While there continues to be no guarantee as to the timing or extent of accelerating adoption of electronic billing and payment services, we believe that with our continued efforts toward improved product and service quality, customer satisfaction and cost efficiency, we are better positioned to maintain our market leadership position throughout an accelerated growth cycle, should it occur.
INVESTMENT SERVICES. Revenue in our Investment Services business increased modestly by $0.4 million, or 2%, from $20.0 million for the three months ended March 31, 2002, to $20.4 million for the three months ended March 31, 2003, and increased by $1.8 million, or 3%, from $59.1 million for the nine months ended March 31, 2002, to $60.9 million for the nine months ended March 31, 2003. The total number of portfolios managed has remained relatively flat at approximately 1.2 million quarter over quarter and year over year. Current revenue growth has not matched historical performance as the depressed stock market has had a direct impact on our ability to grow revenue in this business. Our pricing is based primarily on portfolios managed versus assets under management, and portfolio additions continue to be offset by investors reducing stock holdings. Additionally, we have focused on leveraging our economies of scale leadership to secure multi-year contract extensions with certain customers. As a result, we anticipate experiencing similar revenue growth into our fourth fiscal quarter and beyond, until stock market performance improves.
Operating income in our Investment Services business, net of purchase accounting amortization, has decreased by $1.2 million, or 18%, from $6.9 million for the three months ended March 31, 2002, to $5.6 million for the three months ended March 31, 2003, and decreased by $1.4 million, or 8%, from $17.7 million for the nine months ended March 31, 2002, to $16.3 million for the nine months ended March 31, 2003. The decline in operating income is due to investment spending on new product offerings and quality improvement initiatives in anticipation of a positive turn in the economy. Throughout fiscal 2003, key initiatives in our Investment Services business include:
- new product offerings (e.g., Multiple Strategy Portfolios)
with a shortened time to market;
- additional web-based products with increased functionality and
ease of use;
- build out of relationship-based service offerings in our
operations; and
- initiation of a Sigma program designed to improve quality.
SOFTWARE. Revenue in our Software business has increased by $1.5 million, or 10%, from $14.8 million for the three months ended March 31, 2002, to $16.3 million for the three months ended March 31, 2003, and increased by $3.5 million, or 8%, from $43.2 million for the nine months ended March 31, 2002, to $46.8 million for the nine months ended March 31, 2003. The downturn in the economy throughout fiscal 2002 and continuing into 2003 has caused many businesses to curtail discretionary expenditures, which has resulted in an overall dampening of demand for licensed software solutions. While our newer i-Solutions electronic statement and billing software has been impacted most, short-term demand for our reconciliation and ACH processing licenses has been impacted as well. However, during the quarter ended December 31, 2002, we began work on a consulting services agreement with a large bank customer in our ACH business unit that provided greater than normal consulting revenue over the past two quarters. Resulting services revenue was the driving factor behind growth in the Software segment. The services engagement will continue through the remainder of fiscal 2003, but we believe that software license sales in general will continue to be challenging until economic conditions improve.
Operating income in our Software business, net of purchase accounting amortization, has increased from $2.5 million for the three months ended March 31, 2002, to $5.1 million for the three months ended March 31, 2003, and increased from $3.2 million for the nine months ended March 31, 2002, to $12.1 million for the nine months ended March 31, 2003. On March 19, 2002, we announced a company-wide reorganization that resulted in a net reduction in staff. As part of these actions, we announced the closing of our Ann Arbor office. In addition to the recurring savings that resulted from these actions, improvements in operating income are also the result of continued efforts to closely manage discretionary expenses in light of economic conditions.
CORPORATE. Our Corporate segment represents expenses for legal, human resources, finance and other various unallocated overhead expenses. In Corporate, we incurred operating expenses of $8.0 million, or 6% of total revenue, for the three months ended March 31, 2002, and operating expenses of $8.3 million, or 6% of total revenue, for the three months ended March 31, 2003. We incurred operating expenses of $27.4 million, or 8% of total revenue, for the nine months ended March 31, 2002, and $24.5 million, or 6% of total revenue, for the nine months ended March 31, 2003. We continue to closely manage our corporate expenses, resulting in expected leverage in overhead costs.
