NATIONAL PROCESSSING, INC. FORM 10-Q
TABLE OF CONTENTS

NATIONAL PROCESSING, INC.
INDEX
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statement of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosure About Market Risk
Part II — Other Information
SIGNATURES
EX-10.42 US ASSET PURCHASE AGREEMENT
EX-10.43 MEXICO ASSET PURCHASE AGREEMENT
EX-10.44 STOCK PURCHASE AGREEMENT
EX-10.45 LIMITED LIABILITY COMPANY AGREEMENT

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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

     
/X/ Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange of 1934
 
For the quarterly period ended June 30, 2001
 
or
 
/ / Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from________________to___________

Commission File Number: 1-11905

National Processing, Inc.
(Exact name of Registrant as specified in its charter)

     
Ohio 61-1303983
(State or other jurisdiction
of incorporation or organization)		 (I.R.S. Employer Identification No.)
 
1231 Durrett Lane
Louisville, Kentucky		 40213-2008
(Address of principal executive offices) (Zip Code)

(502) 315-2000
(Registrant’s telephone number, including area code)

      Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES    X    NO       

The number of shares outstanding of the Registrant’s Common Stock as of July 31, 2001 was 51,342,187.

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NATIONAL PROCESSING, INC.

INDEX

                 
Part I Financial Information
                 
Page No.
Item 1. Consolidated Financial Statements (unaudited)
 
Consolidated Balance Sheets — June 30, 2001 and December 31, 2000 3
 
Consolidated Statements of Income — Three and Six Months Ended June 30, 2001 and 2000 4
 
Consolidated Statement of Changes in Shareholders’ Equity — Six Months Ended June 30, 2001 5
 
Consolidated Statements of Cash Flows — Six Months Ended June 30, 2001 and 2000 6
 
Notes to Consolidated Financial Statements 7
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 11
 
Item 3. Quantitative and Qualitative Disclosure About Market Risk 17
 
Part II Other Information
 
Item 1. Legal Proceedings (None)
 
Item 2. Changes in Securities and Use of Proceeds (None)
 
Item 3. Defaults Upon Senior Securities (None)
 
Item 4. Submission of Matters to a Vote of Security Holders 18
 
Item 5. Other Information (None)
 
Item 6. Exhibits and Reports on Form 8-K 18
 
Signatures 19

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National Processing, Inc.
Consolidated Balance Sheets
Unaudited
(Dollars in thousands)
                   
June 30 December 31
2001 2000
Assets
Current assets:
Cash and cash equivalents $ 144,670 $ 68,590
Eurodollar deposits — 56,000
Accounts receivable — trade 83,230 128,627
Restricted deposits — customer funds 36,071 31,543
Deferred tax assets 1,785 2,283
Other current assets 7,517 9,901
Assets held for sale (Note 3) 38,869 —
Total current assets 312,142 296,944
Property and equipment:
Furniture and equipment 51,366 69,417
Building and leasehold improvements 11,025 19,231
Software 24,060 24,418
Property leased from affiliate 4,173 4,173
Land and improvements 442 2,390
91,066 119,629
Less: Accumulated depreciation and amortization 46,100 58,675
Property and equipment, net 44,966 60,954
Other assets:
Goodwill, net of accumulated amortization of $6,698 in 2001 and $6,939 in 2000 92,563 79,399
Other intangible assets 45,630 29,697
Deferred tax assets 18,570 4,149
Other assets 6,406 6,328
Total other assets 163,169 119,573
Total assets $ 520,277 $ 477,471
Liabilities and shareholders’ equity
Current liabilities:
Restricted deposits — customer funds $ 36,071 $ 31,543
Accounts payable — trade 13,578 15,243
Accrued bankcard assessments 23,131 24,458
Income tax payable 15,145 7,865
Other accrued liabilities 21,065 33,630
AAMS purchase price payable (Note 4) 48,500 —
Total current liabilities 157,490 112,739
Obligation under property leased from affiliate 1,927 1,993
Deferred tax liabilities 2,271 1,181
Total liabilities 161,688 115,913
Shareholders’ equity:
Preferred stock, without par value; 5,000,000 shares authorized; no shares issued or outstanding — —
Common stock, without par value; 95,000,000 shares authorized; 51,293,029 and 50,935,460 shares issued and outstanding in 2001 and 2000, respectively 1 1
Contributed capital 184,903 178,729
Retained earnings 173,685 182,828
Total shareholders’ equity 358,589 361,558
Total liabilities and shareholders’ equity $ 520,277 $ 477,471

