic and business conditions, among other factors. Management has determined that there was no impairment to our long-lived assets and goodwill on the basis of a review of a discounted cash flow analysis, which for goodwill is performed at the level of the subsidiaries to which the goodwill relates. If there is a material change in the assumptions used in the determination of fair value or a material change in the conditions or circumstances influencing fair value, NAC could be required to recognize a material impairment charge. Self-Insurance Claims: NAC maintained and continues to maintain self-insurance for claims and associated litigation expenses relating to bodily injury or property damage from accidents involving the vehicles rented to customers by its discontinued automobile rental operations occurring in Fiscal 1996 and prior. NAC was, when required by either governing state law or the terms of its rental agreement, self-insured for the first $1.0 million per occurrence, and for losses in excess of $5.0 million per occurrence, for bodily injury and property damage resulting from accidents involving its rental vehicles. NAC was also self-insured, up to certain retained limits, for bodily injury and property damage resulting from accidents involving NAC vehicles operated by employees within the scope of their employment. NAC is subject to certain self-insurance claims and litigation expenses relating to its discontinued automobile rental operations. NAC estimates the required self-insurance liability based upon specific identification of the known matters subject to future claims, the nature of the claim and the estimated costs to be incurred. These estimates include, but are not limited to, NAC's historical loss experience and projected loss factors. The required self-insurance liability is subject to adjustment in the future based upon changes in the nature of the remaining claims or the ultimate cost. As a consequence of NAC's sale of its automobile rental operations in 1995, NAC believes that all incurred claims have been reported to NAC and that there are no longer any incurred but not yet reported claims to be received by NAC. NAC's self-insurance liability at October 31, 2005 was $235,000. Because of the uncertainties related to several residual small claims and legal proceedings involving NAC's former rental operations and self-insurance claims, it is difficult to project with precision the ultimate effect the adjudication or settlement of these matters will have on NAC. As additional information regarding NAC's potential liabilities becomes available, NAC will revise the estimates as appropriate. -23- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Income Taxes: NAC recognizes deferred tax assets and liabilities based on differences between the financial statement carrying amounts and the tax basis of assets and liabilities. Loss carrybacks, reversal of deferred tax liabilities, tax planning and estimates of future taxable income are considered in assessing the need for a valuation allowance. At the time it is determined that NAC is unable to realize deferred tax assets in excess of the recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should management determine that NAC would not be able to realize all or part of its net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS FROM OPERATIONS FOR THE THREE MONTHS ENDED OCTOBER 31, 2005 AS COMPARED TO THE THREE MONTHS ENDED OCTOBER 31, 2004 Service Revenues: Revenues for the three months ended October 31, 2005 were $4.5 million and are comprised principally of revenues derived from the operations of OMI and The Campus Group. Revenues for the three months ended October 31, 2004 were $3.0 million. For the three months ended October 31, 2005, revenues for The Campus Group were $2.0 million as compared to revenues of $2.0 million for the three months ended October 31, 2004. For the three months ended October 31, 2005, revenues for OMI were $2.5 million as compared to revenues of $1.0 million for the three months ended October 31, 2004. The aggregate increase in revenues for the Campus Group and OMI of $1.5 million for the three months ended October 31, 2005 as compared to revenues for the three months ended October 31, 2004 was principally due to an increase in the number, scope and value of client assignments completed during the three months ended October 31, 2005. The nature of OMI's and The Campus Group's business is such that the nature and timing of assignments completed for clients, and the resulting revenue, will vary from period to period. Recently, The Campus Group and OMI hired three senior marketing strategists for corporate communication services to develop new marketing initiatives, create new project opportunities, seek new clients for its services and expand existing client relationships to generate new revenues. Although no assurances can be made, NAC will seek revenue expansion through the retention of these new marketing strategists as a means to reduce year-to-year and quarter-to-quarter fluctuations in its revenues as well as to ultimately increase revenues. Generally, there is a six to twelve month investment period before the Company expects to realize the benefits from the addition of such personnel in the form of new projects and/or clients. Cost of Service Revenues: Cost of revenues for three months October 31, 2005 were $2.4 million and are comprised principally of cost of revenues derived from operations of The Campus Group and OMI, (i) The Campus Group