PURCHASE ACCOUNTING AMORTIZATION. The purchase accounting amortization line represents amortization of intangible assets resulting from all of our various acquisitions from 1996 forward. The total amount of purchase accounting amortization has decreased from $90.3 million for the three months ended March 31, 2002, to $46.0 million for the three months ended March 31, 2003, and from $304.7 million for the nine month period ended March 31, 2002, to $138.3 million for the nine months ended March 31, 2003. In July 2002, we adopted SFAS 142, "Goodwill and Other Intangible Assets." Upon adoption, goodwill is no longer subject to amortization over its estimated useful life. Instead, goodwill is subject to at least an annual assessment for possible impairment. All other intangible assets, such as acquired technology, strategic agreements, trade names, and the like, will continue to be amortized over their respective useful lives. For comparative purposes, the following table breaks out the intangible asset amortization by segment:
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
------------------------------------ ----------------------------------
2002 2003 2002 2003
---------------- ---------------- -------------- ---------------
(In thousands)
Electronic Commerce..................... $ 85,254 $ 43,757 $ 273,974 $ 131,271
Investment Services..................... 1,576 578 4,260 2,068
Software................................ 3,463 1,655 26,487 4,965
---------------- ---------------- -------------- ---------------
Total............................... $ 90,293 $ 45,990 $ 304,721 $ 138,304
================ ================ ============== ===============
IMPAIRMENT OF INTANGIBLE ASSETS. In the quarter ended December 31, 2001, we recorded charges totaling $155.1 million for the impairment of intangible assets. This was the combined result of a charge of $107.4 million for the impairment of goodwill associated with our acquisition of BlueGill Technologies in April 2000 (currently referred to as CheckFree i-Solutions), and of $47.7 million for the retirement of certain technology assets we acquired from TransPoint in September 2000. Please refer to Impairment of Intangible Assets in the Results of Operations section of this report for a detailed explanation of these charges.
REORGANIZATION CHARGE. In January 2002, we announced our plans to close our customer care facility in San Francisco, California, effective April 30, 2002, which resulted in the termination of employees at that facility. At that time we also announced our intent to eliminate certain of our financial planning products within our Investment Services division, which also resulted in a small reduction of employees in our Raleigh, North Carolina office. On March 19, 2002, we further announced the closing of our Houston, Austin, Ann Arbor, and Singapore offices, along with a net reduction in force totaling approximately 450 employees. As a result of these actions, we incurred a charge of $15.9 million consisting primarily of severance and related employee benefits and lease termination fees. We accounted for these actions in accordance with Emerging Issues Task Force (EITF) abstract number 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity." Since then, there has been no material change to the estimated total cost of these actions.
IMPACT OF WARRANTS. During the quarter ended June 30, 2002, we recorded a non-cash charge of $2.7 million against revenue resulting from the probable vesting of warrants issued to a third party. In the quarter ended September 30, 2002, the warrants actually vested. On the date of vesting, however, the fair value of our stock was lower than at June 30, 2002, when we calculated the initial charge. As a result, a true-up of the value of the warrants resulted in a credit to revenue of $0.6 million in the quarter ended September 30, 2002. The charge, and the true-up credit, were based on a Black-Scholes valuation of the warrants and were accounted for as a net charge to revenue in accordance with Emerging Issues Task Force ("EITF") 01-09, "Accounting for Consideration Given by a Vendor to a Customer."
