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 March 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 No. 001-16427
Certegy Inc.
(Exact name of registrant as specified in its charter)
Georgia | 58-2606325 | |
(State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) | |
100 Second Avenue South Suite 1100S St. Petersburg, FL |
33701 | |
(Address of principal executive offices) | (Zip Code) |
(Registrants telephone number, including area code)
(727) 227-8000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.
Title of each class |
Number of shares outstanding at April 30, 2005 | |
Common stock, $0.01 par value | 61,826,294 |
INDEX
2
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(In thousands, except per share amounts)
Three months ended March 31, |
||||||||
2005 |
2004 |
|||||||
Revenues |
$ | 262,458 | $ | 239,340 | ||||
Operating expenses: |
||||||||
Costs of services |
190,292 | 177,240 | ||||||
Selling, general and administrative |
35,114 | 32,130 | ||||||
225,406 | 209,370 | |||||||
Operating income |
37,052 | 29,970 | ||||||
Other income, net |
165 | 220 | ||||||
Interest expense |
(3,305 | ) | (2,976 | ) | ||||
Income from continuing operations before income taxes |
33,912 | 27,214 | ||||||
Provision for income taxes |
(12,757 | ) | (10,363 | ) | ||||
Income from continuing operations |
21,155 | 16,851 | ||||||
Income from discontinued operations, net of taxes of $1.2 million and $0.7 million, respectively (Note 4) |
2,041 | 1,272 | ||||||
Net income |
$ | 23,196 | $ | 18,123 | ||||
Basic earnings per share of Common Stock |
||||||||
Income from continuing operations |
$ | 0.34 | $ | 0.26 | ||||
Income from discontinued operations |
0.03 | 0.02 | ||||||
Net income |
$ | 0.38 | $ | 0.28 | ||||
Diluted earnings per share of Common Stock |
||||||||
Income from continuing operations |
$ | 0.34 | $ | 0.26 | ||||
Income from discontinued operations |
0.03 | 0.02 | ||||||
Net income |
$ | 0.37 | $ | 0.28 | ||||
Average shares outstanding (Note 5) |
||||||||
Basic |
61,794 | 63,677 | ||||||
Diluted |
62,859 | 64,643 | ||||||
Dividends per share of Common Stock (Note 12) |
$ | 0.05 | $ | 0.05 | ||||
The accompanying notes are an integral part of these Consolidated Financial Statements
3
CONSOLIDATED BALANCE SHEETS
(in thousands, except par values)
March 31, 2005 |
December 31, 2004 |
|||||||
(Unaudited) | ||||||||
ASSETS |
||||||||
Current assets: |
||||||||
Cash and cash equivalents |
$ | 50,625 | $ | 41,801 | ||||
Settlement deposits |
43,473 | 44,855 | ||||||
Trade accounts receivable, net of allowance for doubtful accounts of $2,912 and $2,175, respectively |
106,534 | 120,767 | ||||||
Settlement receivables |
44,922 | 49,861 | ||||||
Claims recoverable (Note 2) |
28,447 | 39,316 | ||||||
Other receivables |
47,421 | 48,053 | ||||||
Other current assets (Note 6) |
22,686 | 22,236 | ||||||
Assets held for sale (Note 4) |
39,869 | 41,828 | ||||||
Total current assets |
383,977 | 408,717 | ||||||
Property and equipment, net (Note 7) |
64,438 | 61,490 | ||||||
Goodwill, net (Note 8) |
230,548 | 232,941 | ||||||
Other intangible assets, net (Note 8) |
24,442 | 25,506 | ||||||
Systems development and capitalized contract costs, net |
122,366 | 123,135 | ||||||
Other assets, net (Note 9) |
71,588 | 70,420 | ||||||
Total Assets |
$ | 897,359 | $ | 922,209 | ||||
LIABILITIES AND SHAREHOLDERS EQUITY |
||||||||
Current liabilities: |
||||||||
Accounts payable and other accrued expenses |
$ | 58,794 | $ | 56,764 | ||||
Settlement payables |
88,395 | 94,716 | ||||||
Claims payable (Note 2) |
21,657 | 36,204 | ||||||
Compensation and benefit liabilities |
17,660 | 19,384 | ||||||
Income taxes payable |
21,422 | 14,398 | ||||||
Other payables |
24,113 | 22,882 | ||||||
Other current liabilities (Note 10) |
24,290 | 28,271 | ||||||
Liabilities related to assets held for sale (Note 4) |
15,811 | 17,719 | ||||||
Total current liabilities |
272,142 | 290,338 | ||||||
Long-term debt (Note 11) |
250,209 | 273,968 | ||||||
Deferred income taxes |
29,760 | 33,071 | ||||||
Other long-term liabilities |
17,889 | 17,545 | ||||||
Total liabilities |
570,000 | 614,922 | ||||||
Commitments and contingencies (Note 14) |
||||||||
Shareholders equity: |
||||||||
Preferred stock, $0.01 par value; 100,000 shares authorized; none issued and outstanding |
| | ||||||
Common stock, $0.01 par value; 300,000 shares authorized; 69,272 shares issued and 61,810 and 61,784 shares outstanding in 2005 and 2004, respectively |
693 | 693 | ||||||
Paid-in capital |
294,098 | 290,865 | ||||||
Retained earnings |
315,600 | 295,532 | ||||||
Accumulated other comprehensive loss (Note 12) |
(62,960 | ) | (59,194 | ) | ||||
Treasury stock, at cost; 7,462 and 7,488 shares in 2005 and 2004, respectively |
(220,072 | ) | (220,609 | ) | ||||
Total shareholders equity |
327,359 | 307,287 | ||||||
Total Liabilities and Shareholders Equity |
$ | 897,359 | $ | 922,209 | ||||
The accompanying notes are an integral part of these Consolidated Financial Statements
4
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(In thousands)
Three months ended March 31, |
||||||||
2005 |
2004 |
|||||||
Cash flows from operating activities: |
||||||||
Net income |
$ | 23,196 | $ | 18,123 | ||||
Adjustments to reconcile net income to net cash provided by operating activities of continuing operations: |
||||||||
Income from discontinued operations (Note 4) |
(2,041 | ) | (1,272 | ) | ||||
Depreciation and amortization |
12,529 | 11,084 | ||||||
Amortization of deferred compensation |
3,093 | 4,814 | ||||||
Other non-cash items |
1,497 | 1,279 | ||||||
Deferred income taxes |
(2,661 | ) | 639 | |||||
Changes in assets and liabilities, excluding effects of acquisitions: |
||||||||
Accounts receivable, net |
13,110 | 20,307 | ||||||
Current liabilities, excluding settlement and claims payable |
4,631 | (11,186 | ) | |||||
Claims accounts, net |
(3,678 | ) | (1,348 | ) | ||||
Other current assets |
(1,148 | ) | 1,210 | |||||
Other long-term liabilities |
196 | 1,976 | ||||||
Other long-term assets |
(2,326 | ) | (8,742 | ) | ||||
Net cash provided by operating activities |
46,398 | 36,884 | ||||||
Cash flows from investing activities: |
||||||||
Capital expenditures |
(12,037 | ) | (7,026 | ) | ||||
Acquisitions, net of cash acquired |
| (33,391 | ) | |||||
Net cash used in investing activities |
(12,037 | ) | (40,417 | ) | ||||
Cash flows from financing activities: |
||||||||
Net additions to (repayments of) revolving credit facilities |
(24,300 | ) | 50,000 | |||||
Treasury stock purchases |
| (20,777 | ) | |||||
Proceeds from exercise of stock options |
720 | 1,646 | ||||||
Dividends paid |
(3,119 | ) | (3,218 | ) | ||||
Other |
(308 | ) | (81 | ) | ||||
Net cash (used in) provided by financing activities |
(27,007 | ) | 27,570 | |||||
Effect of foreign currency exchange rates on cash |
(622 | ) | 161 | |||||
Cash provided by discontinued operations (Note 4) |
2,092 | 52 | ||||||
Net cash provided |
8,824 | 24,250 | ||||||
Cash and cash equivalents, beginning of period |
41,801 | 22,280 | ||||||
Cash and cash equivalents, end of period |
$ | 50,625 | $ | 46,530 | ||||
The accompanying notes are an integral part of these Consolidated Financial Statements
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(Dollars in thousands, except per share amounts or unless otherwise noted)
Note 1Basis of Presentation
The Company provides credit card, debit card, and other transaction processing and check risk management services to financial institutions and merchants in the U.S. and internationally through two segments, Card Services and Check Services (see Note 15 for segment information). Card Services provides card issuer services in the U.S., the U.K., Brazil, Chile, Australia, New Zealand, Ireland, Thailand, and the Caribbean. Additionally, Card Services provides merchant processing and e-banking services in the U.S. and card issuer software, support, and consulting services in numerous countries. Check Services provides check risk management services and related processing services in the U.S., the U.K., Canada, France, Ireland, Australia, and New Zealand.
The accompanying consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries and should be read in conjunction with the Companys consolidated financial statements and the notes to those statements for the year ended December 31, 2004 included in the Companys annual report on Form 10-K. Significant accounting policies disclosed in the annual report have not changed, unless specifically indicated in Note 2 herein. All significant intercompany transactions and balances have been eliminated.
The Company has prepared these consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission. This information reflects all adjustments that are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, results of operations, and cash flows for the interim periods presented. All adjustments made have been of a normal recurring nature. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the U.S. (GAAP) have been condensed or omitted, although the Company believes that the disclosures are adequate to make the information presented not misleading. Certain prior period amounts have been reclassified to conform to the current period presentation. Results of operations reported for interim periods are not necessarily indicative of results for the entire year.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements as well as reported amounts of revenues and expenses during the reporting periods. Actual results could differ from these estimates.
Note 2Significant Accounting Policies
Reserve for Card Processing and Check Guarantee Losses. The Company recognizes a reserve for estimated losses related to its card issuing and merchant acquiring businesses based on historical experience and other relevant factors. In the Companys card issuing business, the Company records estimates to accrue for losses resulting from transaction processing errors. The Company utilizes a number of systems and procedures within its card issuing business in order to minimize such transaction processing errors. In the Companys merchant acquiring business, if, due to the insolvency or bankruptcy of the merchant or other reasons, the Company is not able to collect amounts from its merchant customers for cardholder chargebacks, the Company must bear the credit risk for the full amount of the cardholder transaction. The Company requires cash deposits and other types of collateral from certain merchants to minimize any such risk. In addition, the Company utilizes a number of systems and procedures to manage merchant risk and believes that the diversification of its merchant portfolio among industries and geographic regions minimizes its risk of loss. These card processing loss reserve amounts are subject to risk that actual losses may be greater than the Companys estimates. At March 31, 2005 and December 31, 2004, the Company had aggregate card processing loss reserves of $0.6 million and $0.9 million, respectively, which are included in other current liabilities in the consolidated balance sheets.
