ITEM 1. BUSINESS
National Processing, Inc. ("NPI", the "Company" or "Registrant"), through its wholly owned operating subsidiary National Processing Company ("NPC"), is a provider of low-cost high-volume transaction processing services and customized processing solutions. Deploying technology and applications software, the Company currently provides products and services which include (i) processing of card transactions ("Merchant Card Services") and check transactions ("Merchant Check Services") for merchants and other commercial businesses (collectively known as "Merchant Services"), (ii) outsourcing of administrative and financial functions for corporations seeking to reduce overhead costs ("Corporate Services"), and (iii) ticket processing and settlement for providers of travel-related services ("Travel Services").
NPI is an Ohio corporation that was formerly a wholly owned subsidiary of National City Corporation, an Ohio-headquartered bank holding company ("National City" or "NCC"). Following the completion of NPI's initial public offering in August 1996, National City continued to own 85% of NPI's outstanding common stock, without par value ("Common Stock" or "NPI Common Stock"). NPI was formed on June 5, 1996 to hold all of the Common Stock of National Processing Company. To effect the transaction, NPI issued 43,100,000 shares of Common Stock (after giving retroactive effect to the 57,465.67 to 1 stock split which was effective on June 6, 1996) to National City and National City contributed the Common Stock of NPC (then a wholly owned subsidiary of NCC) to NPI. On August 9, 1996, NPI sold 7,475,000 shares of its Common stock in an initial public offering; retaining the net proceeds from the transaction to fund internal business development needs. In May 1997, National City purchased 1,265,400 shares of NPI's common stock in the open market and currently owns 88% of NPI's outstanding common stock. NPI maintains operations, employees and contracts substantially independent of National City's other operating subsidiaries. NPI and National City are parties to agreements pursuant to which National City and its subsidiaries provide NPI, and NPI provides National City and its subsidiaries, certain administrative support, operations, and processing services. NPI is also a party to a tax sharing agreement and a registration rights agreement with National City.
Merchant Services represented approximately 60% of the Company's revenues in 1998 and provided services to approximately 400,000 merchant locations. Corporate Services functions include accounts payable processing, remittance processing, freight bill audit and funds settlement services, outsourcing services and electronic commerce products. Corporate Services represented approximately 30% of the Company's revenues in 1998. Travel Services provides settlement functions to the airline industry for all ticket purchases made through travel agents in the United States. In addition to ticket payment processing, the Company provides lift document processing services for many airline companies. Travel Services includes electronic commission payment solutions which are targeted primarily at travel related companies such as auto rental agencies, hotels and cruise lines, which reduce costs and provide management information. Travel Services accounted for approximately 10% of the Company's revenues in 1998.
An important component of the Company's profitability has been access to low-cost international labor markets. The Company established its initial presence internationally with the opening of a processing facility in Juarez, Mexico in 1988. During 1997, the Company acquired Caribbean Data services, Ltd., a data processing company with operating facilities in Barbados and the Dominican Republic, and MRS Jamaica, Inc., a healthcare form processing company with operating facilities in Jamaica. At December 31, 1998, international operations employed approximately 63.8% of the Company's employees.
The Company announced in late 1998 and early 1999 that the Board of Directors had authorized management to investigate potential strategic options for various product and business lines, including the possible restructuring, divestiture, or liquidation of certain lines. The Company's management closely evaluated the profitability and future growth potential of the Company's various businesses, particularly three business lines within the Corporate Services segment and one business line within the Merchant Services segment. The Corporate Services business lines under consideration engage in freight bill audit and settlement services, the administration of payable functions on an outsourcing basis for large corporations, and remittance processing. The Merchant Services business line under consideration engages in check authorization and guarantee activities. Since that effort began, the Company entered into an agreement in February 1999 to sell the freight payment and payables business lines. In addition, in March 1999, the Board of Directors committed to the definite divestiture, either through sale or liquidation, of the check authorization and remittance business lines. (See further discussion of these events in the sections that follow entitled Merchant Services Segment and the Corporate Services Segment and in Note O to the Consolidated Financial Statements.) These actions will allow
the Company to focus more closely on its core businesses which include merchant card processing, outsourcing services and travel services.
The Company experiences seasonality in its businesses, particularly in its Merchant Services and Travel Services business. The Company typically realizes higher revenues in the third and fourth calendar quarters and lower revenues in the first calendar quarter, reflecting increased transaction volumes and travel in the summer and holiday months and a decrease in transaction volume during the quarter immediately following the holiday season.
The Company estimates that the average tenure of its relationships with its 50 largest customers has been approximately ten years.
Industry Overview
The transaction processing industry has experienced strong volume growth in recent years, as acceptance and use of credit cards, debit cards and checks have grown, and corporations have increasingly outsourced non-core administrative and financial functions in order to reduce costs, capitalize upon advances in technology, and enhance the quality and availability of management information. This growth has created considerable competition in the marketplace which has resulted in additional focus on economies of scale. In addition to competition, the cost of advancing technology and customer demand for a broad product line have caused rapid consolidation among transaction processing providers. The industry is expected to continue to grow and consolidate and to experience continued increases in competition.
Merchant Services Segment
The Company's merchant services business consists of activities related to merchant card processing and merchant check processing. As previously mentioned, in the first quarter of 1999, the Company committed to divest the merchant check business so that the Company can focus more closely on its core merchant card processing business. This business maintains significant scale in an industry that is still experiencing 10% to 15% organic growth.
Payment processing volume for commercial businesses has grown steadily in recent years as a result of a proliferation in the uses and types of credit and debit cards, wider acceptance of such cards among merchants and increased consumer usage of such cards. Advances in payment processing and telecommunications technology have been a key factor contributing to this growth. The transition from paper-based to electronic processing, for example, provides greater convenience to merchants and consumers, reduces fees charged to merchants, and facilitates faster, more accurate settlement of payments.
The merchant card processing market is generally characterized by three tiers of merchants consisting of national, regional, and numerous local merchants. Historically, the Company has focused on servicing national merchants, while many smaller transaction processors, such as Independent Sales Organizations (ISOs) and regional banks, have offered a more limited range of services to regional and local businesses. In October 1997, the Company strategically expanded its card processing business through the acquisition of approximately 80%, and in January 1998, the remaining 20%, of the common stock of FA Holdings, Inc., the sole owner of Financial Alliance Processing Services, Inc., an independent sales organization that specializes in selling credit and debit card processing services to smaller merchants.
This acquisition allowed NPC to diversify its customer base (i.e., prior to this acquisition, the Company had primarily focused on servicing national merchants), enhance its risk management systems and, most importantly, significantly expand its distribution capabilities. Through approximately 300 commission only sales representatives and third party distribution relationships, the Company currently generates approximately 5,000 new merchant applications each month.