LIQUIDITY AND CAPITAL RESOURCES
The following chart summarizes our Consolidated Statement of Cash Flows for the three and nine months ended March 31, 2003:
THREE MONTHS NINE MONTHS
ENDED ENDED
MARCH 31, 2003 MARCH 31, 2003
---------------- -----------------
(In thousands)
Net cash provided by (used in):
Operating activities......................................................... $ 44,865 $ 115,916
Investing activities......................................................... (17,420) (51,446)
Financing activities......................................................... 1,732 (1,530)
---------------- -----------------
Net increase in cash and cash equivalents....................................... $ 29,177 $ 62,940
================ =================
As of March 31, 2003, we have $231.3 million of cash, cash equivalents and short-term investments on hand, and an additional $135.7 million in long-term investments. Our balance sheet reflects a current ratio of 3.1 and related working capital of $225.0 million. Our board of directors has approved up to $40 million for the purpose of repurchasing shares of our common stock or repurchases of our convertible debt between now and August 2003. At this time, no such repurchases have taken place. We believe that existing cash, cash equivalents and investments will be sufficient to meet our presently anticipated requirements for the foreseeable future. To the extent that additional capital resources are required, we have access to an untapped $30.0 million line of credit.
For the nine months ended March 31, 2003, we generated $115.9 million of cash from operating activities. Of this amount, $44.9 million was generated in the quarter ended March 31, 2003, another $47.0 million in the quarter ended December 31, 2002, and the remaining $24.0 million in the quarter ended September 30, 2002. During our September quarter, we typically use a significant amount of cash for such things as payment of annual incentive compensation and commissions related to seasonally high sales from the previous quarter. As a result of efforts to improve our operating efficiency, we have been able to generate an increasing amount of cash from operating activities over the past several quarters.
From an investing perspective, we have used $51.4 million of cash during the nine months ended March 31, 2003. Of this amount, $28.1 million was used for the net purchase of investments and another $20.8 million was used for the purchase of property and equipment. The remaining $2.5 million is the net of a $3.1 million use of cash for the capitalization of software development costs, offset by $0.6 million in proceeds from the sale of fixed assets. We expect to spend approximately $30 million on purchases of property and equipment for the fiscal year ended June 30, 2003.
From a financing perspective, we have used $1.5 million of cash during the nine months ended March 31, 2003. Of this amount, $9.2 million was used for principal payments under capital leases and other long-term obligations. We have also received $7.7 million in combined proceeds from the exercise of employee stock options and the purchase of stock under our employee stock purchase plan.
While the timing of cash payments and collections can cause fluctuations from quarter to quarter and capital expenditure requirements could change, we expect to generate about $120.0 million of free cash flow for the fiscal year ended June 30, 2003. We define free cash flow as cash flow from operating activities less capital expenditures.
RECENT ACCOUNTING PRONOUNCEMENTS
In August 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") 143, "Accounting for Asset Retirement Obligations." SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated retirement costs. We adopted SFAS 143 as of July 1, 2002. The adoption of this statement had no impact on our results of operations or financial position for the nine months ended March 31, 2003.
On July 1, 2002, we adopted SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS 144 superseded SFAS 121, "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and the accounting and reporting provisions of Accounting Principles Board ("APB") Opinion 30, "Reporting Results of Operations - Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" for the disposal of a segment of a business. SFAS 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. The adoption of this statement had no impact on our results of operations or financial position for the nine months ended March 31, 2003.
In April 2002, the FASB issued SFAS 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." This statement eliminates the current requirement that gains and losses on extinguishment of debt must be classified as extraordinary items in the income statement. Instead, the statement requires that gains and losses on extinguishment of debt be evaluated against the criteria in APB Opinion 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" to determine
whether or not it should be classified as an extraordinary item. In addition, the statement contains other corrections to authoritative accounting literature in SFAS 4, 44 and 64. The changes in SFAS 145 related to debt extinguishment are effective for our 2003 fiscal year and the other changes were effective beginning with transactions after May 15, 2002. In August 2002, we announced that our board of directors had authorized a repurchase program under which we may purchase up to $40 million of shares of our common stock and convertible notes. Should we purchase any of our convertible notes and realize a gain or loss on the transaction, SFAS 145 will require us to evaluate the transaction against the criteria in APB Opinion 30 to determine if the gain or loss should be classified as an extraordinary item. If classification as an extraordinary item is not appropriate, the gain or loss would be included as part of income before income taxes. We have not purchased any of our convertible notes and therefore adoption of this statement has had no impact on our results of operations or financial position during the nine months ended March 31, 2003.