As further discussed in Note 4, in September 2004, the Board of Directors approved a plan to sell the Companys merchant acquiring business; therefore, the Companys financial statements reflect the merchant acquiring business as discontinued operations. The portion of the card processing loss reserves related to the merchant acquiring business has not been reclassified to discontinued operations in the consolidated balance sheets as, upon the ultimate sale of the merchant acquiring business, the Company may retain the credit risk for cardholder transactions processed by the Company prior to the sale.
In the Companys check guarantee business, if a guaranteed check presented to a merchant customer is dishonored by the check writers bank, the Company reimburses its merchant customer for the checks face value and pursues collection of the amount from the delinquent check writer. The Companys merchant customers have approximately 60 days from the check date to present claims for dishonored checks to the Company. The Company has a maximum potential liability equal to the value of all checks presented to its merchant customers; however, through historical experience and analysis, the Company is able to reasonably estimate its liability for
6
check returns. The Company recognizes a liability to its merchant customers for estimated check returns (claims payable) and a receivable for amounts the Company estimates it will recover from the check writers (claims recoverable), based on historical experience and other relevant factors. The estimated check returns and recovery amounts are subject to risk that actual amounts returned and recovered may be different than the Companys estimates. The Company had accrued claims payable and accrued claims recoverable balances of $21.7 million and $28.4 million at March 31, 2005 and $36.2 million and $39.3 million at December 31, 2004, respectively.
The Company settles its claim obligations with merchants on average within 14 days. Recoverability of claims from the check writers extends beyond this timeframe, but generally occurs within a one-year timeframe.
Share-Based Compensation. On December 16, 2004, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)), which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123). SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.
SFAS 123(R) permits public companies to adopt its requirements using one of two methods:
| A modified prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123(R) for all shared-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123(R) that remain unvested on the effective date. |
| A modified retrospective method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) all periods presented or (b) prior interim periods of the year of adoption. |
The Company adopted SFAS 123(R) on January 1, 2005, using the Black-Scholes-Merton option valuation model and the modified retrospective method, restating all prior periods. Refer to Note 12 for additional information.
Note 3Acquisitions
On March 1, 2004, the Company completed the purchases of Game Financial, a provider of debit and credit card cash advances, ATM access, and check cashing services in gaming institutions, and Crittson, a full service provider of card and merchant processing services. The acquisition of Game Financial helps position the Company as a leading provider of comprehensive cash access services in the gaming industry and broadens its check risk management product line and customer base, while the acquisition of Crittson further strengthens the Companys U.S. market share as the leading third party credit card processor for community banks and credit unions. On August 6, 2004, the Company completed the acquisition of CariCard, a third-party transaction processor in the Caribbean. CariCard provides a wide range of products and services to financial institutions, retailers, and the petroleum industry that service markets in 16 countries throughout the Caribbean.
These acquisitions had a combined initial cash purchase price of $46.2 million, net of $24.6 million of cash acquired. During 2004, the Company paid net additional consideration of $0.3 million to the former owners of the businesses acquired resulting from a final determination of net assets acquired. These payments were recorded as adjustments to goodwill. Additionally, the Company received $1.0 million from the former owner of one of the businesses acquired as a reduction in purchase price due to the termination of a customer contract subsequent to the acquisition. This payment was recorded as an adjustment to the value assigned to acquired customer contracts.
The purchase price allocation, including the purchase price adjustments of $0.3 million and $1.0 million, resulted in identifiable intangible assets of $20.4 million, which are being amortized primarily over seven years. This intangible asset value was assigned to acquired customer contracts. Goodwill recognized in these acquisitions amounted to $39.3 million, which is expected to be fully deductible for tax purposes. Goodwill was assigned to the Card Services and Check Services segments in the amounts of $21.9 million and $17.4 million, respectively.
During the first quarter of 2005, the Company recorded certain purchase price allocation adjustments. These adjustments resulted in a net decrease in goodwill of $0.5 million to record a reduction in acquisition liabilities and $0.1 million to adjust other accruals relating to the Crittson acquisition.
7
In connection with these acquisitions, the Company recorded acquisition liabilities totaling $7.8 million for early termination costs associated with a data processing contract of one of the acquired businesses, severance and relocation costs for employees of the acquired businesses, and professional fees. These costs were reflected as assumed liabilities in the allocation of the purchase price to net assets acquired. As of March 31, 2005, $6.8 million of these costs had been paid and charged against the liability. As discussed above, acquisition liabilities were reduced by $0.5 million in the first quarter of 2005 as a result of finalization of the assumed liability amounts. The remaining liability of $0.5 million is expected to be paid by the end of 2005.
In connection with the acquisition of Game Financial, the Company may receive purchase price reductions for certain customers if those customers terminate their contracts during designated periods subsequent to the acquisition. The maximum amount that could be received by the Company is $6.0 million at March 31, 2005. Additionally, in connection with the acquisition of Crittson, the Company may be required to pay certain additional amounts of up to $1.2 million, payable in cash and to be accounted for under the purchase method, contingent upon the acquired business achieving specified levels of revenue growth during designated periods subsequent to the acquisition. Any such payments to or by the Company would result in adjustments to goodwill, and in the case of customer contract settlements, to identifiable intangible assets.
The above acquisitions were accounted for as purchases and their results of operations have been included in the consolidated statements of income from the dates of acquisition. The pro forma effects of these acquisitions on the Companys consolidated financial statements were not material.
Approximately $5.8 million of the Crittson purchase price, which represents merchant acquiring operations, was reclassified to discontinued operations (Note 4), including $4.0 million of goodwill and $1.2 million of identifiable intangible assets.
Note 4Discontinued Operations
The Companys merchant processing operations consist of two businesses: (1) merchant acquiring, where the Company is a direct party to contracts with merchants regarding its provision of card processing services for the merchant, and the Company is subject to the associated risk that a cardholder billing dispute will be resolved in favor of the cardholder (referred to as a cardholder chargeback), and (2) institution processing, where the Company provides authorization, settlement, and customer service to community banks and others that contract directly with merchant customers. The Company views merchant acquiring as a non-strategic business and over the past few years, has operated this business conservatively to reduce exposure to merchant risk, which in the short-term improved overall profitability but limited growth. In September 2004, the Board of Directors approved a plan to sell the Companys merchant acquiring business, at which time, the held for sale criteria in SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, were met. The Company expects to reach a definitive agreement regarding the disposition of this business during the second quarter of 2005.
The Companys financial statements reflect the merchant acquiring business as a discontinued operation with the related assets and liabilities classified under the captions Assets held for sale and Liabilities related to assets held for sale in the consolidated balance sheets. The results of operations are treated as income from discontinued operations, net of tax, and separately stated in the consolidated statements of income, below income from continuing operations. The merchant acquiring operations were historically included in the Card Services segment.
The Company plans to continue to operate the institution processing business, which it believes is complementary to its card issuing business.
Summarized financial information for discontinued operations for the three months ended March 31, 2005 and 2004 is as follows (in thousands):
Three months ended March 31, |
||||||||
2005 |
2004 |
|||||||
Revenues |
$ | 25,328 | $ | 24,069 | ||||
Operating expenses |
22,068 | 22,050 | ||||||
Income before income taxes |
3,260 | 2,019 | ||||||
Provision for income taxes |
(1,219 | ) | (747 | ) | ||||
Income from discontinued operations |
$ | 2,041 | $ | 1,272 | ||||
8
The assets held for sale and liabilities related to assets held for sale as of March 31, 2005 and December 31, 2004 are as follows (in thousands):
March 31, 2005 |
December 31, 2004 | |||||
Assets: |
||||||
Settlement deposits |
$ | | $ | 1,716 | ||
Trade accounts receivable, net |
6,554 | 6,424 | ||||
Settlement receivables |
8,494 | 8,774 | ||||
Other current assets |
279 | 372 | ||||
Goodwill, net |
4,005 | 4,005 | ||||
Other intangible assets, net |
20,537 | 20,537 | ||||
Assets held for sale |
$ | 39,869 | $ | 41,828 | ||
Liabilities: |
||||||
Accounts payable and other accrued expenses |
$ | 1,110 | $ | 1,271 | ||
Settlement payables |
8,494 | 10,490 | ||||
Deferred income taxes |
6,207 | 5,958 | ||||
Liabilities related to assets held for sale |
$ | 15,811 | $ | 17,719 | ||
Summarized cash flow information associated with discontinued operations for the three months ended March 31, 2005 and 2004 is as follows (in thousands):
Three months ended March 31, |
||||||||
2005 |
2004 |
|||||||
Income from discontinued operations |
$ | 2,041 | $ | 1,272 | ||||
Deferred income taxes |
249 | 4,149 | ||||||
Changes in assets and liabilities: |
||||||||
Accounts receivable, net |
(130 | ) | 1 | |||||
Current liabilities, excluding settlement and claims payable |
(161 | ) | 114 | |||||
Other current assets |
93 | (352 | ) | |||||
Other long-term assets |
| 753 | ||||||
$ | 2,092 | $ | 5,937 | |||||
Capital expenditures |
| (85 | ) | |||||
Acquisitions (Note 3) |
| (5,800 | ) | |||||
| (5,885 | ) | ||||||
Net cash provided by discontinued operations |
$ | 2,092 | $ | 52 | ||||
Note 5Earnings Per Share
Basic earnings per share (EPS) is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted EPS reflects the potential dilution that would occur if stock options or other contracts to issue common stock were exercised and resulted in additional common shares outstanding during the period. A reconciliation of the average outstanding shares used in the basic and diluted EPS calculations is as follows (in thousands):
Three months ended March 31, | ||||
2005 |
2004 | |||
Weighted average shares outstandingbasic |
61,794 | 63,677 | ||
Effect of dilutive securities: |
||||
Stock options |
696 | 738 | ||
Restricted stock |
369 | 228 | ||
Weighted average shares outstandingdiluted |
62,859 | 64,643 | ||
9
Note 6Other Current Assets
The Companys other current assets at March 31, 2005 and December 31, 2004 consist of the following (in thousands):
March 31, 2005 |
December 31, 2004 | |||||
Prepaid expenses |
$ | 13,805 | $ | 13,395 | ||
Current deferred income taxes |
3,882 | 3,768 | ||||
Inventories and supplies |
2,301 | 2,417 | ||||
Other |
2,698 | 2,656 | ||||
$ | 22,686 | $ | 22,236 | |||
Note 7Property and Equipment
The cost of property and equipment is depreciated on a straight-line basis over estimated useful lives as follows: building40 years; leasehold improvementsnot to exceed lease terms; data processing equipment3 to 5 years; and furniture and fixtures3 to 8 years. Maintenance and repairs are charged to expense as incurred.