cost of revenues of $1.1 million and (ii) OMI cost of revenues of $1.3 million. The average gross margin for the three months ended October 31, 2005 was 43.1% and 48.4% for The Campus Group and OMI, respectively. Cost of revenues for three months October 31, 2004 were $1.8 million and are comprised principally of (i) The Campus Group cost of revenues of $1.4 million and (ii) OMI cost of revenues of $388,000. The average gross margin for the three months ended October 31, 2004 was 26.4% and 61.0% for The Campus Group and OMI, respectively. -24- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED The aggregate increase in gross profit of $1.0 million is due to the combined effect of (i) an increase in revenues and (ii) an increase in production gross margin realized. The aggregate average gross margins for The Campus Group and OMI increased 12.0% for the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 which can be principally attributed to (i) an increase of revenues realized to offset fixed production overhead costs of 6% and (ii) an increase in general production margins of 6% as a consequence of a favorable production mix during the three months ended October 31, 2005. Selling, General and Administrative ("SG&A"): SG&A expenses includes SG&A expenses of OMI's operations ("OMI SG&A"), The Campus Group's operations ("Campus SG&A") and NAC's personnel, occupancy, legal, professional, insurance and other general corporate overhead costs ("NAC SG&A"). For the three months ended October 31, 2005, SG&A expense was $2.2 million comprised of (i) Campus SG&A of $872,000, (ii) OMI SG&A of $417,000, and (iii) NAC SG&A of $921,000. For the three months ended October 31, 2004, SG&A expense was $1.9 million comprised of (i) Campus SG&A of $860,000, (ii) OMI SG&A of $350,000, and (iii) NAC SG&A of $636,000. The increase of SG&A expense of $284,000 for the three months ended October 31, 2005 as compared to the comparable period ended October 31, 2004 is principally the result of the net effects of (i) an increase in personnel costs of $236,000, (ii) an increase for legal and other professional services of $91,000 and (iii) a net decrease in other SG&A of $43,000. Income from AFC Investment: NAC accounts for its investment in AFC using the equity method. For the three months ended October 31, 2005 and 2004, NAC recorded income of $348,000 and $165,000, respectively, representing NAC's share of AFC's net income for the three months ended September 30, 2005 and 2004 respectively. The following sets forth summarized operating results for AFC (in thousands): Three Months Ended September 30, ------------------------ 2005 2004 --------- --------- Revenues $ 2,063 $ 1,478 Film rental 499 269 Operating costs 628 639 Depreciation and amortization 197 198 General and administrative expenses 43 42 --------- --------- 1,367 1,148 --------- --------- Net income $ 696 $ 330 ========= ========= NAC's proportionate share of net income $ 348 $ 165 ========= ========= -25- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED AFC's revenues increased $585,000 for the three months ended September 30, 2005 as compared to the three months ended September 30, 2004, principally as a result of the net effects of (i) a 35.2% increase in attendance, (ii) an increase of $100,000 in other, concession and cafe revenues and (iii) a 4.6% increase in average ticket prices period-to-period. The attendance, and at times the ticket prices, at AFC will vary depending on audience interest in, and the popularity of the films it exhibits and other factors. Film rental, as a percentage of revenue, increased 6.0% to 24.2% from 18.2% for the three months ended September 30, 2005 and 2004, respectively. Film rental expense generally is a factor of a fixed percentage rental rate per film multiplied by the number of tickets sold. AFC experiences fluctuations in film rental expense, as a percentage of revenue, depending upon the rental rate per film and the popularity of the film. Operating costs, as a percent of revenue, decreased 12.8% to 30.4% for the three months ended September 30, 2005 as compared to 43.2% for the three months ended September 30, 2004 due principally to an increase in revenues realized without a corresponding increase in general operating expenses. The nature of AFC's operating costs tend to generally be more fixed overhead-related costs and advertising expenses. Income Taxes: Due to net operating losses and the availability of net operating loss carryforwards, NAC's effective federal income tax rate was zero for the three month periods ended October 31, 2005 and October 31, 2004. NAC has provided a full valuation allowance against its net operating loss carryforward and other net deferred tax asset items due to the uncertainty of their future realization. FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS FROM OPERATIONS FOR THE NINE MONTHS ENDED OCTOBER 31, 2005 AS COMPARED TO THE NINE MONTHS ENDED OCTOBER 31, 2004 Service Revenues: Revenues for the nine months ended October 31, 2005 were $9.0 million and are comprised principally of revenues derived from the operations of OMI and The Campus Group. Revenues for the nine months ended October 31, 2004 were $8.7 million. For the nine months ended October 31, 2005, revenues for The Campus Group were $6.0 million as compared to revenues of $7.1 million for the nine months ended October 31, 2004. For the nine months ended October 31, 2005, revenues for OMI were $3.0 million as compared to revenues of $1.6 million for the nine