The Company's current customer base consists of approximately 140,000 customers with over 400,000 locations, all of which are based in the United States. No one customer contributes more than 10% to merchant card revenue. In 1998 and 1997, card processing represented approximately 77.9% and 71.2%, respectively, and 89.4% and 79.6%, respectively, of total merchant services revenues and operating profit.
The merchant services market is extremely competitive, which results in pricing pressure and creates the need for continuous improvement in technology both to satisfy customer demands and to reduce operating costs. The costs to meet merchant requirements for improved service, satisfy the demands for additional technology-driven applications, and the scale driven nature of the industry have made it difficult for small scale
transaction processors to remain competitive. As a result, the transaction processing industry will likely continue to undergo rapid consolidation over the next few years.
According to published industry sources, the three largest credit and debit card transaction processors handled 51.8% of total credit and debit card sales volume for calendar year 1997. (the Nilson Report - March, 1998). The remaining market is highly fragmented among smaller merchant service providers. The Company is well positioned to grow aggressively its national and regional customer portfolios through continued expansion of direct and third party distribution channels.
Corporate Services Segment
The Company's Corporate Services business provides outsourcing services, remittance processing, accounts payable processing and freight bill audit and settlement services to businesses. The corporate outsourcing marketplace is competitive with a few relatively large providers and numerous smaller providers. The cost advantages associated with large-scale processing, and the ability to invest in new technology that delivers value-added services at lower per unit costs have enabled large-scale providers to capture much of the transaction processing and outsourcing requirements of large corporations. Corporate Services' response to this competition has been to acquire additional international labor infrastructure, initially in Mexico and, through 1997 acquisitions, in Dominican Republic, Barbados and Jamaica. Secondly, Corporate Services is spending capital and management time to re-engineer processing platforms to incorporate outsourcing services and internet technologies and to maximize the benefit of the international labor infrastructure. These changes are expected to position Corporate Services with a more competitive product capability in the future.
In 1999, management committed to a plan to divest the remittance processing, accounts payable processing and freight bill audit and settlement services business lines so that the Company can focus more closely on its core outsourcing services business. Collectively, the three business lines that will be divested made up 62.4% and 77.7% of total Corporate Services revenues for 1998 and 1997, respectively. These lines had an operating loss of $12.1 million for 1998 out of a total operating loss of $6.9 million for Corporate Services. These lines contributed $8.1 million, or 48.5% of the total corporate services operating profit of $16.6 million for 1997.
The remaining business within Corporate Services is outsourcing services and represents a growing business that began in the early 1990's. Within this business, the Company performs numerous administrative and clerical outsourcing services for over 60 major companies. This includes operation of mailrooms, image scanning, data entry, fulfillment and database creation services. Revenues from outsourcing services increased $26.0 million, or 105.3%, from 1997 to 1998, caused partly by the full year revenue recognition of two businesses acquired during 1997. Operating profit from outsourcing services for 1998 amounted to $5.2 million and represented 15.2% of total operating profit for the business segments of the Company.
The market for outsourcing services continues to grow. Large companies are outsourcing non-strategic functions within their organizations to companies such as NPC. The Company's customers for outsourcing services include health insurance companies, credit card issuers, airlines, transportation companies and brokerage services. In 1998, several new customer relationships were developed and the new sales outlook for 1999 remains attractive.
In order to remain cost competitive, the Company and many of its competitors have moved to international locations to reduce operating expenses. The Company has four strategic international locations in the Caribbean and Mexico.
Travel Services Segment
The Company's Travel Services business derived approximately 76% of its revenues in 1998 from an exclusive long-term contract with the Airlines Reporting Corporation ("ARC"). The Company is compensated on a "cost plus" basis under its current contract with the ARC, which expires in December 2001. That contract is currently being renegotiated, and, as a result, is expected to be extended through December 2005. The Company believes that there are only a few other providers that can compete in providing high volume processing for the travel related industries.
Regulation
As a result of National City's ownership in NPI and as long as National City has a controlling interest, NPI is subject to banking laws, regulations and orders (collectively, the "Banking Laws"). For example, NPI is subject to the supervision and examination of the Board of Governors of the Federal Reserve System ("FRB"), one of the principal regulatory bodies having jurisdiction over National City. The FRB reviews acquisitions and new businesses to be engaged in by NPI, and the FRB's written approval is required in order for NPI to consummate an acquisition. Pursuant to the Bank Holding Act, NPI shall not engage in any activity, or own, control, or have the power to vote more than 5% of any class of voting security of any company engaged in any activity (i) for which the Bank Holding Act requires a bank holding company to receive prior approval from the FRB without such approval having been obtained, or (ii) that would cause NPI or any affiliate of NPI to violate any regulation, administrative order, or court order made pursuant to the Bank Holding Act. If at any time it is determined that any activity conducted by NPI or any subsidiary does not comply with the requirements of the Bank Holding Act, NPI is required to take all reasonable steps to cease such activity, or to divest any ownership or control position. If National City is unable to obtain the necessary consent or approval for any business activity substantially different from those business activities NPI currently conducts, then NPI may not engage in any of those new business activities or proceed with the contemplated acquisition of a business that would engage in such new activities. NPI does not believe, however, that either the Banking Laws or the Bank Holding Act will impede significantly the manner in which NPI intends to conduct its business or its product and service offerings, although there can be no assurance that the Banking Laws or Bank Holding Act will not have such an effect.
The Company is currently engaged in check guarantee and collection services. As such, the Company is subject to certain consumer collection laws, orders and regulations (collectively, "Consumer Laws") and the laws of the various states in which such activities are conducted, which among other things: (i) require the Company to obtain and maintain certain licenses and qualifications; (ii) limit the fees and other charges the Company is allowed to charge; and (iii) require specified disclosures. The Company is also subject to various other federal, state, local and foreign laws, orders and regulations applicable to the Company's operations in the jurisdictions where it conducts business. Where applicable, regulators and other persons are authorized to seek remedies against entities such as the Company for violations of such laws, including the Consumer Laws.
Through National City Bank of Kentucky, which serves as a member bank for the Company, the Company is registered with VISA(R) and MasterCard(R) as a certified processor and member service provider. As a result, the Company must adhere to the standards of the VISA(R) and MasterCard(R) credit card associations or else risk suspension or termination of its designation and/or status. There can be no assurance that (i) VISA(R) and MasterCard(R) will maintain the Company's registrations; (ii) the current VISA(R) and MasterCard(R) rules allowing the Company and other nonbank transaction processors to market and provide transaction processing services will remain in effect; or (iii) VISA(R) and MasterCard(R) will continue to interpret their rules as they have done in the past, which may have an impact on the Company's business operations.
Employees
As of December 31, 1998, the Company and its subsidiaries had 10,478 full-time and 308 part-time employees.
ITEM 2.