Property and equipment at March 31, 2005 and December 31, 2004 consists of the following (in thousands):
March 31, 2005 |
December 31, 2004 |
|||||||
Land |
$ | 1,500 | $ | 1,500 | ||||
Building and improvements |
39,146 | 38,852 | ||||||
Data processing equipment |
75,530 | 72,014 | ||||||
Furniture and other equipment |
63,184 | 60,283 | ||||||
$ | 179,360 | $ | 172,649 | |||||
Less accumulated depreciation |
(114,922 | ) | (111,159 | ) | ||||
$ | 64,438 | $ | 61,490 | |||||
Equipment under capital lease, which is included in data processing equipment above, totaled $6.6 million at March 31, 2005 and $6.2 million at December 31, 2004. Accumulated depreciation related to these assets totaled approximately $1.5 million at March 31, 2005 and $1.3 million at December 31, 2004.
Note 8Goodwill and Other Intangible Assets
Information related to the Companys goodwill by segment is as follows (in thousands):
March 31, 2005 |
December 31, 2004 | |||||
Card Services |
$ | 182,870 | $ | 184,899 | ||
Check Services |
47,678 | 48,042 | ||||
$ | 230,548 | $ | 232,941 | |||
The change in the carrying amount of goodwill from December 31, 2004 to March 31, 2005 was the result of adjustments to the purchase price allocation of the Crittson acquisition (Note 3) and currency translation adjustments.
10
Information related to the Companys other intangible assets subject to amortization is as follows (in thousands):
March 31, 2005 |
December 31, 2004 |
|||||||||||||
Gross Carrying Amount |
Accumulated Amortization |
Gross Carrying Amount |
Accumulated Amortization |
|||||||||||
Acquired customer contracts |
$ | 27,433 | $ | (6,522 | ) | $ | 27,328 | $ | (5,431 | ) | ||||
Other |
4,853 | (1,322 | ) | 4,853 | (1,244 | ) | ||||||||
32,286 | (7,844 | ) | 32,181 | (6,675 | ) | |||||||||
Net book value |
$ | 24,442 | $ | 25,506 | ||||||||||
The Companys other intangible assets primarily consist of acquired customer contracts, data files, and customer lists, which are generally amortized on a straight-line basis over their estimated useful lives, ranging from 5 to 15 years. Amortization expense associated with the Companys acquired intangible assets totaled $1.2 million and $1.4 million for the three months ended March 31, 2005 and 2004, respectively. Estimated amortization expense for the Companys acquired intangible assets for each of the five succeeding fiscal years is as follows: 2006$4.6 million; 2007$4.6 million; 2008$3.1 million; 2009$3.1 million; and 2010$3.1 million.
The change in the carrying amount of other intangible assets from December 31, 2004 to March 31, 2005 was the result of currency translation adjustments.
The Company has no intangible assets with indefinite useful lives.
Note 9Other Assets
Other assets, net at March 31, 2005 and December 31, 2004 consist of the following (in thousands):
March 31, 2005 |
December 31, 2004 | |||||
Prepaid pension cost |
$ | 15,471 | $ | 16,656 | ||
Cash surrender value of life insurance policies |
14,911 | 13,998 | ||||
Deferred income taxes |
4,290 | 4,873 | ||||
SERP intangible asset |
4,742 | 4,742 | ||||
Deferred financing costs, net |
2,303 | 2,596 | ||||
Other |
29,871 | 27,555 | ||||
$ | 71,588 | $ | 70,420 | |||
Note 10Other Current Liabilities
The Companys other current liabilities at March 31, 2005 and December 31, 2004 consist of the following (in thousands):
March 31, 2005 |
December 31, 2004 | |||||
Deferred revenue |
$ | 8,992 | $ | 8,414 | ||
Accrued interest |
426 | 2,810 | ||||
Other |
14,872 | 17,047 | ||||
$ | 24,290 | $ | 28,271 | |||
11
Note 11Long-Term Debt
Long-term debt at March 31, 2005 and December 31, 2004 consists of the following (in thousands):
March 31, 2005 |
December 31, 2004 | |||||
Unsecured notes, 4.75%, due 2008, net of unamortized discount |
$ | 199,574 | $ | 199,543 | ||
Borrowings under revolving credit facility |
24,300 | 48,600 | ||||
Notes payable, 3.48% at March 31, 2005 and 2.25% at December 31, 2004, due 2009 |
22,364 | 22,364 | ||||
Capital lease obligations, less current portion |
3,971 | 3,461 | ||||
$ | 250,209 | $ | 273,968 | |||
Note 12Shareholders Equity
As discussed in Note 2, the Company adopted SFAS 123(R) on January 1, 2005, using the Black-Scholes-Merton option valuation model and the modified retrospective method, restating all prior periods. The Company currently awards stock options, restricted stock, and restricted stock units to its employees and members of the Board of Directors, the terms of which are described in further detail below.
Stock Options. In June 2001, the Companys Board of Directors adopted the Certegy Inc. Stock Incentive Plan (the Employee Stock Plan), pursuant to which 6.6 million shares of authorized but unissued common stock were reserved. Under the provisions of the Employee Stock Plan, the number of shares available for grant is increased each January through 2008 based on the number of common shares issued and outstanding. The Employee Stock Plan provides that qualified and nonqualified stock options may be granted to officers and other key employees at exercise prices not less than market value on the date of grant. Options generally vest over a three or four-year period subject to the employees continued service and are exercisable for seven to ten years from the date of grant. Options generally provide for accelerated vesting in the event of a change in control. Options generally continue to vest in accordance with the original vesting schedule upon retirement or permanent disability when eligible to retire subject to the individual being available to perform reasonable services for the Company as a consultant through the vesting date of the grant, and subject to the conditions that the individual does not commence employment with a competitor of the Company, does not engage in solicitation of the Companys employees, customers or suppliers, and does not disclose the Companys confidential information or trade secrets.
Additionally, the Company adopted the Certegy Inc. Non-Employee Director Stock Option Plan (the Director Stock Plan), pursuant to which 200,000 shares of stock are available for grant to non-employee directors in the form of stock options.
Prior to January 1, 2005, the Company accounted for stock option awards using APB 25s intrinsic value method as permitted by SFAS 123. As such, no compensation cost was recognized in the income statement, as the exercise price equaled the market value of the underlying common stock on the date of grant. Additionally, prior to January 1, 2005, the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows. SFAS 123(R) requires that such tax benefits be classified as financing cash flows. The effect of the adoption of SFAS 123(R) is summarized below in the section entitled Effect of SFAS 123(R) Adoption.
The following is a summary of the stock option activity during the three months ended March 31, 2005 (options in thousands):
Options |
Weighted- Average Exercise Price |
Weighted- Average Remaining Contractual Term (years) |
Aggregate Intrinsic Value | ||||||||
Balance, December 31, 2004 |
4,608 | $ | 28.34 | ||||||||
Granted (at market price) |
718 | 35.35 | |||||||||
Exercised |
(26 | ) | 28.03 | ||||||||
Cancelled |
(35 | ) | 29.64 | ||||||||
Balance, March 31, 2005 |
5,265 | $ | 29.29 | 6.10 | $ | 28,062 | |||||
Exercisable, March 31, 2005 |
3,622 | $ | 27.70 | 5.78 | $ | 25,064 | |||||
12
The fair value of options granted is estimated on the date of grant using the Black-Scholes-Merton option pricing model based on the assumptions summarized in the following table. Expected volatility and expected term are derived primarily based on the Companys historical data. In computing historical volatility, the Company disregards any identifiable period of time in which its share price is extraordinarily volatile because of events that are not expected to recur during the expected term. In 2005, the Company began evaluating expected term based on separate employee groups with similar historical exercise behavior. The range provided in the table below results from certain groups of employees exhibiting different exercise behavior. The risk-free interest rate is based on the U.S. Treasury zero-coupon issues with a remaining term approximating the expected term. The dividend yield is calculated based on the anticipated dividends over the expected term.
Three months ended March 31, |
||||||
2005 |
2004 |
|||||
Expected volatility |
25 | % | 40 | % | ||
Expected term (in years) |
4.96 6.97 | 4.86 | ||||
Risk-free interest rate |
4.21 4.37 | % | 3.52 | % | ||
Dividend yield |
0.50 | % | 0.60 | % |
The weighted-average grant-date fair value of options granted during the three months ended March 31, 2005 and 2004 was $12.16 and $12.85, respectively. The Company recognizes compensation cost for awards with graded vesting using the straight-line attribution method, with the amount of compensation cost recognized at any date at least equal to the portion of the grant-date value of the award that is vested at that date. At March 31, 2005, the unamortized compensation cost related to stock option awards totaled $16.3 million, which is expected to be recognized over a weighted-average period of 2.56 years.
Stock option expense for 2004 was as follows (in thousands, except per share data):
2004 |
||||||||||||||||||||
1st Qtr |
2nd Qtr |
3rd Qtr |
4th Qtr |
Year |
||||||||||||||||
Stock option expense |
$ | 3,557 | $ | 2,769 | $ | 2,414 | $ | 2,418 | $ | 11,158 | ||||||||||
Income tax benefit |
(1,022 | ) | (651 | ) | (580 | ) | (707 | ) | (2,960 | ) | ||||||||||
$ | 2,535 | $ | 2,118 | $ | 1,834 | $ | 1,711 | $ | 8,198 | |||||||||||
Diluted EPS |
$ | 0.04 | $ | 0.03 | $ | 0.03 | $ | 0.03 | $ | 0.13 | ||||||||||
Restricted Stock. In June 2001, the Companys Board of Directors adopted the Certegy Inc. Key Management Long-Term Incentive Plan for officers and other key employees. This plan, in conjunction with the Employee Stock Plan, provides for the issuance of restricted stock awards. Restricted stock generally vests over a specified period subject to the employees continued service. Certain restricted stock awards contain performance-accelerated provisions; accordingly, compensation expense associated with these awards can fluctuate each year based on the likelihood that the performance criteria will be met. Restricted stock generally provides for accelerated vesting in the event of a change in control or death. Restricted stock generally continues to vest in accordance with the original vesting schedule upon retirement or permanent disability when eligible to retire subject to the individual being available to perform reasonable services for the Company as a consultant through the vesting date of the grant, and subject to the conditions that the individual does not commence employment with a competitor of the Company, does not engage in solicitation of the Companys employees, customers or suppliers, and does not disclose the Companys confidential information or trade secrets. Additionally, employees receive dividends on restricted stock awards. The Company recognizes compensation cost for restricted stock on a straight-line basis over the vesting period based on the quoted fair market value of the Company stock on the date of grant.