months ended October 31, 2004. The aggregate increase in revenues for the Campus Group and OMI of $319,000 for the nine months ended October 31, 2005 as compared to revenues for the nine months ended October 31, 2004 was principally due to an increase in the number, scope and value of client assignments completed during the nine months ended October 31, 2005 and 2004. The nature of OMI's and The Campus Group's business is such that the nature and timing of assignments completed for clients, and the resulting revenue, will vary from period to period. As indicated above, The Campus Group and OMI recently hired three senior marketing strategists for corporate communication services to develop new marketing initiatives, create new project opportunities, seek new clients for its services and expand existing client relationships to generate new revenues. Although no assurances can be made, NAC will seek revenue expansion through the retention of these new marketing strategists as a means to reduce year-to-year and quarter-to-quarter fluctuations in its revenues as well as to ultimately increase revenues. Generally, there is a six to twelve month investment period before the Company expects to realize the benefits from the addition of such personnel in the form of new projects and/or clients. -26- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Cost of Service Revenues: Cost of revenues for nine months ended October 31, 2005 were $5.1 million and are comprised principally of cost of revenues derived from operations of The Campus Group and OMI, (i) The Campus Group cost of revenues of $3.6 million and (ii) OMI cost of revenues of $1.5 million. The average gross margin for the nine months ended October 31, 2005 was 39.8% and 48.6% for The Campus Group and OMI, respectively. Cost of revenues for nine months October 31, 2004 were $5.1 million and are comprised principally of (i) The Campus Group cost of revenues of $4.2 million and (ii) OMI cost of revenues of $944,000. The average gross margin for the nine months ended October 31, 2004 was 40.5% and 41.6% for The Campus Group and OMI, respectively. The aggregate increase in gross profit of $298,000 is due to the combined effect of (i) an increase in revenues and (ii) an increase in gross margin. The aggregate average gross margins for The Campus Group and OMI increased 1.9% for the nine months ended October 31, 2005 as compared to the nine months ended October 31, 2004 principally due to an increase in revenues realized to offset fixed production overhead costs during the nine months ended October 31, 2005. Selling, General and Administrative ("SG&A"): SG&A expenses includes SG&A expenses of OMI's operations ("OMI SG&A"), The Campus Group's operations ("Campus SG&A") and NAC's personnel, occupancy, legal, professional, insurance and other general corporate overhead costs ("NAC SG&A"). For the nine months ended October 31, 2005, SG&A expense was $6.0 million comprised of (i) Campus SG&A of $2.3 million, (ii) OMI SG&A of $923,000, and (iii) NAC SG&A of $2.8 million. For the nine months ended October 31, 2004, SG&A expense was $5.5 million comprised of (i) Campus SG&A of $2.3 million, (ii) OMI SG&A of $870,000, and (iii) NAC SG&A of $2.4 million. The increase of SG&A expense of $534,000 for the nine months ended October 31, 2005 as compared to the comparable period ended October 31, 2004 is principally the result of the net effects of (i) an increase in personnel costs of $362,000, (ii) the $100,000 charge to SG&A for legal fees associated with the Selling Shareholders, (iii) the $208,000 charge to SG&A for the excess cost over the market value of Common Stock acquired and (ii) a net decrease of other SG&A of $136,000 as NAC reduced, other legal costs and general SG&A expenditures from period-to-period. -27- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Income from AFC Investment: NAC accounts for its investment in AFC using the equity method. For the nine months ended October 31, 2005 and 2004, NAC recorded income of $564,000 and $354,000, respectively, representing NAC's share of AFC's net income for the nine months ended September 30, 2005 and 2004 respectively. The following sets forth summarized operating results for AFC (in thousands): Nine Months Ended September 30, -------------------------- 2005 2004 ---------- ---------- Revenues $ 4,615 $ 4,045 Film rental 1,033 772 Operating costs 1,743 1,849 Depreciation and amortization 584 589 General and administrative expenses 127 127 ---------- ---------- 3,487 3,337 ---------- ---------- Net income $ 1,128 $ 708 ========== ========== NAC's proportionate share of net income $ 564 $ 354 ========== ========== AFC's revenues increased $570,000 for the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004, principally as a result of the combined effects of (i) a 13.9% increase in attendance, (ii) an increase of $121,000 in other, concession and cafe revenues and (iii) a 3.8% increase in average ticket prices period-to-period. The attendance, and at times the ticket prices, at AFC will vary depending on audience interest in, and the popularity of the films it exhibits and other factors. Film rental, as a percentage of revenue, increased 3.3% to 22.4% from 19.1% for the nine months ended September 30, 2005 and 2004, respectively. Film rental expense generally is a factor of a fixed percentage rental rate per film multiplied by the number of tickets sold. AFC experiences fluctuations in film rental expense, as a percentage of revenue, depending upon the rental