In June 2002, the FASB issued SFAS 146, "Accounting for Costs Associated with Exit or Disposal Activities," which addresses accounting for reorganization and similar costs. SFAS 146 supersedes previous accounting guidance, principally Emerging Issues Task Force ("EITF") 94-03, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)". SFAS 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF 94-03, a liability for an exit cost was recognized at the date of a company's commitment to an exit plan. SFAS 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS 146 may affect the timing of recognizing any future reorganization costs as well as the amount recognized. The provisions of SFAS 146 were effective for reorganization activities initiated after December 31, 2002 and we have had no such activities since that time.
In November 2002, the EITF reached a consensus on Issue 00-21, "Multiple Deliverable Revenue Arrangements." EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. It also addresses when and how an arrangement involving multiple deliverables should be divided into separate units of accounting. The guidance in EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003, with early application permitted. Companies may elect to report the change in accounting as a cumulative effect of a change in accounting principle in accordance with APB Opinion 20, "Accounting Changes" and SFAS 3, "Reporting Accounting Changes in Interim Financial Statements (an amendment of APB Opinion No. 28)." We are in the process of evaluating the effects of EITF 00-21.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). This interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. We had no significant guarantees we were required to disclose under FIN 45. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002.
In December 2002, the FASB issued SFAS 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an Amendment of FASB Statement No. 123," which provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. SFAS 148 requires prominent disclosure about the effects on reported net income of an entity's accounting policy decisions with respect to stock-based employee compensation and amends APB Opinion 28, "Interim Financial Reporting," to require disclosure about those effects in interim financial information. We have included the required disclosure, including comparisons to the same periods in the prior year, in the Notes to Unaudited Condensed Consolidated Unaudited Financial Statements elsewhere in this report.
In April 2003, the FASB issued SFAS 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities," which amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS 149 is effective for contracts entered into or modified after June 30, 2003. We are in the process of evaluating any effects of this new statement.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Critical accounting policies are those policies that are both important to the portrayal of our financial condition and results of operations, and that require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. In our June 30, 2002 annual report, we described the policies and estimates relating to intangible assets, equity instruments issued to customers and deferred income taxes as our critical accounting policies. As of July 1, 2002, we adopted SFAS 142, "Goodwill and Other Intangible Assets." Goodwill has always been considered an intangible asset and therefore our critical accounting policy related to intangible assets has included goodwill. However, as a result of SFAS 142, there are now unique accounting guidelines related specifically to goodwill. Goodwill is no longer subject to amortization over its estimated useful life. Rather it is now subject to at least an annual assessment for impairment by applying a fair-value-based test. Due to the complex judgments required by management in such an impairment evaluation, we have added Accounting for Goodwill as a separate and distinct critical accounting policy effective July 1, 2002. The addition of Accounting for Goodwill as a critical accounting policy was discussed with the audit committee of our board of directors by our senior financial management team.
Accounting for Goodwill. Upon adoption of SFAS 142, we were required to perform a transitional impairment test related to our goodwill balances. We performed the test as of July 1, 2002. The impairment test required us to (1) identify our various reporting units, (2) determine the carrying value of each reporting unit by assigning assets and liabilities, including existing goodwill and intangible assets, to those reporting units, and (3) determine the fair value of each reporting unit. If we determined the carrying value of a reporting unit exceeded its fair value, additional testing was required to see if the goodwill carried on the balance sheet was impaired. The amount of any goodwill impairment was determined through an analysis similar to that of a purchase price allocation, where the fair value of each of the tangible and intangible assets (excluding goodwill) and liabilities was compared to the fair value of the reporting unit. The fair value of goodwill was estimated using the residual method and compared to the carrying value of goodwill. The amount of the goodwill impairment was equal to the carrying amount less the fair value of goodwill. We determined two of our reporting units to correlate directly with our Electronic Commerce and our Investment Services business segments. Although our i-Solutions Software division has the same operating characteristics of our other Software divisions, because it is a fairly new product and therefore not as mature as our other Software units, we split our software segment into two reporting units, i-Solutions Software and CFACS/ACH Software.