13
The following is a summary of the restricted stock activity during the three months ended March 31, 2005 (shares in thousands):
Shares |
Weighted- Average Grant- Date Fair Value | |||||
Balance, December 31, 2004 |
599 | $ | 31.31 | |||
Granted (at market price) |
143 | 35.22 | ||||
Vested |
| | ||||
Cancelled |
(5 | ) | 32.51 | |||
Balance, March 31, 2005 |
737 | $ | 32.06 | |||
Weighted average remaining contractual term (years) |
2.21 | |||||
The restricted stock awards granted during the three months ended March 31, 2005 become fully vested in one or three years if certain performance criteria are met; otherwise, the awards will vest at the end of two or five years. During the three months ended March 31, 2004, the Company granted approximately 130 thousand restricted stock awards with a weighted-average grant-date fair value of $32.55 per share. Approximately 133 thousand restricted stock awards vested during the three months ended March 31, 2004 with a weighted-average grant-date fair value of $31.84. The compensation cost and the related tax benefit associated with restricted stock awards totaled $1.4 million and $0.6 million, respectively, during the three months ended March 31, 2005, and $1.3 million and $0.5 million, respectively, during the three months ended March 31, 2004. At March 31, 2005, the unamortized compensation cost related to restricted stock awards totaled $13.1 million, which is expected to be recognized over a weighted-average period of 2.21 years.
Prior to the adoption of SFAS 123(R), restricted stock awards were recorded as deferred compensation, a reduction of shareholders equity, based on the quoted fair market value of the Companys stock on the date of grant. The common or treasury stock balances were adjusted on the date of grant to reflect the issuance of the restricted stock awards. Under to the provisions of SFAS 123(R), restricted stock awards are not deemed to be issued until the end of the vesting period. Accordingly, SFAS 123(R) requires that compensation cost be recognized over the requisite service period with an offsetting credit to paid-in capital. The effect of the adoption of SFAS 123(R) is summarized below in the section entitled Effect of SFAS 123(R) Adoption.
Restricted Stock Units. In July 2004, 13,475 restricted stock units were awarded to the Companys Board of Directors. The restricted stock units vest one year from the grant date, at which time common stock will be issued unless the Board member elects to defer delivery of the stock. Compensation expense is recognized on a straight-line basis over the vesting period based on the quoted fair market value of the Companys stock on the date of grant. The weighted-average grant-date fair value is $37.80 per unit. Compensation cost and the related tax benefit associated with restricted stock units totaled $127 thousand and $50 thousand, respectively, during the three months ended March 31, 2005. As of March 31, 2005, the unamortized compensation cost related to restricted stock units totaled $127 thousand, which will be recognized during the second quarter of 2005. The adoption of SFAS 123(R) did not have a material effect on the Companys accounting treatment of restricted stock units.
Treasury Stock. The Company made no share repurchases in the first quarter of 2005. In May 2004, the Board of Directors of the Company approved a $100 million share repurchase program, which replaced the prior authority. As of March 31, 2005, the Company had $43.3 million remaining under this program for future share repurchases. When available, the Company uses treasury shares for employee stock option exercises and restricted stock awards. During the first three months of 2005, the Company reissued approximately 0.2 million treasury shares in connection with employee stock option exercises and restricted stock awards, net of cancellations.
Dividends. In February 2005, the Companys Board of Directors approved a quarterly common stock dividend of $0.05 per share, or $3.1 million, which was paid on April 15, 2005 to shareholders of record as of the close of business on April 1, 2005.
14
Comprehensive Income. The components of comprehensive income for the three months ended March 31, 2005 and 2004 are as follows (in thousands):
Three months ended March 31, |
||||||||
2005 |
2004 |
|||||||
Net income |
$ | 23,196 | $ | 18,123 | ||||
Change in cumulative foreign currency translation adjustment |
(3,960 | ) | 1,561 | |||||
Change in cumulative loss from cash flow hedging activities |
194 | (129 | ) | |||||
Comprehensive income |
$ | 19,430 | $ | 19,555 | ||||
Accumulated other comprehensive loss at March 31, 2005 and December 31, 2004 consists of the following components (in thousands):
March 31, 2005 |
December 31, 2004 |
|||||||
Cumulative foreign currency translation adjustment |
$ | (62,605 | ) | $ | (58,645 | ) | ||
Cumulative loss from cash flow hedging activities |
(355 | ) | (549 | ) | ||||
Accumulated other comprehensive loss |
$ | (62,960 | ) | $ | (59,194 | ) | ||
Effect of SFAS 123(R) Adoption. The effect of the adoption of SFAS 123(R) on the consolidated statements of income and cash flows is as follows (in thousands, except per share data):
Three months ended March 31, |
||||||||||||||||||||||||
2005 |
2004 |
|||||||||||||||||||||||
Without SFAS 123(R) |
SFAS 123(R) impact |
With SFAS 123(R) |
Without SFAS 123(R) |
SFAS 123(R) impact |
With SFAS 123(R) |
|||||||||||||||||||
Income from continuing operations before income taxes |
$ | 35,432 | $ | (1,520 | ) | $ | 33,912 | $ | 30,771 | $ | (3,557 | ) | $ | 27,214 | ||||||||||
Provision for income taxes |
(13,172 | ) | 415 | (12,757 | ) | (11,385 | ) | 1,022 | (10,363 | ) | ||||||||||||||
Income from continuing operations |
22,260 | (1,105 | ) | 21,155 | 19,386 | (2,535 | ) | 16,851 | ||||||||||||||||
Net income |
24,301 | (1,105 | ) | 23,196 | 20,658 | (2,535 | ) | 18,123 | ||||||||||||||||
Net cash provided by operating activities |
46,411 | (13 | ) | 46,398 | 36,893 | (9 | ) | 36,884 | ||||||||||||||||
Net cash (used in) provided by financing activities |
(27,020 | ) | 13 | (27,007 | ) | 27,561 | 9 | 27,570 | ||||||||||||||||
Basic earnings per share |
$ | 0.39 | $ | (0.01 | ) | $ | 0.38 | $ | 0.32 | $ | (0.04 | ) | $ | 0.28 | ||||||||||
Diluted earnings per share |
$ | 0.39 | $ | (0.02 | ) | $ | 0.37 | $ | 0.32 | $ | (0.04 | ) | $ | 0.28 |
The effect of the adoption of SFAS 123(R) on the consolidated balance sheet at December 31, 2004 is as follows (in thousands):
Without SFAS 123(R) |
SFAS 123(R) impact |
With SFAS |
||||||||||
Deferred income tax assets (included in net deferred income tax liability) |
$ | 40,295 | $ | (7,224 | ) | $ | 33,071 | |||||
Common stock |
695 | (2 | ) | 693 | ||||||||
Paid-in capital |
253,995 | 36,870 | 290,865 | |||||||||
Retained earnings |
325,681 | (30,149 | ) | 295,532 | ||||||||
Deferred compensation |
(9,648 | ) | 9,648 | | ||||||||
Treasury stock |
(211,466 | ) | (9,143 | ) | (220,609 | ) |
15
Note 13Employee Benefits
Net periodic benefit cost for the Companys retirement, supplemental retirement (SERP), and postretirement benefit plans includes the following components for the three months ended March 31, 2005 and 2004:
Retirement Plans |
Postretirement Benefit Plan |
|||||||||||||||
Three months ended March 31, |
||||||||||||||||
2005 |
2004 |
2005 |
2004 |
|||||||||||||
Service cost |
$ | 1,139 | $ | 903 | $ | 67 | $ | 60 | ||||||||
Interest cost |
926 | 790 | 39 | 32 | ||||||||||||
Expected return on plan assets |
(1,135 | ) | (1,108 | ) | | | ||||||||||
Recognized actuarial loss |
409 | 109 | | | ||||||||||||
Amortization of net (gain) or loss |
| | | (32 | ) | |||||||||||
Amortization of prior service cost (benefit) |
128 | 128 | (21 | ) | (17 | ) | ||||||||||
Net periodic benefit cost |
$ | 1,467 | $ | 822 | $ | 85 | $ | 43 | ||||||||
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) was enacted. The Act introduced both a Medicare prescription drug benefit and a federal subsidy to sponsors of retiree healthcare plans. In January 2004, the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. 106-1 (FSP 106-1), Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003. This statement permitted a sponsor of a postretirement benefit plan that provides a prescription drug benefit to make a one-time election to defer recognizing the effects of the Act until authoritative guidance on accounting for the federal subsidy was issued or until certain other events occurred.
In May 2004, the FASB issued FASB Staff Position No. 106-2 (FSP 106-2), Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003, which superseded FSP 106-1. FSP 106-2, which became effective in the third quarter of 2004, provides guidance on accounting for the effects of the Act and requires certain disclosures regarding the effect of the federal subsidy provided by the Act. To qualify for the subsidy, plan sponsors of Medicare-eligible retirees must provide prescription drug benefits which are at least as valuable as the benefits that those retirees would be entitled to under Medicare Part D. The Company maintains a postretirement benefit plan which provides a prescription drug benefit. At this time, the Company is unable to determine whether it is eligible to receive federal subsidies. Thus, the accumulated postretirement benefit obligation (APBO) and net periodic postretirement benefit cost amounts do not reflect any amount associated with the potential subsidy. The Company does not believe that the Act will have a material impact on the Companys consolidated financial statements.
Note 14Commitments and Contingencies
Synthetic Leases. The Company is the tenant of certain real property located in St. Petersburg, Florida. The aggregate value of the building and land at that site when the Company entered into this arrangement was $23.2 million. Subject to the satisfaction of certain conditions, the Company has the option to acquire this leased property at its original cost, or to direct the sale of this facility to a third party. The Company has provided a guarantee to the lessor that the proceeds from a sale of the facility to a third party will equal or exceed a certain percentage of the original fair market value of the leased property. The Companys maximum exposure under this guarantee is approximately $18.1 million.
Effective December 31, 2003, the Company began consolidating this lease arrangement into its consolidated financial statements in accordance with certain provisions of FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (FIN 46).
The Company is also a party to a synthetic lease arrangement with respect to its facilities in Madison, Wisconsin, which expires in 2009. The aggregate value of the building and land at that site when the Company entered into this arrangement was $10.1 million. Subject to the satisfaction of certain conditions, the Company has the option to acquire this leased property at its original cost, or to direct the sale of this facility to a third party. The Company has provided a guarantee to the lessor that the proceeds from a sale of the facility to a third party will equal or exceed a certain percentage of the original fair market value of the leased property. The Companys maximum exposure under this guarantee is approximately $8.1 million.
16
This lease arrangement does not qualify as a variable interest entity under the provisions of FIN 46; therefore, it is not included in the consolidated financial statements of the Company.
Based on current fair market values of the leased properties, the Company does not expect to be required to make payments under either of these residual value guarantees.
The Company has entered into an interest rate swap arrangement to fix the variable interest rate on the Madison, Wisconsin lease obligation.
Litigation. A number of lawsuits seeking damages are brought against the Company each year in the ordinary course of business. In the opinion of management, the ultimate resolution of these matters, individually or in the aggregate, will not have a materially adverse effect on the Companys financial position, liquidity, or results of operations.