See notes to consolidated financial statements

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National Processing, Inc.
Consolidated Statements of Income
Unaudited
(In thousands, except per share amounts)
                                 
Three Months Ended Six Months Ended
June 30 June 30
2001 2000 2001 2000
Revenue $ 117,876 $ 104,513 $ 226,921 $ 202,380
Operating expense 84,606 76,108 166,464 147,217
General and administrative expense 7,083 6,224 12,658 13,976
Depreciation and amortization 5,184 5,325 10,364 10,700
Impairment, restructuring, and related expense 6,250 1,500 6,250 1,500
Operating profit 14,753 15,356 31,185 28,987
Net interest income 1,893 1,878 4,113 3,693
Income before provision for income taxes 16,646 17,234 35,298 32,680
Provision for income taxes 8,728 6,758 15,841 12,656
Net income $ 7,918 $ 10,476 $ 19,457 $ 20,024
Basic income per common share $ 0.15 $ 0.21 $ 0.38 $ 0.39
Diluted income per common share $ 0.15 $ 0.21 $ 0.38 $ 0.39

See notes to consolidated financial statements

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National Processing, Inc.
Consolidated Statement of Changes in Shareholders’ Equity
Unaudited
(In thousands)
                                         
Common Common Contributed Retained
Shares Stock Capital Earnings Total
Balance at January 1, 2001 50,935,460 $ 1 $ 178,729 $ 182,828 $ 361,558
Net income — — — 19,457 19,457
Common control business unit purchase (Note 4) — — — (28,600 ) (28,600 )
Issuance of common shares under stock-based compensation plans, including related tax effects 357,569 — 6,174 — 6,174
Balance at June 30, 2001 51,293,029 $ 1 $ 184,903 $ 173,685 $ 358,589

See notes to consolidated financial statements

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National Processing, Inc.
Consolidated Statements of Cash Flows
Unaudited
(In thousands)
                     
Six Months Ended
June 30
2001 2000
Operating Activities
Net income $ 19,457 $ 20,024
Items not requiring cash currently:
Depreciation and amortization 10,364 10,700
Impairment, restructuring and related expenses 6,250 1,500
Deferred income taxes 2,567 792
Loss on disposition of fixed assets 33 16
Change in current assets and liabilities:
Accounts receivable – trade 33,871 26,798
Accounts payable – trade (1,033 ) (1,238 )
Accrued bankcard assessments (1,327 ) (1,320 )
Income taxes payable 8,101 (11,653 )
Other current assets/liabilities (9,665 ) (2,049 )
Other, net (80 ) (672 )
Net cash provided by operating activities 68,538 42,898
Investing Activities
Capital expenditures (8,931 ) (6,197 )
Proceeds from sales of fixed assets 34 75
Purchases of Eurodollar deposits — (76,000 )
Proceeds from maturities of Eurodollar deposits 56,000 40,000
Common control business unit purchase (44,000 ) —
Other investing activities — (2,000 )
Net cash provided by (used in) investing activities 3,103 (44,122 )
Financing Activities
Principal payments under property leased from affiliate (66 ) (65 )
Issuance of common stock 4,505 341
Net cash provided by financing activities 4,439 276
Net increase (decrease) in cash and cash equivalents 76,080 (948 )
Cash and cash equivalents, beginning of period 68,590 32,042
Cash and cash equivalents, end of period $ 144,670 $ 31,094
Supplemental cash flow information:
Taxes paid $ 9,197 $ 21,905