ITEM 2. PROPERTIES
The Company leases its processing facility in Louisville, Kentucky, consisting of approximately 223,000 square feet, from National City Bank of Kentucky, a wholly owned subsidiary of National City. (See Transactions with Affiliates, Note E to Consolidated Financial Statements). The Company's lease for the Louisville processing facility expires on February 28, 2019. The Company also leases its operations center in Phoenix, Arizona. The Phoenix facility consists of approximately 50,000 square feet for which the final lease term expires on July 31, 1999. In an effort to improve both its operating efficiencies and standardize its customer service levels, at the expiration of this lease, the Company plans to consolidate significantly all of its remaining operations in its Phoenix, AZ facility to its Louisville, KY facility. The Company's Juarez operation owns and utilizes four properties totaling 225,000 square feet. The Company's other processing facilities have varying lease expiration terms and range in size from 3,900 square feet to 41,300 square feet and are located throughout the United States, Barbados, Dominican Republic, Jamaica, and Mexico. The Company's 26 marketing and sales offices have varying lease expiration
terms and range in size from 100 square feet to 9,000 square feet and are located throughout the United States. All properties leased and owned by the Company are in good repair and suitable condition for the purposes for which they are used. The Company periodically reviews its space requirements to consolidate and dispose of or sublet facilities which are no longer required in connection with its businesses and to acquire new space to meet the needs of its businesses.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Various legal actions arising in the ordinary course of business are pending against the Company. None of the litigation pending against the Company, individually or collectively, in the opinion of management, is expected to have a material adverse effect on the Company's financial condition, results of operations or liquidity.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The Company's common stock is traded on the New York Stock Exchange under the symbol NAP. The common stock has been quoted on the New York Stock Exchange since August 9, 1996, the date of the initial public offering of the Company's common stock. The quarterly high and low closing price and the final day's closing price of the Company's common stock for each of the quarterly periods in 1998 and 1997 were:
The number of holders of record of the Company's common stock as of March 23, 1999 was 127. The Company believes that it has significantly more than 127 beneficial holders of its common stock.
The Company has never declared or paid cash dividends on its common stock and has no plans to pay cash dividends in the foreseeable future. The declaration and payment of cash dividends on the Company's common stock is at the discretion of the Company's Board of Directors and any decision to declare a dividend will be based on a number of factors, including, but not limited to, earnings, financial condition, borrowing covenants and other factors deemed relevant.
The name and address of the Company's common stock transfer agent and registrar is National City Bank, Corporate Trust Operations, Department 5352, P.O. Box 92301, Cleveland, Ohio, 44193-0900 (1-800-622-6757).
Investors or analysts requiring further information should contact Thomas A. Richlovsky, Investor Relations, Department 2101, P.O. Box 5756, Cleveland, Ohio, 44101-0756 (1-216-575-2126).
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following data should be read in conjunction with the consolidated financial statements and related notes thereto and management's discussion and analysis of financial condition and results of operations included in Item 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
The Company is a provider of low-cost, high-volume transaction processing services and customized processing solutions. The Company deploys technology and applications software primarily to merchants and other commercial businesses, corporations and providers of travel-related services.
Components of Revenue and Expenses
Revenues. The Company's revenues are generated from a variety of sources. The Company's Merchant Services revenues are primarily derived from fees paid by merchants for the authorization and settlement of credit and debit card transactions, exclusive of interchange fees, and for the acceptance of checks. Merchant fees paid to the Company include assessment fees, which are amounts charged by credit card associations for clearing services, advertising and other expenses. Revenues from Corporate Services are derived from transaction fees for the processing of remittances, accounts payable and freight bills, and for outsourced services. Revenues from Travel Services are dependent on the volume of ticket sales by travel agents on behalf of airlines. A small portion of revenues is derived from earnings on cash balances, which are maintained by customers pursuant to contract terms. Revenues derived from services provided to affiliates are immaterial.
Expenses. Operating expenses include all direct costs of providing services to customers, excluding wages and other personnel expenses. The most significant components of operating expenses are assessment fees, authorization fees and data processing expenses. Wages and benefits include wages and benefits for hourly employees. General and administrative expenses include management salaries and benefits, facilities maintenance and software applications programming.
Results of Operations
The following table summarized the Company's operating results and sets forth such results as a percentage of revenues for the periods indicated:
Year Ended December 31, 1998 compared to Year Ended December 31, 1997
Revenues: Consolidated revenues increased $77.5 million, or 19.1% to $483.2 million for the year ended December 31, 1998 from $405.7 million for 1997. The increase was primarily due to revenues generated from the last five acquisitions that contributed $70.5 million. The remaining increase resulted primarily from increases in the merchant card operations partially offset by decreases in the remittance and merchant check operations.
The composition of the Company's revenues for these periods is as follows:
Other Income: Other income in 1998 reflects a settlement for the cancellation of a third party merchant card processing contract.
Costs and Expenses: Consolidated costs and expenses increased $86.2 million, or 22.9%, to $463.0 million for the year ended December 31, 1998 from $376.8 million during 1997.
Operating expenses increased $49.1 million, or 25.4%, to $242.5 million for the year ended December 31, 1998 from $193.4 million in 1997. The increase was primarily due to the last six acquisitions that contributed $23.0 million in operating expenses. The Company's core businesses reflected increases in operating expense of $26.1 million, principally due to increased volumes and expanded sales distribution channels, information technology and customer services at the merchant card operations and increases at the remittance operations due to $5.2 million for research adjustments and $2.4 million in additional expenses due to delays in converting to its new imaging technology. The Company's remittance operation accepts checks received on behalf of customers and remits the funds to the customer. The research adjustments relate to the amounts charged back by the banks to the Company for errors in deposits, NSF checks, etc. The Company maintains an in-process inventory of these items that it normally settles without significant charges. As a result of problems associated with the conversion of the remittance product to a new image based system, the in-process inventory of bank charge backs increased over normal operating levels. Additional increases resulted from the write-off of internally developed software and related costs following the cancellation of a significant customer contract at the freight operations. These increases were offset by decreases at the merchant check operations.
Wages and other personnel expenses increased $25.4 million, or 25.0%, to $127.0 million for the year ended December 31, 1998, from $101.6 million in 1998. This increase was due primarily to the last six acquisitions that added $29.0 million in 1998. These increases were partially offset by wage decreases at the remittance and travel operations resulting from decreases in processing volumes.
General and administrative expenses increased $16.0 million, or 31.7%, to $66.8 million for the twelve months ended December 31, 1998, from $50.8 million in 1997. This increase resulted principally from increases in information technology expenses including $4.7 million incurred for Year 2000 compliance, $1.2 million of the total $2.6 million freight software write-off discussed above, and increases in sales and support services related to the company's last three acquisitions.