On October 22, 2004, a complaint for patent infringement was filed in the matter of USA Payments, Inc. and Global Cash Access, Inc. v. U.S. Bancorp dba U.S. Bank, et al., Case No. CV-S-04-1470-JCM PAL, U.S. District Court, District of Nevada. The complaint named Certegy Inc. and three of its subsidiaries, Certegy Check Services, Inc., Game Financial Corporation, and GameCash, Inc. as defendants. The plaintiffs are seeking injunctive relief, an unspecified amount of damages (but no less than an unspecified reasonable royalty), a trebling of damages, together with pre-judgment interest, and attorneys fees. Discovery has recently commenced and no trial date has been set. Management believes it has meritorious defenses and is defending the matter vigorously.
Note 15Segment Information
Segment information for the three months ended March 31, 2005 and 2004 is as follows (intersegment sales and transfers, which are not material, have been eliminated):
Three months ended March 31, |
||||||||
2005 |
2004 |
|||||||
Revenues: |
||||||||
Card Services |
$ | 153,956 | $ | 138,654 | ||||
Check Services |
108,502 | 100,686 | ||||||
$ | 262,458 | $ | 239,340 | |||||
Operating income: |
||||||||
Card Services |
$ | 31,046 | $ | 29,013 | ||||
Check Services |
14,202 | 8,051 | ||||||
45,248 | 37,064 | |||||||
General corporate expense |
(8,196 | ) | (7,094 | ) | ||||
$ | 37,052 | $ | 29,970 | |||||
Total assets by segment at March 31, 2005 and December 31, 2004 are as follows (in thousands):
March 31, 2005 |
December 31, 2004 | |||||
Card Services |
$ | 534,836 | 533,304 | |||
Check Services |
268,828 | 292,936 | ||||
Corporate |
53,826 | 54,141 | ||||
Discontinued Operations (Note 4) |
39,869 | 41,828 | ||||
$ | 897,359 | $ | 922,209 | |||
17
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the consolidated financial statements for the three months ended March 31, 2005 and 2004, including the notes to those statements, included elsewhere in this report. We also recommend that this managements discussion and analysis be read in conjunction with the managements discussion and analysis and consolidated financial statements included in our annual report on Form 10-K for the year ended December 31, 2004.
Throughout this managements discussion and analysis, we refer to certain financial amounts both on a before- and after-tax basis. Management believes it is helpful to include the after-tax effect of certain financial charges to allow investors and management to evaluate their impact on net income and diluted earnings per share.
Overview
We provide credit card, debit card, and other transaction processing and check risk management services to financial institutions and merchants in the U.S. and internationally through two segments, Card Services and Check Services. Card Services provides card issuer services in the U.S., the U.K., Brazil, Chile, Australia, New Zealand, Ireland, Thailand, and the Caribbean. Additionally, Card Services provides merchant processing and e-banking services in the U.S. and card issuer software, support, and consulting services in numerous countries. Check Services provides check risk management services and related processing services in the U.S., the U.K., Canada, France, Ireland, Australia, and New Zealand.
Card Services. Card Services provides a full range of card issuer services that enable banks, credit unions, retailers, and others to issue VISA and MasterCard credit and debit cards, private label cards, and other electronic payment cards for use by both consumer and business accounts. Additionally, we process American Express cards in Australia, the Caribbean, and Brazil. Our debit card services support both off-line debit cards, which are processed similarly to credit cards, and on-line debit cards, through which cardholders obtain immediate access to funds in their bank accounts through ATMs or merchant point-of-sale terminals. In the U.S., our card processing business is concentrated in the independent community bank and credit union segments of the market, while internationally, we service both large and small financial institutions. We provide our card issuer services internationally through our operations in the U.S., Brazil, Chile, the U.K., Australia, and the Caribbean. Our merchant processing services enable retailers and other businesses to accept credit, debit, and other electronic payment cards from purchasers of their goods and services, while our e-banking services enable financial institutions to offer Internet banking and related products to consumers and businesses. Card issuing software, support, and consulting services allow customers to manage their credit card programs.
Card transactions continue to increase as a percentage of total point-of-sale payments, which fuels continuing demand for card-related products. We continue to launch new products aimed at serving this demand. In recent years, we have introduced a variety of stored-value card types, Internet banking, and electronic bill presentment/payment products, as well as a number of card enhancement and loyalty/reward programs. The common theme among these offerings continues to be convenience and security for the consumer coupled with value to the financial institution.
Over the past seven years, we pursued growth in international markets through acquisitions in Brazil, Chile, and the Caribbean, and the start-up of our card processing operations in the U.K. and Australia. In 2000, we entered into a five-year agreement with a multi-national Australian-based financial institution to process cards issued in Australia, New Zealand, the U.K., and Ireland, with operations commencing in the second quarter of 2001. This financial institution is serviced from our card processing operation in Australia, as well as from our card processing operation in the U.K. In 2003, we entered into an eight-year agreement with a Thailand financial institution to process its VISA and MasterCard credit cards and unsecured personal loans. This financial institution is also serviced from our card processing operation in Australia. Card Services plans to pursue further card processing opportunities in the Asia Pacific Region, utilizing our Australian operation as the processing center.
We believe that the increased use of credit, debit, and other electronic payment cards around the globe will continue to present the card processing industry with significant growth opportunities. We intend to continue to expand our card processing business in the independent community bank and credit union segments of the market. Moreover, our future growth and profitability will significantly depend upon our ability to penetrate additional international markets, including emerging markets for electronic transaction processing. Our certification as an American Express processor also provides further growth opportunities for us in the global card market.
Check Services. Check Services provides check risk management and related processing products and services to businesses accepting or cashing checks at the point-of-sale. These services utilize our proprietary check authorization systems and risk assessment decision platforms. A significant portion of our revenues from check risk management services is generated from several large national and regional merchants, including national retail chains. Other customers of our Check Services segment include
18
hotels, automotive dealers, telecommunications companies, supermarkets, casinos, mail order houses, and other businesses. Our services allow our clients to run their customers personal and business checks through an automated decision-making process that assesses the likelihood that a check will clear. We provide our check risk management products and services internationally in Canada, the U.K., Ireland, France, Australia, and New Zealand. Our principal product in all those countries is check guarantee services, although mass retailers are beginning to utilize our check verification, collection services, and deferred debit processing services.
In recent years, we have introduced several new products for existing and new markets, such as third-party check collections; electronic check risk management solutions for point-of-sale, call center, and electronic commerce applications; and PayCheck Accept, which enables supermarkets and gaming establishments to reduce the risk of check losses and fraud in connection with their payroll check cashing services. Additionally, the acquisition of Game Financial Corporation (Game Financial) on March 1, 2004, helps position us as a leading provider of comprehensive cash access services in the gaming industry and broadens our check risk management product line and customer base.
We believe check writing has begun to decline as a total percentage of point-of-sale payments due, in part, to the growing use of debit and credit cards. At the same time, however, demand for our services is strong due to factors that include increasing sophistication of check fraud and higher concentration of bad checks written at the point-of-sale due to a trend of higher credit quality consumers paying more with credit and debit cards and writing fewer checks. These factors are contributing to a growing reliance of retailers and other businesses on outside vendors, such as us, to provide check risk management services.
Key Performance Indicators. Management uses various key indicators to manage its business, including revenue and operating income growth, operating margin, earnings per share growth, number of cards and accounts on file, and volumes processed.
Comparability of Financial Results. Certain of the recent developments described in the next section affected the comparability of our financial results for the three months ended March 31, 2005 and 2004.
Recent Developments
Adoption of SFAS No. 123 (revised). Prior to January 1, 2005, we accounted for our employee stock option plan under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. No stock-based employee compensation cost was recognized in the statement of income for periods prior to January 1, 2005, as all stock options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2005, we adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), Share-Based Payment, using the modified retrospective transition method. Under that transition method, compensation cost recognized includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). Results for all prior periods presented have been restated based on the amounts previously recognized under SFAS No. 123 for purposes of pro forma disclosures.
19
Additionally, prior to January 1, 2005, we presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows. SFAS No. 123(R) requires that such tax benefits be classified as financing cash flows. The effect of the adoption of SFAS 123(R) on the consolidated statements of income and cash flows is detailed below (in thousands, except per share data):
Three months ended March 31, |
||||||||||||||||||||||||
2005 |
2004 |
|||||||||||||||||||||||
Without SFAS 123(R) |
SFAS 123(R) impact |
With SFAS 123(R) |
Without SFAS 123(R) |
SFAS 123(R) impact |
With SFAS 123(R) |
|||||||||||||||||||
Income from continuing operations before income taxes |
$ | 35,432 | $ | (1,520 | ) | $ | 33,912 | $ | 30,771 | $ | (3,557 | ) | $ | 27,214 | ||||||||||
Provision for income taxes |
(13,172 | ) | 415 | (12,757 | ) | (11,385 | ) | 1,022 | (10,363 | ) | ||||||||||||||
Income from continuing operations |
22,260 | (1,105 | ) | 21,155 | 19,386 | (2,535 | ) | 16,851 | ||||||||||||||||
Net income |
24,301 | (1,105 | ) | 23,196 | 20,658 | (2,535 | ) | 18,123 | ||||||||||||||||
Net cash provided by operating activities |
46,411 | (13 | ) | 46,398 | 36,893 | (9 | ) | 36,884 | ||||||||||||||||
Net cash (used in) provided by financing activities |
(27,020 | ) | 13 | (27,007 | ) | 27,561 | 9 | 27,570 | ||||||||||||||||
Basic earnings per share |
$ | 0.39 | $ | (0.01 | ) | $ | 0.38 | $ | 0.32 | $ | (0.04 | ) | $ | 0.28 | ||||||||||
Diluted earnings per share |
$ | 0.39 | $ | (0.02 | ) | $ | 0.37 | $ | 0.32 | $ | (0.04 | ) | $ | 0.28 |
The fair value of options granted is estimated on the date of grant using the Black-Scholes-Merton option pricing model based on certain assumptions, including the expected term of the option, the expected volatility of the price of the underlying share for the expected term of the option, the expected dividends on the underlying share for the expected term, and the risk-free interest rate for the expected term of the option. Expected volatility and expected term are derived primarily based on our historical data. In computing historical volatility, we disregard any identifiable period of time in which our share price is extraordinarily volatile because of events that are not expected to recur during the expected term. In 2005, we began evaluating expected term based on separate employee groups with similar historical exercise behavior. The risk-free interest rate is based on the U.S. Treasury zero-coupon issues with a remaining term approximating the expected term. The dividend yield is calculated based on the anticipated dividends over the expected term.
Three months ended March 31, |
||||||
2005 |
2004 |
|||||
Expected volatility |
25 | % | 40 | % | ||
Expected term (in years) |
4.96 6.97 | 4.86 | ||||
Risk-free interest rate |
4.21 4.37 | % | 3.52 | % | ||
Dividend yield |
0.50 | % | 0.60 | % |
The weighted-average grant-date fair value of options granted during the three months ended March 31, 2005 and 2004 was $12.16 and $12.85, respectively. We recognize compensation cost for awards with graded vesting using the straight-line attribution method, with the amount of compensation cost recognized at any date at least equal to the portion of the grant-date value of the award that is vested at that date.