See notes to consolidated financial statements

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NATIONAL PROCESSING, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Unaudited
     
1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES
 
     The consolidated financial statements include the accounts of National Processing, Inc. and its subsidiaries (the Company). All significant intercompany transactions and balances have been eliminated. The accounting and reporting policies of the Company conform with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. For the interim periods presented, management believes the unaudited consolidated financial statements reflect all adjustments of a normal recurring nature and disclosures which are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period. The Company experiences seasonality in its businesses and typically realizes higher revenue in the third and fourth quarters, reflecting increased transaction volume in the summer and holiday months.
 
     Although the balance sheet at December 31, 2000 has been derived from the audited consolidated financial statements at that date, the accompanying interim consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States. These interim financial statements should be read in conjunction with the Company’s 2000 Annual Report on Form 10-K.
 
     Certain 2000 amounts have been reclassified to conform with the 2001 presentation.
 
2. DIVESTED BUSINESS UNITS AND NONRECURRING ITEMS
 
     In June 2001, the Company committed to a formal plan to dispose of its Business Process Outsourcing (BPO) business units. These business units primarily process healthcare claims, credit card applications, and airline lift tickets. In conjunction with the formal plan of disposal in June 2001 the Company recorded a $6.3 million pre-tax charge primarily related to an impairment associated with the divestiture. The charge totaled $6.2 million, after-tax, or $0.12 per share. On July 11, 2001 the Company signed a definitive agreement with Affiliated Computer Services (ACS), whereby ACS will acquire the BPO business units for $43 million in cash. This transaction is expected to close in August 2001.
 
     In the second quarter of 2000, a pre-tax charge of $1.5 million was recorded for site consolidation initiatives related to the BPO business units. The charge totaled $1.0 million after-tax, or $0.02 per share, and related primarily to the write-off of leasehold improvements and the accrual of future contractual rent payments on abandoned facilities.

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     Divested business units also include the Company’s Springfield remittance operation sold in August 2000 and the Denver collections operation discontinued in March 2001.
 
     For the three months ended June 30, 2001 and 2000, the divested business units had revenue of $15.3 million and $19.4 million, respectively, and operating profit (loss) of $(5.1) million and $0.8 million, respectively. For the six months ended June 30, 2001 and 2000, the divested business units had revenue of $31.4 million and $37.3 million, respectively, and operating profit (loss) of $(3.8) million and $2.3 million, respectively. Operating profit (loss) includes impairment and restructuring charges related to the divested business units totaling $6.3 million in the second quarter of 2001 and $1.5 million in the second quarter of 2000.
 
     The effective tax rates for the three and six months ended June 30, 2001 were 52.4% and 44.9%, respectively. The effective tax rates were higher than prior year due to additional provisions related to the sale of the BPO business units. These additional provisions were for nondeductible losses, repatriation of previously untaxed earnings in foreign countries, and dividends from foreign subsidiaries.
 
3. ASSETS HELD FOR SALE
 
     At June 30, 2001, assets held for sale totaled $38.9 million related to the divestiture of the BPO business units. These assets have been classified as current assets on the consolidated balance sheet and are summarized as follows (in thousands):
         
Accounts receivable $ 11,526
Other current assets 412
Property and equipment, net 18,249
Goodwill, net 9,602
Other intangible assets, net 2,740
Account payable — trade (632 )
Other accrued liabilities (3,028 )
Total net assets $ 38,869
     
4. ACQUISITIONS
 
     On June 28, 2001, the Company acquired a 70 percent interest in ABN AMRO Merchant Services, LLC (AAMS) for $48.5 million, which was settled on July 2, 2001 using existing cash balances. Under the terms of the agreement, the Company will provide AAMS with all merchant-processing services including both authorization and settlement of all card-based transactions. The Company expects AAMS to generate approximately $38 million in annual revenue. The acquisition, accounted for as a purchase, increased the Company’s goodwill by approximately $27 million, to be amortized on a straight-line basis over 20 years. The remainder of the purchase price was allocated to other identifiable intangibles, primarily acquired merchant contracts, which are being amortized on a straight-line basis over 10 years. The results of operations of AAMS have been included in the consolidated financial statements since the date of its acquisition.