Depreciation and amortization increased $9.0 million, or 50.2%, to $26.8 million for the year ended December 31, 1998, from $17.8 million in 1997. The increase was primarily due to the amortization of intangibles and the depreciation of fixed assets acquired in the last six acquisitions, which contributed $6.5 million, and additional fixed asset expenditures.
Net Interest Income: The Company earned net interest income of $0.9 million for the year ended December 31, 1998 compared to $4.0 million in 1997. This decrease resulted from decreased investment balances reflecting the cash used for the 1997 and 1998 acquisitions.
Tax Provision: The provision for income taxes for 1998 was $9.8 million compared to $11.7 million in 1997. The decrease resulted from the decrease in taxable income of $7.7 million to $25.1 million. Additionally, the 1997 effective tax rate was lower than the 1998 rate due to a significant increase in non-tax deductible goodwill amortization in 1998 resulting from 1997 and 1998 business acquisitions and due to non-taxable interest income from investments in 1997. The Company has approximately $51.0 million of state net operating loss carryforwards for income tax purposes available to offset future taxable income in the related states from 1999 to 2013. In 1998, the Company determined that it was more likely than not that future taxable income would be generated in these states sufficient to justify the deferred tax assets recorded, net of the related valuation allowance of $2.4 million.
Net Income: Excluding the 1997 restructuring charge, which totaled $8.1 million after-tax, net income for the year ended December 31, 1998 decreased $13.9 million to $15.3 million from $29.2 million for the same period in 1997. The decrease resulted primarily from the additional expenses for research adjustments, the additional expenses due to delays in converting to new imaging technology, the write-off of internally developed software and costs incurred in conjunction with Year 2000 compliance.
Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
Revenues. Consolidated revenues increased $32.0 million, or 8.6% to $405.7 million for the year ended December 31, 1997 from $373.7 million for 1996. The increase was primarily due to revenue gains in Merchant Services and Corporate Services which offset a revenue decline in Travel Services. Merchant Card Services revenue increased 6.7% in 1997 compared to 1996 due to increased transaction volume and an increase in revenue per transaction due to a shift in mix toward smaller volume customers. This shift in mix was in part due to the October 1997 acquisition of FA Holdings, Inc., a credit and debit card processing company specializing in smaller merchants. Corporate Services revenue grew 28.2% in 1997. 67% of this growth was due to 1997 acquisitions in the Company's freight and electronic imaging operations. The Company processed 2.8 billion transactions during 1997, representing a 7.7% transaction volume increase over the prior year.
The composition of the Company's revenues for these periods is as follows:
Costs and Expenses: Consolidated costs and expenses increased $49.5 million, or 15.1%, to $376.8 million for the year ended December 31, 1997 from $327.3 million during 1996. The increase was primarily due to higher wages and other personnel expenses within the Corporate Services operations of electronic imaging solutions and freight, principally due to 1997 acquisitions; and higher levels of purchased services as a result of higher business volumes and increases in software development costs in Merchant Services.
Additional increases resulted from restructuring charges of $6.3 million in the first quarter of 1997 related to severance pay and other costs resulting from an organizational restructuring and $7.0 million in the fourth quarter of 1997 for the consolidation of operations and facilities following the acquisition of FA Holdings, Inc.
Depreciation and amortization for the year ended December 31, 1997 was $17.8 million compared to $12.8 million during 1996. This increase was primarily due to greater expenditures on fixed assets relating to technology improvements and increased amortization of intangibles related to the Company's 1997 acquisitions.
These increases were partially offset by lower operating costs at Travel Services.
Net Income. Net income for the year ended December 31, 1997 decreased 32.6% to $21.1 million from $31.4 million for the year ended December 31, 1996. The decrease resulted principally from the $8.1 million of after-tax restructuring charges in 1997 and a 1996 $2.5 million after-tax gain on the sale of a portfolio of merchant contracts.
Business Segment Review
Selected financial information for the Company's three business segments, Merchant Services, Travel Services and Corporate Services, are discussed in Note N, Segment Reporting. The following is an analysis of the Company's operations by business segment.
Merchant Services
Revenues for the year ended December 31, 1998 increased $53.8 million due to merchant card revenue increases of $37.7 million from the FA Holdings acquisition and additional increases at core operations, partially offset by lower merchant check revenues from the elimination of certain unprofitable customers and re-pricing of some continuing customers. Operating profit includes other income of $4.0 million for a cancellation settlement of a merchant card contract. This contract represented approximately 2% of the 1998 merchant card revenues prior to cancellation.
Travel Services
Revenues for the year ended December 31, 1998 increased $3.5 million primarily due to the January 1998 acquisition of JBH Travel Audit, Inc. Operating profit was $9.9 million for the year compared to $9.0 million for 1997. This increase was also due to the acquisition of JBH Travel Audit, Inc. and additional increases recorded at the core travel operations due to cost savings bonuses which exceeded decreases in volumes and income from the ARC contract.
Corporate Services
The year ended December 31, 1998 reflected an operating loss of $6.9 million compared to an operating profit of $16.6 million for 1997. The decrease was primarily due to a $5.2 million reserve for research adjustments and additional expenses related to the implementation of imaging technologies and reduced revenues in remittance operations. Additional decreases resulted from a $2.6 million write-off of internally developed software and related costs following the cancellation in June of a significant freight customer contract.
Corporate
In March, 1997, the Company recorded expenses of $6.3 million, including $5.0 million for severance pay for approximately 79 employees, and $1.2 million for other costs, related to organizational restructuring. In December, 1997, the Company recorded expenses of $7.0 million following the acquisition of FA Holdings, Inc. The expenses resulted principally from the write-off of certain fixed assets (totaling $5.5 million) related to several of the Company's operating facilities which have been or are in the process of being closed and consolidated into the Company's current facilities.
Liquidity and Capital Resources
The Company's primary uses of capital resources include acquisitions, capital expenditures and working capital. Future business acquisitions may be funded through current liquidity, borrowed funds, and/or issuances of common stock.
The Company's capital expenditures include amounts for computer systems hardware and software, scanning and other document processing equipment as well as buildings and leasehold improvements to the Juarez, Mexico and Louiseville operation facilities. During the year ended December 31, 1998 the Company's capital expenditures totaled $42.5 million. Such expenditures were principally financed from operating cash flow, which totaled approximately $44.6 million. Operating cash flow during the year ended December 31, 1997 totaled $34.6 million. Capital expenditures for 1997 were $28.3 million. The Company expects capital expenditures for 1999 to be approximately $16 million principally to enhance processing capabilities in Merchant Services and Corporate Services.
As the Company does not carry significant amounts of inventory and historically has experienced short collection periods for its accounts receivable, it does not require substantial working capital to support its revenue growth. Working capital requirements will vary depending upon future acquisition activity. Increases in working capital needs are expected to be financed through operating cash flow and current cash. The Company maintains cash balances held on behalf of clients pending distribution to vendors that are shown on the balance sheet as assets and equivalent, offsetting liabilities. These cash
balances totaled approximately $91.5 million and $83.2 million as of December 31, 1998 and 1997, respectively. From time to time, the Company also maintains cash deposits from certain Merchant Card Services customers as collateral for potential contingent liabilities that are the responsibility of such customers. At December 31, 1998 and 1997, the amount of such cash deposits was immaterial.