The adoption of SFAS No. 123(R) reduced first quarter 2005 and 2004 diluted earnings per share by $0.02 and $0.04, respectively. We expect the full year 2005 impact to diluted earnings per share to be $0.08 compared to $0.13 per share in 2004. Compensation cost recognized in any period is impacted by the number of stock options granted and the vesting period (which generally varies between three and four years), as well as the underlying assumptions used in estimating the fair value on the date of grant.
We also issue restricted stock awards to employees and restricted stock units to non-employee directors under certain of our compensation plans. The adoption of SFAS 123(R) did not have a material effect on our accounting treatment of restricted stock awards and restricted stock units. Refer to Note 12 in the consolidated financial statements for further information. The unamortized compensation cost related to our issued stock options, restricted stock, and restricted stock unit awards at March 31, 2005 is $16.3 million, $13.1 million, and $0.1 million, respectively.
Discontinued Operations. Our merchant processing operations consist of two businesses: (1) merchant acquiring, where we are a direct party to contracts with merchants regarding our provision of card processing services for the merchant, and we are subject to the associated risk that a cardholder billing dispute will be resolved in favor of the cardholder (referred to as a cardholder chargeback), and (2) institution processing, where we provide authorization, settlement, and customer service to community banks and others that contract directly with merchant customers. We view merchant acquiring as a non-strategic business and over the past few years, have operated this business conservatively to reduce exposure to merchant risk, which in the short-term improved overall profitability but limited growth. In September 2004, the Board of Directors of Certegy approved a plan to sell our merchant acquiring business, at which time, the held for sale criteria in SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), were met. We plan to continue to operate the institution processing business, which we believe is complementary to our card issuing business.
20
We expect to reach a definitive agreement regarding the disposition of this business during the second quarter of 2005. We currently anticipate that the proceeds from the sale of this business will be used to pay down our revolving credit facility borrowings. We could change the use of this cash for strategic acquisitions if deemed appropriate.
Our financial statements reflect the merchant acquiring business as a discontinued operation with the related assets and liabilities classified under the captions Assets held for sale and Liabilities related to assets held for sale in the consolidated balance sheets. The results of operations are treated as income from discontinued operations, net of tax, and separately stated in the consolidated statements of income, below income from continuing operations. The merchant acquiring operations were historically included in the Card Services segment. Refer to Note 4 in the consolidated financial statements for further information.
Acquisitions. On March 1, 2004, we completed the purchases of Game Financial, a provider of debit and credit card cash advances, ATM access, and check cashing services in gaming institutions, and Crittson Financial Services LLC (Crittson), a full service provider of card and merchant processing services. The acquisition of Game Financial helps position us as a leading provider of comprehensive cash access services in the gaming industry and broadens our check risk management product line and customer base, while the acquisition of Crittson further strengthens our U.S. market share as the leading third party credit card processor for community banks and credit unions. On August 6, 2004, we completed the acquisition of Caribbean CariCard Services, Inc. (CariCard), a third party transaction processor in the Caribbean. CariCard provides a wide range of products and services to financial institutions, retailers, and the petroleum industry that service markets in 16 countries throughout the Caribbean.
The above acquisitions were accounted for as purchases and their results of operations have been included in the consolidated statements of income from the dates of acquisition. The pro forma effects of these acquisitions on our consolidated financial statements were not material.
Share Repurchase Authority. In May 2004, the Board of Directors approved a $100 million share repurchase program, which replaced the prior authority. As of March 31, 2005, we had approximately $43.3 million remaining authority for share repurchases.
Components of Income Statement
Card Services generates revenues from charges based on transaction volumes, accounts or cards processed, and fees for various services and products, while Check Services generates revenues from charges based on transaction volumes, face value of checks guaranteed, and fees for various check services and products. Revenues depend upon a number of factors, such as demand for and price of our services, the technological competitiveness of our product line, our reputation for providing timely and reliable service, competition within our industry, and general economic conditions. Costs of services consist primarily of the costs of transaction processing systems; personnel costs to develop and maintain applications, operate computer networks, and provide customer support; losses from check guarantee services; interchange (processing fees paid to credit card associations) and other fees related to merchant processing; depreciation and occupancy costs associated with the facilities where these functions are performed; and reimbursed out-of-pocket expenses. Selling, general, and administrative expenses consist primarily of salaries, wages, and related expenses paid to sales, non-revenue customer support functions, and administrative employees and management.
As mentioned previously, our merchant processing operations consist of two businesses, merchant acquiring and institution processing. In our merchant acquiring business, where we are a direct party to contracts with merchants, revenues collected for services are based primarily on a discount rate, which considers the cost of interchange fees. In our institution processing business, where our relationship is with the financial institution that contracts directly with the merchant, we collect the interchange fees in addition to transaction fees. In both instances, we are responsible for collecting the interchange fees after settling with the credit card associations and thus, interchange fees are recorded as a component of revenues and costs of services in the consolidated statements of income. Interchange fees reflected in the consolidated statements of income for the three months ended March 31, 2005 and 2004 from continuing operations (institution processing) were $19.7 million and $16.1 million, respectively.
Highlights of the First Quarter 2005 Consolidated Financial Results
Highlights of the 2005 first quarter consolidated financial results, as compared to the 2004 first quarter (restated for the adoption of SFAS No. 123(R) and discontinued operations), are as follows:
| Revenues grew 9.7 percent to $262.5 million. |
| Operating income increased 23.6 percent to $37.1 million. |
| Interest expense of $3.3 million increased by $0.3 million. |
| Net income increased 28.0 percent to $23.2 million, comprised of $21.2 million from continuing operations and $2.0 million from discontinued operations. |
21
| Diluted earnings per share increased 32.1 percent to $0.37 per share, comprised of $0.34 from continuing operations and $0.03 from discontinued operations. |
In the first quarter of 2005, capital expenditures totaled $12.0 million.
Consolidated Results of Operations
The following table summarizes our consolidated results for the three months ended March 31, 2005 and 2004, restated for the adoption of SFAS No. 123(R) and discontinued operations (in millions, except per share amounts):
Three Months Ended March 31, |
||||||||
2005 |
2004 |
|||||||
Revenues |
$ | 262.5 | $ | 239.3 | ||||
Operating expenses |
$ | 225.4 | $ | 209.4 | ||||
Operating income |
$ | 37.1 | $ | 30.0 | ||||
Other income, net |
$ | 0.2 | $ | 0.2 | ||||
Interest expense |
$ | (3.3 | ) | $ | (3.0 | ) | ||
Income from continuing operations, net of tax |
$ | 21.2 | $ | 16.9 | ||||
Income from discontinued operations, net of tax |
$ | 2.0 | $ | 1.3 | ||||
Net income |
$ | 23.2 | $ | 18.1 | ||||
Diluted earnings per share: |
||||||||
Income from continuing operations |
$ | 0.34 | $ | 0.26 | ||||
Income from discontinued operations |
$ | 0.03 | $ | 0.02 | ||||
Net income |
$ | 0.37 | $ | 0.28 |
Consolidated Revenues
First Quarter 2005 compared with First Quarter 2004
Consolidated revenues in the first quarter of 2005 of $262.5 million increased $23.1 million, or 9.7 percent, over the first quarter of 2004. Card Services revenues grew $15.3 million, or 11.0 percent, while Check Services experienced revenue growth of $7.8 million, or 7.8 percent.
Overall, our revenue growth was driven by growth in our North American and international card issuing operations, prior year acquisitions, and favorable currency rates. The strengthening of certain foreign currencies against the U.S. dollar increased total U.S. dollar revenues by $1.5 million in the first quarter of 2005.
Consolidated Operating Expenses
First Quarter 2005 compared with First Quarter 2004
Consolidated operating expenses in the first quarter of 2005 of $225.4 million increased $16.0 million, or 7.7 percent, over the first quarter of 2004. Operating expenses for Card Services increased $13.3 million, or 12.1 percent, while Check Services increased $1.7 million, or 1.8 percent. Corporate expenses of $8.2 million increased $1.1 million above the first quarter of 2004. The strengthening of certain foreign currencies against the U.S. dollar increased total U.S. dollar operating expenses by $1.6 million in the first quarter of 2005.
Costs of services in the first quarter of 2005 of $190.3 million increased $13.1 million, or 7.4 percent, over the first quarter of 2004. Card Services experienced a $12.5 million, or 12.8 percent, increase in costs of services primarily driven by a $3.6 million increase in card merchant processing interchange fees (costs of services included $19.7 million and $16.1 million of interchange fees in 2005 and 2004, respectively), a $2.7 million increase in reimbursable expenses, the Crittson and CariCard acquisitions in March 2004 and August 2004, respectively, and volume growth in our domestic and international operations. Costs of services in Check Services increased $0.6 million, or 0.7 percent, driven by the acquisition of Game Financial in March 2004, which was partially offset by a reduction in check guarantee net losses attributable to enhanced fraud modeling and increased collection rates.
Selling, general, and administrative (SG&A) expenses in the first quarter of 2005 of $35.1 million increased $3.0 million, or 9.3 percent, over the first quarter of 2004. Card Services experienced a $0.8 million, or 6.7 percent, increase in SG&A costs due to higher costs in our global issuing operations resulting from core revenue growth and the Crittson and CariCard acquisitions, as well as
22
higher international business development costs. SG&A costs in Check Services increased $1.1 million, or 8.3 percent, primarily driven by the Game Financial acquisition and increased selling costs. Corporate SG&A expense increased $1.1 million, primarily resulting from higher audit and employee-related costs.
Consolidated Operating Income
First Quarter 2005 compared with First Quarter 2004
Consolidated operating income in the first quarter of 2005 of $37.1 million increased $7.1 million, or 23.6 percent, over the first quarter of 2004. Card Services operating income increased $2.0 million, or 7.0 percent, while Check Services operating income increased $6.2 million, or 76.4 percent. General corporate expense increased $1.1 million, or 15.5 percent, over the first quarter of 2004. Our consolidated operating margin grew from 12.5 percent in the first quarter of 2004 to 14.1 percent in the first quarter of 2005.
The operating income growth experienced in the first quarter of 2005 was primarily driven by improved profitability in our Check Services segment, attributable to reduced check guarantee net losses and increased margins in our cash access business, as well as prior year acquisitions and growth in our global card issuing operations.
Consolidated Other Income, Net
First Quarter 2005 compared with First Quarter 2004
Consolidated other income, net, which principally consists of interest income and net foreign currency exchange gains of $165 thousand in the first quarter of 2005 was comparable to the prior year quarter other income, net of $220 thousand.
Consolidated Interest Expense
First Quarter 2005 compared with First Quarter 2004
Interest expense during the first quarter of 2005 of $3.3 million increased by $0.3 million compared to the first quarter of 2004, due to higher average interest rates on revolving credit borrowings.