We applied significant judgment in determining the fair value of each of our reporting units as such an analysis includes projections of expected future cash flow related specifically to the reporting unit. Our projections included, but were not limited to, expectations of product sales and related revenues, cost of sales, and other operating expenses supporting the reporting unit five years into the future. Additionally, we estimated terminal values for the reporting units, which represented the present value of future cash flow beyond the five-year period. Finally, we assumed a discount rate that we believed fairly represented the risk-free rate and a risk premium appropriate for the reporting unit. Upon completion of this analysis, only one reporting unit, i-Solutions Software, had a carrying value exceeding its fair value. This indicated the possibility of goodwill impairment within the i-Solutions Software reporting unit. For our Electronic Commerce, Investment Services, and ACH/CFACS Software reporting units, we determined that a 10% fluctuation in our underlying value drivers, either positive or negative, would not have indicated a possible impairment in goodwill within the respective reporting unit that would have resulted in additional transition testing.
As a result of the possible impairment of the i-Solutions reporting unit goodwill, we took the next step in the transitional impairment test and assigned fair value to each of the individual assets and liabilities of the reporting unit. We applied significant judgment in determining the fair value of each identified intangible asset as such an analysis includes projections of expected future cash flows related specifically to the intangible asset. The fair value of the i-Solutions reporting unit was estimated using a combination of the cost, market, and income approaches.
Specifically, the discounted cash flow and market multiples methodologies were utilized to determine the fair value of the reporting unit by estimating the present value of future cash flows of the reporting unit along with reviewing revenue and earnings multiples for comparable publicly traded companies and applying these to the reporting unit's projected cash flows. Fair value of each of the assigned assets and liabilities was determined using either a cost, market or income approach, as appropriate, for each individual asset or liability. Upon completion of the analysis, we determined the goodwill associated with the i-Solutions Software reporting unit to be impaired by $2.9 million and we recorded this charge as a cumulative effect of an accounting change in the three-month period ended September 30, 2002. We performed a sensitivity analysis and determined that a 10% decrease in the underlying estimates driving the fair value of intangible assets would have increased the impairment charge to approximately $4.2 million. An increase of 10% in the underlying estimates driving the fair value of intangible assets would have decreased the impairment charge to approximately $2.1 million.
We plan on performing our annual evaluation of possible impairment of goodwill balances during the quarter ending June 30, 2003.
INFLATION
We believe the effects of inflation have not had a significant impact on our results of operations.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Except for the historical information contained herein, the matters discussed in this Quarterly Report on Form 10-Q include certain forward-looking statements within the meaning of Section 27A of the Securities Act, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. Those statements include, but may not be limited to, all statements regarding management's intent, belief and expectations, such as statements concerning our future profitability, and our operating and growth strategy. Investors are cautioned that all forward-looking statements involve risks and uncertainties including, without limitation, the factors set forth under the caption "Business - Business Risks" in the Annual Report on Form 10-K for the year ended June 30, 2002, and other factors detailed from time to time in our filings with the Securities and Exchange Commission. One or more of these factors have affected, and in the future could affect, our businesses and financial results in the future and could cause actual results to differ materially from plans and projections. Although we believe that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate. Therefore, there can be no assurance that the forward-looking statements included in this Quarterly Report will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as representations by us or any other person that our objectives and plans will be achieved. All forward-looking statements made in this Quarterly Report are based on information presently available to our management. We assume no obligation to update any forward-looking statements contained herein.
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