rate per film and the popularity of the film. Operating costs, as a percent of revenue, decreased 7.9% to 37.8% for the nine months ended September 30, 2005 as compared to 45.7% for the nine months ended September 30, 2004 due principally to an increase in revenues combined with a decrease in general operating expense for the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004. The nature of AFC's operating costs tend to generally be more fixed overhead-related costs and advertising expenses. Income Taxes: Due to net operating losses and the availability of net operating loss carryforwards, NAC's effective federal income tax rate was zero for the nine month periods ended October 31, 2005 and October 31, 2004. NAC has provided a full valuation allowance against its net operating loss carryforwards and other net deferred tax asset items due to the uncertainty of their future realization. Income tax expense for the nine months ended October 31, 2005 is comprised of various state and local minimum income tax expense for the period. -28- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED LIQUIDITY AND CAPITAL RESOURCES Throughout the nine months ended October 31, 2005 and as of December 12, 2005, NAC had no external source of financing and has operated on its existing cash balances, proceeds from its income tax refund, net proceeds from the Shareholder Settlement, cash flows from operations, and distributions from its investment in AFC. NAC will continue to pursue reductions in its operating expenses and new debt or equity financing (which there can be no assurance NAC will obtain such financing) as means of supplementing NAC's resources available to pursue new acquisitions, joint ventures or other business development opportunities. At October 31, 2005, NAC had cash of $859,000 which together with any cash flow derived from its investment in AFC and the operations of NAC's corporate communications business will be used to pursue such opportunities. As a consequence of periodic fluctuations in NAC's working capital needs based upon the timing of collections, periods of increased media production activity and the then pending collection of the income tax refundable, on July 14, 2004 NAC consummated a Loan and Security Agreement ("Loan Agreement") with a lender and issued a Promissory Note ("Note") of $1.0 million. The lender, Time Passages Corp., is an unaffiliated third party lender. The President of Time Passages Corp. was a former director of NAC who last served on NAC's board in January 2002. Pursuant to the terms of the Note, (i) the outstanding principal of the Note was due July 13, 2005, (ii) NAC was required to pay interest only, monthly and in arrears, during the term and (iii) the Note accrued interest at twenty percent per annum. In January and February 2005, NAC prepaid $650,000 and $350,000, respectively, and retired the Note. As a consequence of NAC's acquisition of The Campus Group effective July 31, 2003, NAC issued to Mr. Campus and certain family trusts promissory notes of $9.9 million and a convertible promissory note of $2.8 million. Of the $9.9 million in promissory notes issued by NAC, $6.6 million of the promissory notes ("Base Notes") bear interest at 5% per annum and are repayable in quarterly installments according to a formula based upon the future cash flows realized from The Campus Group over a period not to exceed seven years. The remaining $3.3 million in promissory notes ("Trailing Notes") issued by NAC bear interest at 5% per annum and are repayable in quarterly installments, commencing upon the retirement of the Base Notes, according to a formula based upon the future cash flows realized from The Campus Group over a period not to exceed three years subsequent to the retirement of the Base Notes. The $2.8 million convertible promissory note (i) bears interest at 5% per annum, payable quarterly in cash or accumulating as principal at the election of NAC, (ii) requires principal payments to commence upon the retirement of the $9.9 million of Base Notes and the Trailing Notes and is then repayable in quarterly installments according to a formula based upon the future cash flows realized from The Campus Group over a period not to exceed three years and (iii) is convertible at the option of the holder into shares of NAC common stock at a base conversion price of $1.50 per share. The holder may not convert the convertible promissory note into NAC common stock prior to repayment of the Base Notes and the Trailing Notes. The promissory notes are secured by the capital stock of the companies comprising The Campus Group. At October 31, 2005, NAC has outstanding obligations under the terms of the Base Notes, Trailing Notes and the Convertible Notes of $6.0 million, $3.3 million and $2.8 million, respectively. -29- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED As a consequence of NAC's acquisition of OMI effective April 1, 2003, NAC assumed $814,000 in bank debt and capital lease obligations to financial institutions and issued a promissory note payable to Mr. Thompson in the amount of $153,000. During 2001, OMI obtained a $300,000 bank term loan (the "Term Loan") to finance certain capital expenditures. The Term Loan is payable in monthly installments of $6,000, comprised of principal and interest, over a five year term, expiring in July 2006. The Term Loan bears interest at the rate of 8.25% per annum. The Term Loan is collateralized by substantially all of OMI's assets and the personal guarantee of Mr. Thompson. The