Effective Tax Rate
First Quarter 2005 compared with First Quarter 2004
Our effective tax rates for continuing operations of 37.6 percent and 38.1 percent in the first quarters of 2005 and 2004, respectively, include the impact of expensing stock options in accordance with our adoption of SFAS No. 123(R). The overall rate decrease is primarily due to lower non-deductible stock compensation expense in conjunction with higher operating income in the first quarter of 2005 as compared to the first quarter of 2004.
Consolidated Net Income and Earnings per Share
First Quarter 2005 compared with First Quarter 2004
Consolidated net income in the first quarter of 2005 of $23.2 million increased $5.1 million, or 28.0 percent, compared to the first quarter of 2004. Diluted earnings per share of $0.37 in the first quarter of 2005 increased $0.09, or 32.1 percent, compared to the prior year quarter. Income from continuing operations of $21.2 million in the first quarter of 2005 increased $4.3 million, or 25.5 percent, while income from discontinued operations of $2.0 million increased $0.8 million, or 60.5 percent. The discontinued operating results in the first quarter of 2005 benefited from $0.5 million of reduced after-tax amortization expense, in accordance with the requirements of SFAS 144, which requires amortization of long-lived assets to cease upon classification as held for sale.
The repurchase of 2.0 million shares of common stock subsequent to the first quarter of 2004 had a favorable impact on earnings per share compared to the prior year by reducing our weighted average shares outstanding in the first quarter of 2005 by approximately 1.3 million shares.
23
Segment Results
The following table summarizes our segment results for the three months ended March 31, 2005 and 2004 (restated for the adoption of SFAS No. 123(R) and discontinued operations) (in millions):
Three months ended March 31, |
||||||||
2005 |
2004 |
|||||||
Revenues: |
||||||||
Card Services |
$ | 154.0 | $ | 138.6 | ||||
Check Services |
108.5 | 100.7 | ||||||
$ | 262.5 | $ | 239.3 | |||||
Operating income: |
||||||||
Card Services |
$ | 31.1 | $ | 29.0 | ||||
Check Services |
14.2 | 8.1 | ||||||
45.3 | 37.1 | |||||||
General corporate expense |
(8.2 | ) | (7.1 | ) | ||||
$ | 37.1 | $ | 30.0 | |||||
Card Services
First Quarter 2005 compared with First Quarter 2004
Card Services revenues of $154.0 million in the first quarter of 2005 increased $15.3 million, or 11.0 percent, above the first quarter of 2004, attributable to growth in both our North American and international businesses, incremental revenue from our prior year acquisitions of Crittson and CariCard, and favorable currency trends. The strengthening of certain foreign currencies against the U.S. dollar increased our U.S. dollar revenues by approximately $0.9 million in the first quarter of 2005. At March 31, 2005, we were processing 50.3 million cards compared to 46.8 million at March 31, 2004.
Our North American card business, which now includes our continuing merchant processing product, generated revenues of $125.1 million, a $10.6 million, or 9.2 percent, increase over the prior year quarter. This growth was fueled by new customer signings, and growth in e-banking, card loyalty programs, and institution merchant processing.
Our international card business, which includes our software maintenance and support services, generated revenues of $28.9 million, a $4.7 million, or 19.7 percent, increase over the prior year quarter. This growth was driven by new customers, expanding card programs of existing customers, particularly in Brazil, higher software maintenance and support, and favorable currency trends. The strengthening of certain foreign currencies against the U.S. dollar increased our U.S. dollar revenues by approximately $0.9 million in the first quarter of 2005.
Card Services operating income of $31.1 million in the first quarter of 2005 increased $2.0 million, or 7.0 percent, above the first quarter of 2004. Card Services operating margin of 20.2 percent in the first quarter of 2005 decreased by 70 basis points compared to an operating margin of 20.9 percent in the prior year quarter, primarily driven by higher revenue growth in our lower-margin products, for example institution merchant processing.
Check Services
First Quarter 2005 compared with First Quarter 2004
Check Services revenues of $108.5 million in the first quarter of 2005 increased $7.8 million, or 7.8 percent, over the first quarter of 2004, driven by growth in our cash access operations primarily attributable to the prior year acquisition of Game Financial, and favorable currency trends. The strengthening of certain foreign currencies against the U.S. dollar increased our U.S. dollar revenues by approximately $0.6 million in the first quarter of 2005. The face amount of checks we authorized totaled $10.9 billion in the first quarter of 2005 as compared to $9.1 billion in the prior year quarter.
North American check revenues of $90.4 million increased $7.2 million, or 8.6 percent, over the first quarter of 2004, driven by new customer signings, growth in third-party collections, and cash access services attributable primarily to the acquisition of Game Financial. The first quarter North American growth rate was impacted by the strong volumes in the first quarter of 2004, and the prior year termination of unprofitable contracts, including our contract with 7-Elevens kiosk-based payroll check cashing service (Vcom), which generated revenue in the first half of 2004. The face amount of checks we authorized in the U.S. totaled $10.1 billion in the first quarter of 2005 as compared to $8.2 billion in the prior year quarter.
24
International check revenues of $18.1 million increased $0.6 million, or 3.6 percent, compared to the first quarter of 2004. The first quarter international growth rate was impacted by soft retail sales in France and the strong volumes in the first quarter of 2004 in both France and the U.K. The face amount of checks we authorized remained at approximately $0.9 billion consistent with the first quarter of 2004. The strengthening of foreign currencies against the U.S. dollar increased our U.S. dollar revenues by approximately $0.6 million in the first quarter of 2005.
Check Services operating income of $14.2 million in the first quarter of 2005 increased $6.2 million, or 76.4 percent, compared to the first quarter of 2004. Check Services operating margin of 13.1 percent in the first quarter of 2005 increased by 510 basis points compared to an operating margin of 8.0 percent in the prior year quarter. Our proprietary risk modeling technology, improved collections, and increased margins in cash access services drove the significantly improved profitability in the check segment. We will anniversary the prior year start-up losses in our check-cashing business in the second quarter of 2005, and we expect operating income growth to moderate, but remain strong throughout the remainder of the year.
General Corporate Expense
First Quarter 2005 compared with First Quarter 2004
General corporate expense of $8.2 million in the first quarter of 2005 increased $1.1 million over the first quarter of 2004. The increase in general corporate expense is primarily attributable to higher audit-related and employee costs.
Liquidity and Capital Resources
We have historically generated and continue to generate strong cash flows from our operating activities that we use to further invest in our business through expenditures for capital and strategic acquisitions. Additionally, since our spin-off from Equifax in 2001, we have engaged in periodic repurchases of our common shares, when it has been deemed appropriate, and began to pay cash dividends to our shareholders in 2003. Proceeds from stock option exercises have varied each year, primarily driven by changes in our stock price.
In conjunction with the spin-off from Equifax, we made a cash payment to Equifax in the amount of $275 million in July 2001 to reflect Certegys share of Equifaxs pre-distribution debt used to establish our initial capitalization. This payment was funded through $400 million of unsecured revolving credit facilities we obtained. Since that time, we have used available cash flow to reduce our outstanding balance on these facilities and on September 10, 2003, we used the proceeds from our offering of 4.75 percent fixed rate five-year notes with a face value of $200 million to pay down the remaining revolver balance.
On March 1, 2004, we completed the purchases of Game Financial and Crittson and on August 6, 2004, we completed the purchase of CariCard. These acquisitions had a combined cash purchase price of $45.5 million, net of $24.6 million of cash acquired and additional consideration adjustments settled during 2004. Approximately $5.8 million of the Crittson purchase price, which represents the merchant acquiring operations, was reclassified to discontinued operations (see Note 4 to the consolidated financial statements for further information). We funded these acquisitions through borrowings on our revolving credit facility and as of March 31, 2005, had $24.3 million outstanding on this facility. A majority of the cash acquired with these acquisitions relates to Game Financial, which provides check cashing and cash advance services for the gaming industry. In certain casino locations, Game Financial maintains cash access booths, where consumers can cash personal checks, and various point-of-sale devices, where cash advance services are facilitated. These point-of-sale devices include PCs, kiosks, and ATMs. In other casino locations, these transactions are conducted in the casinos own cage operation by casino employees using Game Financials system.
We regularly evaluate cash requirements for current operations, development activities, and acquisitions. We may elect to raise additional funds for these purposes, either through further bank financing or the public capital markets, as appropriate. Based on our recent financial results and current financial position, we believe that additional funding will be available if required to meet our capital requirements.
Operating Activities. Operating cash flows totaled $46.4 million in the first quarter of 2005, which represents an increase of $9.5 million compared to the first quarter of 2004. The first quarter of 2005 cash flow generated from net income was $23.2 million, adjusted for income from discontinued operations of $2.0 million, depreciation and amortization of $12.5 million, deferred taxes of $2.7 million, and other amortization and non-cash items of $4.6 million. Cash inflows from changes in assets and liabilities were $10.8 million as compared to $2.2 million in the prior year, an increase of $8.6 million which is primarily driven by the timing of payment of payables and required funding of employee life insurance premiums and deferred compensation plans in the first quarter of 2004.
25
We used our cash flow from operating activities in the first quarter of 2005 primarily to reinvest in our existing businesses through expenditures for equipment and systems development, make dividend payments, and make repayments of revolving credit borrowings.
Investing Activities. Capital expenditures in the first quarter of 2005 totaled $12.0 million, which represents an increase of $5.0 million compared to the prior year quarter. Capital expenditures in the first quarter of 2005 were primarily for processing equipment and software in our global card issuing operations and systems development for new products and services. The acquisitions of Game Financial, Crittson, and CariCard in the prior year quarter totaled $33.4 million, which is net of cash acquired.
Financing Activities. Net repayments of borrowings on our revolving credit facility in the first quarter of 2005 totaled $24.3 million, compared to net additions to borrowings of $50.0 million in the prior year quarter, which were primarily related to the acquisitions and share repurchases. Dividend payments to shareholders totaled $3.1 million and $3.2 million in the first quarters of 2005 and 2004, respectively. Proceeds from the exercise of stock options totaled $0.7 million in the first quarter of 2005 compared to $1.6 million in the prior year. Cash expended for share repurchases totaled $20.8 million in the first quarter of 2004.
Discontinued Operations. Cash provided by discontinued operations was $2.1 million in the first quarter of 2005 compared to $0.1 million in the first quarter of 2004, consisting of operating cash flows of $2.1 million in the first quarter of 2005 compared to $5.9 million in the prior year quarter. The decrease in operating cash flows is primarily driven by deferred income taxes on acquired merchant portfolios. Investing cash outflows in the first quarter of 2004 consist of $0.1 million of capital expenditures and $5.8 million for the acquisition of the merchant acquiring portfolio of Crittson. There were no investing cash flows in the first quarter of 2005.