Year 2000
Management initiated the process of preparing its computer systems and applications for the Year 2000 in February 1996. The process involves identifying and remediating date recognition problems in computer systems and software and other operating equipment that could be caused by the date change from December 31, 1999 to January 1, 2000.
Management has completed its assessment of all business processes that could be affected by the Year 2000 issue. Each business process assessment included a review of the information systems used in that process, including related hardware and software, the involvement of any third parties, and any affected operating equipment. To date, 95% of the work necessary to complete the assessment, remediation and testing of those business processes determined to be "mission critical" has been completed. Management expects to complete the remediation and testing of all affected systems within the critical business processes by the end of the second quarter of 1999.
Management is also working with significant customers, vendors, and business counter parties to monitor the progress of their Year 2000 efforts.
Management believes it has an effective plan in place to resolve the Year 2000 issue in a timely manner, and, thus far, the Company's Year 2000 remediation activities have tracked in accordance with its plan. Management is in the process of modifying its existing business continuity plans and is also developing contingency plans to address potential risks in the event of Year 2000 failures, including non-compliance by third parties. Despite the Company's efforts to date to remediate affected systems and develop contingency plans for potential risks, management has not yet completed all activities associated with resolving its Year 2000 issues. Under the unlikely scenario that the additional phases are not completed, the Company could be materially adversely affected as a result of not being able to process transactions related to its core business activities. In addition, non-compliance by third parties and disruptions to the economy in general resulting from Year 2000 issues could also have a material negative impact of undeterminable magnitude on the Company.
The total cost of the Year 2000 project is estimated at $8.5 million. Approximately 20% of this estimate represents costs related to internal personnel working on the project and certain capitalizable costs related to replacing non-compliant hardware and software. To date $4.7 million of the total project costs have been incurred, all of which were incurred in 1998.
Forward Looking Statement
In Item 1, Business, the sections entitled Merchant Services Segment, Corporate Services Segment and Travel Services Segment, and in Item 7, the section entitled Year 2000 contain certain forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995). These forward-looking statements involve risks and uncertainties, including changes in general economic conditions, the Company's ability to execute its business plans, including its plan to address the Year 2000 issue, the ability of third parties to effectively address their Year 2000 issues and the Company's ability to carry out its plans to divest of the payables, freight, check and remittance business lines. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Market risk for purposes of this disclosure relates to losses due to adverse changes in the fair value of a financial instrument caused by changes in interest rates, foreign exchange rates or commodity prices. These exposures are considered immaterial to the Company's financial position, results of operations, and cash flows.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Index to Consolidated Financial Statements at Item 14.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT; ITEM 11.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. Financial Statements
Page Number Description in Report ----------- -----------
Report of Independent Auditors 18
Consolidated Balance Sheets as of December 31, 1998 19 and 1997
Consolidated Statements of Income for each of the 21 three years in the period ended December 31, 1998
Consolidated Statements of Changes in Shareholders' 22 Equity for each of the three years in the period ended December 31, 1998
Consolidated Statements of Cash Flows for each of 23 the three years in the period ended December 31, 1998
Notes to Consolidated Financial Statements 24
2. Financial Statement Schedules
Omitted due to inapplicability or because the required information is immaterial to the Company's financial statements.
3. Exhibits
The index of exhibits has been filed as separate pages of the 1998 Form 10-K and is available to shareholders on request from the Secretary of the Company at the principal executive offices. Copies of the exhibits may be obtained at a cost of 30 cents per page.
(b) Reports on Form 8-K.
October 14, 1998: On October 14, 1998, the Registrant issued a press release reporting earnings for the third quarter and first nine months of fiscal 1998. The press release also disclosed that due to the lower than expected third quarter results and an unsettled outlook, the Registrant indicated that full-year 1998 earnings could fall short of the September 30, 1998 consensus earnings estimate of $.42 by as much as one-third.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 31, 1999.
NATIONAL PROCESSING, INC.
By: /s/ Jim W. Cate Executive Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated.
* The undersigned by signing his name hereto, does sign and execute the Annual Report on Form 10-K for fiscal year 1998 pursuant to the Power of Attorney executed by the above named Directors of the Company and which have been filed with the Securities Exchange Commission on behalf of such directors.
By: /s/ Carlton E. Langer --------------------- Carlton E.Langer As Attorney-in-Fact
Report of Independent Auditors
The Shareholders National Processing, Inc.
We have audited the accompanying consolidated balance sheets of National Processing, Inc. and subsidiaries (a majority owned subsidiary of National City Corporation) as of December 31, 1998 and 1997, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Processing, Inc. and subsidiaries at December 31, 1998 and 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles.
Cleveland, Ohio February 1, 1999
/s/ Ernst & Young LLP
NATIONAL PROCESSING, INC.
Consolidated Balance Sheets (Dollars in thousands)
See notes to consolidated financial statements.
NATIONAL PROCESSING, INC.
Consolidated Balance Sheets (Dollars in thousands)
See notes to consolidated financial statements.
NATIONAL PROCESSING, INC.
Consolidated Statements of Income (In thousands, except per share amounts)
See notes to consolidated financial statements.
NATIONAL PROCESSING, INC.
Consolidated Statements of Changes in Shareholders' Equity (Dollars in thousands)
See notes to consolidated financial statements.
NATIONAL PROCESSING, INC.
Consolidated Statements of Cash Flows (Dollars in thousands)
See notes to consolidated financial statements.
NATIONAL PROCESSING, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. Organization and Business
Organization
National Processing, Inc. and subsidiaries (the "Company") (a majority owned subsidiary of National City Corporation ("NCC"), a bank holding company headquartered in Cleveland, Ohio) became the owner of all of the outstanding shares of National Processing Company ("NPC") on June 5, 1996. In connection with its organization, the Company issued 43,100,000 shares of common stock (after giving retroactive effect to the 57,465.67 to 1 stock split which was effective June 6, 1996) to NCC, and NCC contributed the common stock of NPC (then a wholly owned subsidiary of NCC) to the Company. Since both the Company and NPC are subsidiaries of NCC, this transfer of assets was accounted for on the basis of historical cost. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany transactions are eliminated in consolidation.
In August 1996, the Company sold 7,475,000 shares of its common stock in an initial public offering at a price of $16.50 per share. Following the initial public offering, NCC owned 85% of the Company's outstanding common stock. In May 1997, NCC purchased 1,265,000 shares of the Company's common stock in the open market and currently owns approximately 88% of the Company's outstanding common stock.