outstanding balance of the Term Loan at October 31, 2005 was $45,000. On April 25, 2002, OMI obtained a $402,000 loan guaranteed by the U.S. Small Business Administration (the "SBA Loan") to finance losses incurred as a result of the September 11, 2001 terrorist attacks in New York City. At October 31, 2005, the remaining balance of the SBA Loan of $367,000 is repayable in monthly installments of $3,309 with the last payment due in April 2017. The SBA Loan bears interest at the rate of 4% per annum. The promissory note payable to Mr. Thompson is payable in monthly installments of principal and interest over a 36 month period expiring April 2006. The promissory note bears interest at 5% per annum. The outstanding balance of the promissory note at October 31, 2005 was $44,000. For the nine months ended October 31, 2005, NAC's cash and cash equivalents increased $388,000 due principally to the net effects of (i) cash flows provided by operations of $1.7 million, inclusive of the net proceeds derived from the Shareholder Settlement of $2.0 million, (ii) proceeds from AFC distributions of $408,000, offset by (iii) payments to acquire Common Stock of $1.1 million, (iv) capital expenditures of $199,000, and (v) the repayment of debt of $485,000. Principle components of NAC's cash flows from operations for the nine months ended October 31, 2005 included the collection of NAC's $826,000 income tax refund and the net proceeds derived from the New York Settlement Stipulation of $2.0 million. The cash flows from the distributions from AFC decreased for the nine months ended October 31, 2005, as compared to those for the nine months ended October 31, 2004, as a consequence of the timing of distributions by AFC. NAC believes that the available cash and cash equivalents totaling $859,000 at October 31, 2005 and any cash distributions from its investment in AFC and cash flow from operations will be sufficient to pay operating expenses, existing liabilities, fund existing debt repayments and fund its activities through the next twelve months as NAC explores new strategic business alternatives. Additionally, as previously discussed, NAC's lack of external financing sources may limit its ability to pursue strategic business alternatives being considered by NAC's Board of Directors. Such limitations may have an adverse impact on NAC's financial position, results of operations and liquidity. -30- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED OTHER New Accounting Pronouncements ----------------------------- In December, 2004 the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 123R (revised 2004), Share-Based Payment, which replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first interim or annual period after December 15, 2005, with early adoption encouraged. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. NAC is required to adopt SFAS 123R at the beginning of Fiscal 2007 (effective February 1, 2006). Under SFAS No. 123R, NAC must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include prospective and retrospective adoption options. Under the retrospective option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption while the retrospective methods would record compensation expense for all unvested stock options and restricted stock beginning with the first period restated. NAC has not yet determined the method of adoption or the effect of adopting SFAS 123R, and has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123. In December 2004, the FASB issued SFAS No. 153, Exchange of Nonmonetary Assets, which is an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions. The guidance in APB Opinion No. 29 is based on the principle that exchanges of nonmonetary assets should be measured based upon the fair value of the assets exchanged, with certain exemptions to that principle. SFAS No. 153 eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a consequence of the exchange. The adoption of SFAS No. 153 will be effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005. NAC expects that the adoption of SFAS No. 153 will not have a material impact NAC's consolidated financial statements. -31- NATIONAL AUTO CREDIT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED In May 2005, FASB issued Statement No. 154, Accounting Changes and Error Corrections ("SFAS 154"). SFAS 154 replaces APB No. 20, Accounting Changes, and SFAS 3, Reporting Accounting Changes in Interim Financial Statements, and establishes retrospective application as the required method for reporting a change in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 applies to all voluntary changes in accounting principles and to changes required by an accounting pronouncement in the instance that the pronouncement does not include specific transition provisions. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. NAC expects that the adoption of SFAS 154 will not have a material impact on NAC's consolidated financial position or results of operations. Inflation --------- NAC's exposure to the risks of inflation is generally limited to the potential impact of inflation on its operating and general and administrative expenses. To date, inflation has not had a material adverse impact on NAC. NAC does not utilize futures, options or other derivative financial instruments. -32- FORWARD-LOOKING STATEMENTS Some of the information in this report contains forward looking statements within the meaning of the federal securities laws that relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause us or our industry's actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements. You should not rely on forward-looking statements in this report. Forward-looking statements typically are identified by use of terms such as "anticipate", "believe", "plan", "expect", "intend", "may", "will", "should", "estimate", "predict", "potential", "continue" and similar words although some forward-looking statements are expressed differently. This report may contain forward-looking statements attributed to third parties relating to their estimates regarding the growth of our markets. All forward-looking statements address matters that involve risk and uncertainties, and there are many important risks, uncertainties and other factors that could cause our actual results, as well as those of the markets we serve, levels of activity, performance, achievements and prospects to differ materially from the forward-looking statements contained in this report. You should also consider carefully the statements under other sections of this report which address additional facts that could cause our actual results to differ from those set forth in any forward-looking statements. We undertake no obligation to publicly update or review any forward-looking statements, whether as a result of new information, future developments or otherwise. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Like virtually all commercial enterprises, NAC can be exposed to the risk ("market risk") that the cash flows to be received or paid relating to certain financial instruments could change as a result of changes in interest rate, exchange rates, commodity prices, equity prices and other market changes. NAC does not engage in trading activities and does not utilize interest rate swaps or other derivative financial instruments or buy or sell foreign currency, commodity or stock indexed futures or options. Accordingly, NAC is not exposed to market risk from these sources. As of October 31, 2005, the interest rates under NAC's long term and convertible debt are fixed. As a result NAC has limited market risk associated with market interest rates. ITEM 4. CONTROLS AND PROCEDURES As of the end of the period covered by this interim report on Form 10-Q, the Chief Executive Officer and the Chief Financial Officer of NAC (the "Certifying Officers") have conducted evaluations of NAC's disclosure controls and procedures. As defined under Sections 13a-15(e) and 15d-15(e)) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), the term "disclosure controls and procedures" means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer's management, including its principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. The Certifying -33- Officers have reviewed NAC's disclosure controls and procedures and have concluded that those disclosure controls and procedures were effective as of the end of our most recent fiscal quarter. In compliance with Section 302 of the Sarbanes-Oxley Act of 2002, (18 U.S.C. 1350), each of the Certifying Officers executed an Officer's Certification included in this Quarterly Report on Form 10-Q. During our most recent fiscal quarter, there were no changes in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. -34- PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Shareholder Complaints ---------------------- In July and August 2001, NAC received three separate derivative complaints filed with the Court of Chancery of Delaware ("Delaware Court") by each of Academy Capital Management, Inc ("Academy Complaint")., Levy Markovich, ("Markovich Complaint") and Harbor Finance Partners ("Harbor Complaint"), all shareholders of NAC, against James J. McNamara, John A. Gleason, William S. Marshall, Henry Y.L. Toh, Donald Jasensky, Peter T. Zackaroff, Mallory Factor, and Thomas F. Carney, Jr. (the "Director Defendants") and names NAC as a nominal defendant. By order of the Delaware Court on November 12, 2001, the Academy, Markovich and Harbor Complaints were consolidated under the title "In re National Auto Credit, Inc. Shareholders Litigation," Civil Action No. 19028 NC (Delaware Court) ("Delaware Action") and the Academy Complaint were consolidated as the Delaware Action. The Delaware Action principally sought: (i) a declaration that the Director Defendants breached their fiduciary duties to NAC, (ii) a judgment voiding an employment agreement with James J. McNamara and rescinding a stock exchange agreement in which NAC acquired ZoomLot, (iii) a judgment voiding the grant of stock options and the award of director fees allegedly related thereto, (iv) an order directing the Director Defendants to account for alleged damages sustained and profits obtained by the Director Defendants as a result of the alleged various acts complained of, (v) the imposition of a constructive trust over monies or other benefits received by the Director Defendants, (vi) a judgment requiring the Director Defendants to promptly schedule an annual meeting of shareholders and (vii) an award of costs and expenses. On October 12, 2001, NAC received a derivative complaint filed by Robert Zadra, a shareholder of NAC, that had been filed with the Supreme Court of the State of New York ("New York Court") on or about October 12, 2001 against James J. McNamara, John A. Gleason, William S. Marshall, Henry Y. L. Toh, Donald Jasensky, Peter T. Zackaroff, Mallory Factor, Thomas F. Carney, Jr., and NAC as Defendants. On or about May 29, 2002 the complaint was amended to include class action allegations (the "New York Action"). The New York Action contained allegations similar to those in the Delaware Action concerning the Board's approval of the employment agreement with James McNamara, option grants and past and future compensation to the Director Defendants, and the ZoomLot transaction. The New York Action sought (i) a declaration that as a result of approving these transactions the Director Defendants breached their fiduciary duties to NAC, (ii) a judgment enjoining Director Defendants from proceeding with or exercising the option agreements, (iii) rescission of the option grants to Director Defendants, if exercised, (iv) an order directing the Director Defendants to account for alleged profits and losses obtained by the Director Defendants as a result of the alleged various acts complained of, (v) awarding compensatory damages to NAC and the class, together with prejudgment interest, and (vi) an award of costs and expenses. NAC has vigorously defended against each of the respective claims made in the Delaware Action and New York Action, as it believes that the claims have no merit. -35- The parties in the New York Action thereafter engaged in settlement negotiations and, in December 2002, the parties entered into a stipulation of settlement which was thereafter amended in November 2004 (the "New York Settlement Stipulation"). Under the terms of the New York Settlement Stipulation, NAC agreed (subject to certain terms and conditions) to, among other things, (a) adopt or implement certain corporate governance procedures or policies, (b) issue to a class of NAC shareholders who had continuously held NAC Common Stock from December 14, 2000 through December 24, 2002 ("Eligible NAC Shareholders") up to one million warrants (one warrant per 8.23 shares of Common Stock), with each warrant having a five year term and being exercisable for shares of NAC Common Stock at a price of $1.55 per share, (c) cancel 50% of certain stock options granted on December 15, 2000, and (d) make certain payments for legal fees for counsel to the plaintiffs in the New York Action. The New York Settlement Stipulation created for the benefit of NAC a Settlement Fund in the amount of $2.5 million to be funded by an insurance policy. The New York Court also subsequently approved $500,000 for legal fees for counsel to the plaintiffs in the New York Action to be paid from the proceeds from the Settlement Fund. In order to facilitate the settlement and dismissal of the separate Delaware Action as well as the New York Action, on April 22, 2005, NAC entered into a Stock Purchase Agreement ("Agreement") with Academy Capital Management, Inc., Diamond A. Partners, L.P., Diamond A. Investors, L.P., Ridglea Investor Services, Inc. and William S. Banowsky (hereinafter referred to collectively as the "Selling Stockholders"). The Selling Stockholders had also raised objections to the settlement of the New York Action. The New York Court (a) had rejected the objections raised by the Selling Stockholders and (b) had approved as fair and in the best interests of NAC and its shareholders the proposed settlement of the New York Action as set forth in the New York Settlement Stipulation. The Selling Stockholders had then filed an appeal (the "Appeal") to such determination by the New York Court. Pursuant to the terms of the Agreement, the Selling Stockholders agreed, among other things, to do the following: o enter into a stipulation (to be filed with the New York Court) pursuant to which they will (a) irrevocably withdraw, with prejudice, any objections they had asserted or might have asserted with respect to the settlement of the New York Action, (b) stipulate to the entry of an order dismissing the New York Action and (c) agree to the dismissal of the Appeal. o enter into a stipulation (to be filed with the Appellate Division, First Department, of the Supreme Court of the State of New York) providing for the dismissal of the Appeal. o enter into a stipulation (to be filed in the Delaware Court), pursuant to which they will agree to the dismissal of the Delaware Action with prejudice. The Selling Stockholders executed and delivered to NAC and NAC filed with the applicable New York Court and Delaware Court each of the stipulations referred to above. Effective May 5, 2005, the New York Court entered a Final Order and Judgment in which it approved the Stipulation of Dismissal of Objections, finding the terms set forth therein fair, reasonable and adequate, and dismissed the New York Action and the objections to the New York Settlement with prejudice. Effective May, 13, 2005, the Appellate Division, First Department, of the Supreme Court of the State of New York granted the dismissal of the Appeal. Effective May 18, 2005, the Delaware Court granted an Order and Judgment Dismissing Action with Prejudice the Delaware Action. As a consequence of each of the above actions by the respective courts, settlement of the New York Action and the Delaware Action, was deemed final in June 2005 and NAC received net proceeds of $2.0 million from NAC's insurer from the Settlement Fund in the New York Action. -36- Pursuant to the Agreement, NAC agreed (subject to certain terms and conditions set forth in the Agreement) to purchase from the Selling Shareholders their 1,562,500 shares of Common Stock at a price of $0.6732 per share (or a total purchase price of $1,051,875) and to contribute $100,000 to cover a portion of the legal fees incurred by the Selling Shareholders. Effective June 30, 2005, NAC purchased 1,562,500 