Seasonality, Inflation, and Economic Downturns
We are subject to certain seasonal fluctuations, such as peak activity during the holiday buying season. We do not believe that inflation has had a material effect on our operating results; however, inflation could adversely affect our financial results were it to result in a substantial weakening in economic conditions that adversely affects the level of consumer spending.
The Brazilian market is characterized by economic uncertainty that causes volatility in currency values, and historically has resulted in severe inflationary pressures. Notwithstanding this uncertainty, we believe that the long-term prospects offered by the Brazilian market are attractive and our continued focus on growing our Brazilian business and attaining cost efficiencies should provide us with a cost structure that can withstand short-term declines in business driven by the uncertain market and the loss of a large customer in March 2003.
Our Brazilian operations had net assets of approximately $109.1 million at March 31, 2005, which includes a net equity reduction of $87.8 million as a result of cumulative foreign currency translation. Pursuant to SFAS 142 and SFAS 144, these assets are subject to regular evaluations to assess their recoverability. In the opinion of management, these assets are appropriately valued at March 31, 2005 and December 31, 2004; however, if we are unable to achieve our business plans and improve profitability in our Brazilian operations by growing revenue or achieving the necessary cost efficient structure in the future, this could have an impact on our opinion regarding the valuation of these assets, which could lead to an impairment charge against net income.
Forward-Looking Statements
This quarterly report on Form 10-Q contains forward-looking statements that are based on current expectations, assumptions, estimates, and projections about our business and our industry. They are not guarantees of future performance and are subject to risks and uncertainties, many of which are outside of our control, that may cause actual results to differ significantly from what is expressed in those statements. Without limitation, statements in this Form 10-Q regarding the anticipated future benefits of our acquisitions, growth opportunities in the payment risk management and card processing industries, and our strategy for penetrating additional international markets are forward-looking statements. The factors that could, either individually or in the aggregate, affect our performance include the following, some of which are described in greater detail in the section entitled Certain Factors Affecting Forward-Looking Statements in our 2004 Annual Report on Form 10-K: our reliance on a small number of financial industries for the majority of our revenues; our reliance on key strategic relationships; the necessity to maintain qualifications set by bank card associations in order to continue to provide transaction processing services; potential liability when merchant customers cannot or do not reimburse us for charge-backs resolved in favor of cardholders, or when checks we guarantee are dishonored by the check writers bank; potential loss of customers from continued consolidation in the financial services and in retail industries; declines in check writing; changes in regulation or industry standards applicable to our businesses or those of our customers; the level of economic
26
growth or other factors affecting demand for our products and services; ability to maintain or improve our competitive positions against current and potential competitors; database security and reliability of our information technology systems; risks associated with investments and operations in foreign countries, including exchange rate fluctuations and local political, social, and economic factors; the need to integrate acquired businesses; and those other risks listed in the above-referenced section of our Form 10-K.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
We have no material changes to the disclosure on this matter made in our Annual Report on Form 10-K for the year ended December 31, 2004.
Item 4. Controls and Procedures
An evaluation of the Companys disclosure controls and procedures, as defined in Exchange Act Rules 13a-15(e) and 15d-15(e), was carried out by the Companys management, with the participation of the chief executive and chief financial officers, as of the end of the period covered by this Quarterly Report on Form 10-Q. No system of controls, no matter how well designed and operated, can provide absolute assurance that the objectives of the system of controls are met, and no evaluation of controls can provide absolute assurance that the system of controls has operated effectively in all cases. Our disclosure controls and procedures however are designed to provide reasonable assurance that the objectives of disclosure controls and procedures are met.
Based on the evaluation discussed above, our Chief Executive and Chief Financial Officers have concluded that our disclosure controls and procedures were effective as of the date of that evaluation to provide reasonable assurance that the objectives of disclosure controls and procedures are met.
There were no changes in the Companys internal control over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.
27
Exhibits:
The following is a list of Exhibits included as part of this report, including those incorporated by reference. A list of those documents filed with this report is set forth on the Exhibit Index appearing elsewhere in this report and is incorporated by reference.
Exhibit No |
Description | |
12.1 | Statements re Computation of Ratios. | |
31.1 | Certification of Lee A. Kennedy, Chief Executive Officer of Certegy Inc., pursuant to Rule 13a-14(a) or 15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
31.2 | Certification of Michael T. Vollkommer, Chief Financial Officer of Certegy Inc., pursuant to Rule 13a-14(a) or 15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
32.1 | Certification of Lee A. Kennedy, Chief Executive Officer of Certegy Inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
32.2 | Certification of Michael T. Vollkommer, Chief Financial Officer of Certegy Inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
28
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 duly authorized officers.
Date: May 10, 2005 | CERTEGY INC. | |||
By: | /S/ LEE A. KENNEDY | |||
Lee A. Kennedy | ||||
Chairman and Chief Executive Officer | ||||
(Principal Executive Officer) | ||||
/S/ MICHAEL T. VOLLKOMMER | ||||
Michael T. Vollkommer | ||||
Executive Vice President and Chief Financial Officer | ||||
(Principal Financial Officer) | ||||
/S/ PAMELA A. TEFFT | ||||
Pamela A. Tefft | ||||
Senior Vice President and Controller | ||||
(Principal Accounting Officer) |
29
INDEX TO EXHIBITS
The following documents are being filed with this report:
Exhibit No |
Description | |
12.1 | Statements re Computation of Ratios. | |
31.1 | Certification of Lee A. Kennedy, Chief Executive Officer of Certegy Inc., pursuant to Rule 13a-14(a) or 15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
31.2 | Certification of Michael T. Vollkommer, Chief Financial Officer of Certegy Inc., pursuant to Rule 13a-14(a) or 15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
32.1 | Certification of Lee A. Kennedy, Chief Executive Officer of Certegy Inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
32.2 | Certification of Michael T. Vollkommer, Chief Financial Officer of Certegy Inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
30
Exhibit 12.1
CERTEGY INC.
RATIO OF EARNINGS TO FIXED CHARGES
($ in thousands, except ratio data)
For the year ended December 31, |
Three months ended 2005 | |||||||||||||||||
2000 |
2001 (2) |
2002 (2) |
2003 (2) |
2004 (2) |
||||||||||||||
Earnings: |
||||||||||||||||||
Income before income taxes (1) |
$ | 144,536 | $ | 132,077 | $ | 126,945 | $ | 132,573 | $ | 156,789 | $ | 33,912 | ||||||
Add: |
||||||||||||||||||
Interest expense |
1,301 | 7,200 | 7,120 | 7,950 | 12,914 | 3,305 | ||||||||||||
Other adjustments |
5,594 | 5,069 | 4,549 | 4,653 | 4,632 | 1,361 | ||||||||||||
Total earnings |
$ | 151,431 | $ | 144,346 | $ | 138,614 | $ | 145,176 | $ | 174,335 | $ | 38,578 | ||||||
Fixed charges: |
||||||||||||||||||
Interest expense |
$ | 1,301 | $ | 7,200 | $ | 7,120 | $ | 7,950 | $ | 12,914 | $ | 3,305 | ||||||
Other adjustments |
5,594 | 5,069 | 4,549 | 4,653 | 4,632 | 1,361 | ||||||||||||
Total fixed charges |
$ | 6,895 | $ | 12,269 | $ | 11,669 | $ | 12,603 | $ | 17,546 | $ | 4,666 | ||||||
Ratio of earnings to fixed charges |
21.96x | 11.77x | 11.88x | 11.52x | 9.94x | 8.27x |
(1) | Income from continuing operations before income taxes and cumulative effect of a change in accounting principle, but including minority interests. |
(2) | On January 1, 2005, the Company adopted SFAS 123(R), as further described in Notes 2 and 12 to the consolidated financial statements, which requires all share-based payments to employees to be recognized in the income statement based on their fair values. Periods from the Company's spin-off from Equifax Inc. on July 7, 2001 to December 31, 2004 were restated to conform to this presentation. |
For the purposes of calculating the ratio of earnings to fixed charges, fixed charges consist of interest on indebtedness, amortization of deferred financing costs, and an estimated amount of rental expense that is deemed to be representative of the interest factor.
Exhibit 31.1
CERTIFICATION PURSUANT TO RULE 13A-14(A) OR 15D-14(A) OF THE EXCHANGE ACT
I, Lee A. Kennedy, certify that:
1. | I have reviewed this quarterly report on Form 10-Q of Certegy Inc.; |
2. | Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; |
3. | Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; |
4. | The registrants other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: |
(a) | Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; |
(b) | Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; |
(c) | Evaluated the effectiveness of the registrants disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and |
(d) | Disclosed in this report any change in the registrants internal control over financial reporting that occurred during the registrants first fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrants internal control over financial reporting; and |
5. | The registrants other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrants auditors and the audit committee of the registrants board of directors (or persons performing the equivalent functions): |
(a) | All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrants ability to record, process, summarize and report financial information; and |
(b) | Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal control over financial reporting. |
Date: May 10, 2005
/S/ LEE A. KENNEDY |
Lee A. Kennedy Chairman and Chief Executive Officer |
Exhibit 31.2
CERTIFICATION PURSUANT TO RULE 13A-14(A) OR 15D-14(A) OF THE EXCHANGE ACT
I, Michael T. Vollkommer, certify that:
1. | I have reviewed this quarterly report on Form 10-Q of Certegy Inc.; |
2. | Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; |
3. | Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; |
4. | The registrants other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: |
(a) | Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; |
(b) | Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; |
(c) | Evaluated the effectiveness of the registrants disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and |
(d) | Disclosed in this report any change in the registrants internal control over financial reporting that occurred during the registrants first fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrants internal control over financial reporting; and |
5. | The registrants other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrants auditors and the audit committee of the registrants board of directors (or persons performing the equivalent functions): |
(a) | All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrants ability to record, process, summarize and report financial information; and |
(b) | Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal control over financial reporting. |
Date: May 10, 2005
/S/ MICHAEL T. VOLLKOMMER |
Michael T. Vollkommer Executive Vice President and Chief Financial Officer |
Exhibit 32.1
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350
The undersigned certifies, pursuant to 18 U.S.C. Section 1350 as adopted by Section 906 of the Sarbanes-Oxley Act of 2002, that:
(1) the Quarterly Report on Form 10-Q of Certegy Inc. (the Company) for the quarterly period ended March 31, 2005 (the Report) fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934; and
(2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
Date: May 10, 2005 | /S/ LEE A. KENNEDY | |
Lee A. Kennedy Chairman and Chief Executive Officer |
Exhibit 32.2
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350
The undersigned certifies, pursuant to 18 U.S.C. Section 1350 as adopted by Section 906 of the Sarbanes-Oxley Act of 2002, that:
(1) the Quarterly Report on Form 10-Q of Certegy Inc. (the Company) for the quarter period ended March 31, 2005 (the Report) fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934; and
(2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
Date: May 10, 2005 | /S/ MICHAEL T. VOLLKOMMER | |
Michael T. Vollkommer Executive Vice President and Chief Financial Officer |