The Company and NCC are parties to a Registration Rights Agreement whereby NCC has the right to require the Company to use its best efforts to register under the Securities Act of 1933, as amended, all or a portion of the issued and outstanding common stock held by NCC. NCC also has the right to participate, or "piggy-back", in equity offerings initiated by the Company, subject to reduction of the size of the offering on the advice of the managing underwriter.
Business
The Company is a leading provider of transaction processing services and customized processing solutions. The Company currently provides these services in three principal areas: Merchant Services, Corporate Services and Travel Services. Within Merchant Services, the Company focuses primarily on markets for credit and debit card processing and for check acceptance and collection. The Company's Corporate Services business provides integrated outsourcing solutions for customers' remittance processing, freight bill processing, corporate accounts payable, and imaging functions (see Note O). Customers of the Company's Merchant Services and Corporate Services are diverse in terms of both industries and size with no significant concentration in any particular industry or customer type. Through an exclusive contract with the Airlines Reporting Corporation ("ARC"), which expires in December 2001, Travel Services acts as a processor and clearing house for all airline ticket payment transactions generated by travel agents in the United States.
B. Summary of Significant Accounting Policies
Use of Estimates
Financial statements prepared in accordance with generally accepted accounting principles necessitate the use of estimates and assumptions by management that affect the reported amounts of revenues and expenses, assets and liabilities, and the disclosure requirement for contingent assets and liabilities during and at the date of the financial statements. Consequently, actual results could differ from those estimates.
Revenue Recognition
The Company recognizes as fee income the amounts charged by its various businesses for the related processing activities. All revenues are recognized at the time services are rendered.
Cash and Cash Equivalents
Cash equivalents consist of highly liquid bank overnight repurchase agreements, which are readily convertible to cash.
Financial Instruments
The Company's financial instruments consist of cash equivalents, accounts receivable, restricted deposits, accounts payable, merchants payable, and payables to affiliates. The carrying values of these financial instruments approximate their fair values.
Check Inventory
The amount paid for checks submitted to the Company by merchants participating in its various check guarantee programs are recorded at the amount the Company deems ultimately collectible, subject to revision based on a continual review of collection statistics. The check inventory is classified as current in accordance with trade practice.
Restricted Deposits--Customer Funds
The Company's travel and freight processing businesses regularly receive funds, as part of the settlement process, in advance of the related disbursement. Such monies are set aside in restricted accounts and a liability is recorded for an equal and offsetting amount. As such, customer funds are not eligible for use by the Company in its operations other than to pay related liabilities. In all cases, customer funds are invested in highly liquid, investment grade interest bearing securities. Investment of customer funds in equity securities is prohibited by the Company's investment guidelines established by the Board of Directors.
Property and Equipment
Property and equipment is stated at cost and depreciated on a straight-line basis over the estimated useful life or term of the lease, whichever is shorter. Maintenance and repairs are expensed as incurred, while improvements that extend the useful life of the related asset are capitalized and depreciated over the remaining life of the related asset. The ranges of estimated useful lives are as follows:
Upon the sale or disposal of property or equipment, the cost and accumulated depreciation accounts are adjusted accordingly and any gain or loss is recognized in income. Depreciation expense was $18.3 million, $14.2 million, and $10.3 million in 1998, 1997, and 1996, respectively.
The Company capitalizes certain costs incurred to develop or obtain internal-use software. For purposes of amortization and impairment, capitalized costs would be treated in the same manner as other long-lived assets. To be considered as internal-use software the software is either acquired, internally developed, or modified solely to meet the Company's internal needs with no plans to market the software externally. Project costs that are considered research and development costs are expensed as incurred. Capitalized software development and purchased software costs are reported at unamortized cost. Commencing the month following project completion, these costs are amortized on a straight-line basis over the estimated life of the software, not to exceed five years. For the years ended December 31, 1998, 1997 and 1996, capitalized software amortization totaled $.8 million, $1.3 million, and $1.3 million, respectively.
In June 1998, the Company wrote-off $2,600,000 of internally developed software and related costs, which is included in operating expenses in the Consolidated Statements of Income, following the cancellation of a significant customer contract.
Acquired Merchant Portfolios
Acquired merchant portfolios represent costs allocated to customer contracts acquired through acquisitions. These costs are amortized on a straight-line basis over periods ranging from 7 to 15 years.
Deferred Contract Costs
Other assets include $2.1 million and $3.2 million of deferred contract costs in 1998 and 1997, respectively. Deferred contract costs primarily represent costs incurred to acquire new customer contracts.
These costs are amortized on a straight-line basis over the life of the customer contract. Recoverability of these costs is assessed on an ongoing basis and writedowns to net realizable values are recorded as necessary.
Acquisitions
Operations of companies acquired in purchase transactions are included in the consolidated statements of income from the respective acquisition dates. The excess of the purchase price over the net assets acquired (goodwill) is amortized on a straight-line basis over 40 years.
Asset Impairment
The company records impairment losses on long-lived assets held for use when events and circumstances indicate that the assets may be impaired and the undiscounted net cash flows estimated to be generated by those assets are less than their carrying amounts. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less cost to sell.
Merchant Payable--Check Services
As part of its check services operations, the Company reimburses merchants for checks that are dishonored. The liability to merchants for returned checks guaranteed by the Company is established in part based upon an estimate of the volume of checks accepted by the various merchants which are expected to be dishonored. Differences between the estimated and actual merchant guaranteed check liability are recorded at the time the checks are acquired from the merchants.
Accrued Bankcard Assessments
The liability to the VISA(R) and MasterCard(R) organizations originating from the Company's agreements with these agencies, as an authorized processor, is accrued and settled on a monthly and quarterly basis, respectively. The Company recovers these assessment charges through various contractual arrangements with its customers.
Income Taxes
The Company is included in the consolidated federal income tax return of NCC. NCC's policy is to allocate income taxes to its subsidiaries on a separate return basis.
Reclassifications
Certain prior year amounts in the financial statements and notes have been reclassified to conform with the current year presentation.
C. Recent Accounting Pronouncements
Reporting Comprehensive Income
In June 1997 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 130, Reporting Comprehensive Income. This statement establishes standards for reporting the components of comprehensive income and requires that all items that are required to be recognized under accounting standards as components of comprehensive income be included in a financial statement that is displayed with the same prominence as other financial statements. Comprehensive income includes net income as well as certain items that are reported directly within a separate component of stockholders' equity and bypass net income. The Company adopted the provisions of this statement in 1998, however, any difference between net income and comprehensive income are insignificant.
Disclosures about Segments of an Enterprise and Related Information
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131. Disclosures about Segments of an Enterprise and Related Information. The provisions of this statement require disclosure of financial and descriptive information about an enterprise's operating segments in annual and interim financial reports issued to shareholders. The statement defines an operating segment as a component of an enterprise that engages in business activities that generate revenue and incur expense, whose operating results are regularly reviewed by the chief operating decision maker in the determination of resource allocation and assessment of performance, and for which discrete financial information is available. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company adopted the
provisions of this statement for 1998 annual reporting, and the related disclosures are included in Note N to these financial statements.