shares of NAC Common Stock from the Selling Stockholders. As acknowledged by the Selling Shareholders in the Agreement, NAC was willing to enter into the Agreement, settle the New York Action and the Delaware Action and consummate the other transactions contemplated by the Agreement in order to terminate prolonged and expensive litigation and NAC's entry into the Agreement would not constitute or be deemed to constitute or evidence any improper or illegal conduct by or on behalf of NAC (or any of its directors, officers, employees and other agents or representatives) or any other wrong doing by NAC (or any of its directors, officers, employees and other agents or representatives). The Agreement was approved by the disinterested and independent members of NAC's Board of Directors. Management believes that settlement of the New York Action and the Delaware Actions, as provided for in the Agreement and the New York Settlement Stipulation, will allow management to concentrate its efforts on NAC's business and will allow NAC to avoid the costs and distractions of prolonged litigation. Self-Insurance Reserves for Property Damage and Personal Injury Claims ---------------------------------------------------------------------- NAC, under the names Agency Rent-A-Car, Inc. ("ARAC"), Altra Auto Rental and Automate Auto Rental, previously engaged in the rental of automobiles on a short-term basis, principally to the insurance replacement market. In Fiscal 1996, NAC disposed of its rental fleet business through the sale of certain assets and through certain leases to a national car rental company. All liabilities related to the discontinued rental business, principally self-insurance claims, were retained by NAC. NAC maintained and continues to maintain self-insurance for claims relating to bodily injury or property damage from accidents involving the vehicles rented to customers by its discontinued automobile rental operations occurring in Fiscal 1996 and prior. NAC was, when required by either governing state law or the terms of its rental agreement, self-insured for the first $1.0 million per occurrence, and for losses in excess of $5.0 million per occurrence, for bodily injury and property damage resulting from accidents involving its rental vehicles. NAC was also self-insured, up to certain retained limits, for bodily injury and property damage resulting from accidents involving NAC vehicles operated by employees within the scope of their employment. NAC is the subject to certain self-insurance claims and litigation expenses relating to its discontinued automobile rental operations. NAC estimates the required self-insurance liability based upon specific identification of the known matters subject to future claims, the nature of the claim and the estimated costs to be incurred. These estimates include, but are not limited to, NAC's historical loss experience and projected loss factors. The required self-insurance liability is subject to adjustment in the future based upon changes in the nature of the remaining claims or the ultimate cost. As a consequence of NAC's sale of its automobile rental operations in 1995, NAC believes that all incurred claims have been reported to NAC and that there are no longer any incurred but not yet reported claims to be received by NAC. NAC's self-insurance liability at October 31, 2005 was $235,000. -37- Because of the uncertainties related to several residual small claims and legal proceedings involving NAC's former rental operations and self-insurance claims, it is difficult to project with precision the ultimate effect the adjudication or settlement of these matters will have on NAC. As additional information regarding NAC's potential liabilities becomes available, NAC will revise the estimates as appropriate. Other Litigation ---------------- In the normal course of its business, NAC is named as defendant in legal proceedings. It is the policy of NAC to vigorously defend litigation and/or enter into settlements of claims where management deems appropriate. In the opinion of management, the amount of ultimate liability with respect to any current actions, if any, is unlikely to materially affect our financial position, results of operations or liquidity. ITEM 1A. RISK FACTORS Not applicable ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Not applicable ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable ITEM 4. SUBMISSION OF MATTER TO A VOTE OF SECURITY HOLDERS Not applicable ITEM 5. OTHER INFORMATION Not applicable ITEM 6. EXHIBITS EXHIBIT PAGE NUMBER TITLE OF EXHIBIT NUMBER -------------------------------------------------------------------------------- 31.1 Officer's Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) 40 31.2 Officer's Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) 41 32.1 Certification of Principal Executive Officer Pursuant to 18 U.S.C. 1350 (Section 906 of the Sarbanes-Oxley Act of 2002) 42 32.2 Certification of Principal Financial Officer Pursuant to 18 U.S.C. 1350 (Section 906 of the Sarbanes-Oxley Act of 2002) 43 -38- 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. NATIONAL AUTO CREDIT, INC. Date: December 12, 2005 By:/s/ James J. McNamara ----------------- --------------------------------------------- James J. McNamara Chairman of the Board and Chief Executive Officer (principal executive officer) By:/s/ Robert V. Cuddihy, Jr. ---------------------------------------------- Robert V. Cuddihy, Jr. Chief Financial Officer (principal accounting and financial officer) -39-