Internal Use Software
In March 1998, the Accounting Standards Executive Committee issued Statement of Position (SOP), 98-1 Internal Use Software. This statement requires the capitalization of costs to acquire or develop internal use software after certain conditions are met. This statement is effective for fiscal years beginning after December 15, 1998. Because the Company's current policy is not significantly different from this statement, this statement will have no significant impact on the financial position or results of operations of the Company.
D. Acquisitions
On January 15, 1998, the Company acquired all the outstanding shares of JBH Travel Audit Inc. ("JBH"), a company which audits fees payable to travel agencies, for $6.3 million in cash. The purchase price is subject to increase by as much as $2.0 million based upon the earnings of the acquired company during 1999. The acquisition, which has been accounted for as a purchase, increased the Company's goodwill by $5.1 million which is being amortized over 40 years. The results of JBH's operations are included in the Company's results of operations from the date of acquisition. The pro forma effect of the JBH transaction was not material to previously reported periods.
On February 4, 1997, the Company acquired all of the outstanding shares of NTA, Inc., a freight payment processing company. On June 19, 1997, the Company acquired the operating assets and liabilities of InTraCon, Inc., a freight payment processing company. On June 20, 1997, the Company acquired the operating assets and liabilities of MRS Jamaica, Inc., a healthcare form processing company. On September 30, 1997, the Company acquired all of the outstanding shares of Caribbean Data Services, Ltd., a data processing company. The combined purchase price of these acquisitions was $30.3 million in cash and $4.3 million in notes payable. $2.1 million of the notes were paid off in October 1997, $1.1 million were paid off in June 1998 and the $1.1 million balance, plus accrued interest at 5.125% is due and payable in February 1999. The MRS Jamaica, Inc. purchase price increased by $3.3 million in 1998 based upon the 1998 earnings of the acquired company. The acquisitions, which have been accounted for as purchases, increased the Company's goodwill by $32.3 million which is being amortized over 40 years. The results of operations of these acquired companies have been included in the consolidated financial statements since their respective dates of acquisition.
The combined pro forma effect of these transactions was not material to previously reported periods.
On October 24, 1997, the Company acquired 79.6% of the outstanding common stock of FA Holdings, Inc., the sole owner of Financial Alliance Processing Services, Inc. ("Financial Alliance"), for $67.2 million. Financial Alliance is an independent sales organization specializing in selling credit and debit card processing services to smaller merchants. The Company acquired the remaining 20.4% of the common stock for $26.8 million in January 1998. The acquisition, which has been accounted for as a purchase, increased the Company's goodwill by approximately $74 million which is being amortized over 40 years. The results of operations of Financial Alliance have been included in the consolidated financial statements since the date of its acquisition.
The follow unaudited pro forma information gives effect to the Financial Alliance acquisition as if it occurred January 1, 1996 (in thousands, except per share amounts).
The pro forma results include the effect of all material adjustments related to the acquisition and have been prepared using calculations based upon assumptions deemed reasonable by the Company. The pro forma information is presented for informational purposes only and is not necessarily indicative of results that would have occurred had the acquisition taken place on January 1, 1996, nor are they necessarily indicative of future results.
Supplemental cash flow information related to all 1997 acquisitions is as follows (dollars in thousands):
E. Transactions with Affiliates
The Company leases certain facilities from National City Bank of Kentucky ("NCBK"), a wholly owned subsidiary of NCC, under long-term agreements classified as "Property Leased From Affiliate" in the accompanying financial statements. Future minimum payments under these leases, which expire between 1999 and 2019, are $4.2 million, including interest of $1.9 million.
The Company uses the proof and transit department of NCBK to provide processing for remittances. The charges for these services, which are included in operating expenses, were $3.6 million in 1998, $5.5 million in 1997, and $4.1 million in 1996.
The Company receives certain administrative services, such as internal audit and legal, from NCC and its affiliates. Charges for these services are included in general and administrative expenses and totaled $2.1 million, $3.3 million, and $3.4 million, in 1998, 1997, and 1996, respectively.
F. Operating Leases
The Company leases various offices, facilities, and equipment under noncancellable lease agreements with expiration dates through 2019. During the normal course of business, most of these leases will be renewed or replaced by other leases. Future minimum rental payments under these leases are $5.9 million in 1999; $4.5 million in 2000; $2.8 million in 2001; $1.9 million in 2002, $1.6 million in 2003, and $8.9 million thereafter. Rent expense under operating leases was $7.6 million, $7.0 million and $6.0 million, in 1998, 1997, and 1996, respectively.
G. Income Taxes
The provision for income taxes consists of the following (in thousands):
The temporary differences that gave rise to deferred tax assets and liabilities, which are included in the income tax receivable from or payable to NCC, are as follows (in thousands):
The reconciliation of the U.S. statutory income tax rate to the Company's effective tax rate is as follows:
The Company has approximately $51.0 million of state net operating loss carryforwards for income tax purposes available to offset future taxable income in the related states from 1999 to 2013. In 1998, the Company determined that it was more likely than not that future taxable income would be generated in these states sufficient to justify the deferred tax assets recorded, net of the related valuation allowance of $2.4 million.
Income before income taxes from foreign and United States operations was approximately $4.3 million and $20.8 million, respectively in 1998. Income from foreign operations was immaterial in 1997 and 1996.
H. Employee Benefit Plans
An employee thrift plan offers all employees, who meet certain age and eligibility requirements, a program of regular savings and investment funded by their own contributions and discretionary matching contributions of the Company. The Company recorded $2.6 million, $2.8 million, and $2.3 million, respectively, in matching contributions during 1998, 1997, and 1996.
I. Net Income Per Common Share
The calculation of net income per common share follows (in thousands except per share amounts):
J. Stock Options
The Company maintains two stock-based compensation plans that allow for the granting of stock options to eligible employees and directors. The Company has elected not to adopt the recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," which requires a fair-value based method of accounting for stock options and similar equity awards, and continues to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations to account for its stock-based compensation plans.
On June 5, 1996, the Company was authorized to grant up to 4,000,000 options under an employee stock option plan (the "Employee Plan") and up to 200,000 options under a non-employee directors stock option plan (the "Directors Plan"). These options are for the purchase of shares of common stock at their market price at the date of grant. The Employee Plan pertains to officers and key employees and the Directors Plan pertains to certain directors. For both plans, these options generally become exercisable 33% annually beginning one year from the date of grant and expire not later than ten years from the date of grant.
A summary of stock option activity follows:
At December 31, 1998 and 1997, 1,158,060 and 474,444 options, respectively, were exercisable under the Company's option plans. No options were exercisable at December 31, 1996. The weighted average price per share of exerciseable options was $14.40 at December 31, 1998. For options outstanding at December 31, 1998, the option price per share ranged from $6.13 to $20.50, the weighted average price per share of the options was $12.72, and the weighted-average remaining contractual life of the options was 8.0 years.
For purposes of providing the pro forma disclosures required under SFAS No. 123, the fair value of stock options granted in 1996, 1997, and 1998 was estimated at the date of grant using a Black-Scholes option pricing model. The Black-Scholes option-pricing model was originally developed for use in estimating the fair value of traded options, which have different characteristics than the Company's employee stock options. The model is also sensitive to changes in the subjective assumptions, which can materially affect the fair value estimate. As a result, management believes that the Black-Scholes model may not necessarily provide a reliable single measure of the fair value of employee stock options.
Had compensation cost for the Company's stock-based compensation plans been determined consistent with SFAS No. 123, net income and earnings per share for 1998, 1997, and 1996 would have been $12,211,000 and $.24, $18,416,000 and $.36, and $29,756,000 and $.65, respectively. As a result of a partial year's vesting in 1998 and 1997 and possible changes in assumptions used in the fair value calculation, the effects of applying SFAS No. 123 in 1998 and 1997 may not be representative of the pro forma impact in future years.
The following weighted-average assumptions were used in the option-pricing model: a risk-free interest rate of 5.97% in 1998 and 1997 and 6.54% in 1996, an expected life of the option of 7 years, an expected dividend yield of 0%, and a volatility factor of .492 for 1998, .441 for 1997 and .412 for 1996. The weighted-average grant date fair value of options granted was $6.83, $5.16, and $9.04 in 1998, 1997, and 1996, respectively.
K. Commitments and Contingencies
In the normal course of business, the Company is involved in litigation from time to time. In the opinion of management, the ultimate liability, if any, arising from this litigation is not expected to have a material adverse effect on the Company's financial condition, results of operations, or liquidity.
Under the rules of VISA U.S.A. Inc. and MasterCard International Incorporated when the Company acquires card transactions, it has certain contingent liabilities for the transactions it processes. This contingent liability arises in the event of a billing dispute between the merchant and a cardholder that is not ultimately resolved in favor of the merchant and the amount is charged back to the merchant and the disputed amount is refunded to the cardholder. If the Company is unable to collect this amount from the merchant's account and if the merchant refuses or is unable due to bankruptcy or other reasons to reimburse the Company for the chargebacks, the Company will bear the loss for the amount of the refund to the cardholder. The Company maintains merchant deposits from certain customers as an offset to potential contingent liabilities that are the responsibility of such customers. The Company evaluates its risk and estimates its potential loss for chargebacks based on historical experience.
L. Quarterly Results of Operations: (Unaudited)
Selected quarterly data for the years ended December 31, 1998 and 1997 are as follows (in thousands, except per share amounts):
The above information includes the impact of a $6.3 million restructuring charge in the first quarter of 1997; a $7.0 million restructuring charge in the fourth quarter of 1997; a $2.6 million write-off of internally developed software in the second quarter of 1998; $4.0 million in other revenue related to the settlement of a contract cancellation in the third quarter of 1998; and a $5.2 million charge for remittance research adjustments in the third quarter of 1998.
M. Restructuring Charge
In March 1997 the Company recorded expenses of $6.3 million, including $5.0 million for severance pay for approximately 79 employees, and $1.2 million for other costs, related to organizational restructuring. In December 1997 the Company recorded expenses of $7.0 million following the acquisition of FA Holdings, Inc. The expenses resulted principally from the write-off of certain fixed assets (totaling $5.5 million) related to several of the Company's operating facilities which have been or are in the process of being closed and consolidated into the Company's other current facilities. The charges decreased 1997 net income and earnings per share by approximately $8.1 million and $.16, respectively. At December 31, 1998 and 1997, the remaining liability related to the restructuring charge was $1.9 million and $4.0 million, respectively. The remaining liability at December 31, 1998 is primarily related to severance and lease liabilities that are expected to be paid in 1999.
N. Segment Reporting
National Processing, Inc. operates three business segments - merchant services, travel services and corporate services. Merchant services authorizes, processes and settles credit and debit card transactions and authorizes and collects checks for a variety of merchants. Historically, the Company has derived a substantial portion of its merchant services revenues from larger merchants. Travel services principally settles airline ticket purchases made through travel agents on behalf of airlines and thus derives a substantial portion of its revenues from an exclusive contract with the Airlines Reporting Corporation ("ARC"). The Company is compensated on a "cost plus" basis under this contract which expires in December 2001. Revenues from corporate services are derived from transaction fees for the processing of remittances, accounts payable and freight bills and for providing integrated document solutions involving electronic imaging, archival, processing and payment settlement. The business segments are identified by the services they offer. The accounting policies of the reportable segments are the same as those described in Note A.
The reported results reflect the underlying economics of the segments. Indirect general and administrative expenses are allocated to the segments based upon various methods determined by the nature of the expenses. There are no intersegment revenues. The corporate entity reflects the restructuring charges taken in the first quarter and fourth quarter of 1997 for severance pay and other costs related to organizational restructuring.
The following represent reconciliations of the Company's reportable segment operating profit to the consolidated operating profit and the Company's reportable segment net operating assets to consolidated net operating assets.
Depreciation expense for certain corporate fixed assets is allocated to the three segments.
Corporate assets at December 31, 1997 were reduced by the restructuring related liabilities recorded in the first and fourth quarters of 1997 as well as the Acquisition Balance Due to Financial Alliance of approximately $26.8 million.
Revenues from foreign operations in 1998, primarily Barbados, were approximately $50.7 million. Revenues from foreign operations were immaterial in 1997 and 1996. The net book value of foreign long-lived assets, primarily in Juarez, Mexico, were approximately $12.1 million and $7.8 million at December 31, 1998 and 1997, respectively.
Segment information for 1996 has not been presented as it was impractical to do so.
O. Subsequent Events (Unaudited)
In November 1998, the Company formalized a plan to restructure its Barbados facility. As of December 31, 1998, the Company has expensed approximately $262,000 related to the restructuring. In the first quarter of 1999, the Company expects to record approximately $1.3 million in severance charges related to the Barbados restructuring.
In February 1999, the Company entered into an agreement with Investment Services International Co., LLC to sell its payables and freight business lines for approximately $37 million in cash. In addition, in March 1999, the Company adopted a formal plan to either sell or discontinue the check and remittance business lines. Under the provisions of FASB statement 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of, the Company expects to record an impairment loss of approximately $60-$70 million in the first quarter of 1999 related to these business lines. NATIONAL PROCESSING, INC. PART IV ITEM 14: EXHIBIT INDEX