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     On January 8, 2001, the Company purchased the merchant services business units from several of National City Corporation’s (National City) banking subsidiaries for $44.0 million in cash. This acquisition included merchant contracts and additional sales personnel. National Processing also assumed responsibility for all merchant processing sales efforts throughout National City’s 1,200 branch network via an exclusive multi-year marketing agreement. The Company already provided the authorization and settlement processing for these merchants via a third party processing contract with National City. For the three and six months ended June 30, 2001, the Company recorded $3.8 million and $7.9 million, respectively, of incremental revenue as a result of this acquisition. The acquisition was accounted for as a transaction among entities under common control and was recorded at the historical cost bases of National City. The excess of the cash paid over the historical cost bases was recorded as a reduction in shareholders’ equity, net of income taxes. The results of operations of the National City merchant services business units have been included in the consolidated financial statements since the date of acquisition.
 
5. 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.
 
6. NET INCOME PER COMMON SHARE
 
     The calculation of net income per common share follows (in thousands, except per share amounts):
                                   
Three Months Ended Six Months Ended
June 30 June 30
2001 2000 2001 2000
BASIC
Net income $ 7,918 $ 10,476 $ 19,457 $ 20,024
Average common shares outstanding 51,255 50,799 51,107 50,792
Net income per common share – basic $ 0.15 $ 0.21 $ 0.38 $ 0.39
DILUTED
Net income $ 7,918 $ 10,476 $ 19,457 $ 20,024
Average common shares outstanding 51,255 50,799 51,107 50,792
Stock option adjustment 798 166 703 106
Average common shares outstanding – diluted 52,053 50,965 51,810 50,898
Net income per common share – diluted $ 0.15 $ 0.21 $ 0.38 $ 0.39
     
7. SEGMENT REPORTING
 
     The Company operates two business segments – Merchant Card Services and Corporate Outsourcing Solutions. Merchant Card Services authorizes, processes, and settles credit and debit card transactions. Corporate Outsourcing Solutions provides financial settlement, image scanning, data capture, storage and retrieval, and value-added customer reporting services.
 
     The accounting policies of the reportable segments are the same as those of the Company. Prior period amounts have been classified to conform to the current line of business reporting structure.

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     General and administrative expense is allocated to the segments based upon various methods determined by the nature of the expenses. There are no intersegment revenues. Depreciation and amortization expense for corporate fixed assets is allocated to the segments. Corporate net operating assets are comprised primarily of cash, Eurodollar deposits, and income tax balances.
 
(Dollars in thousands)
                                 
Merchant Corporate
Card Outsourcing Consolidated
Services Solutions Corporate Total
For the three months ended June 30, 2001
Revenue $ 95,364 $ 22,512 $ — $ 117,876
Impairment, restructuring and related expense — 6,250 — 6,250
Operating profit (loss) 18,646 (3,893 ) — 14,753
Depreciation and amortization 3,527 1,657 — 5,184
Net interest income 1,664 229 — 1,893
Net operating assets 146,919 49,315 162,355 358,589
For the three months ended June 30, 2000
Revenue $ 76,104 $ 28,409 $ — $ 104,513
Impairment, restructuring and related expense — 1,500 — 1,500
Operating profit 12,195 3,161 — 15,356
Depreciation and amortization 3,372 1,953 — 5,325
Net interest income 1,364 514 — 1,878
Net operating assets 103,004 51,001 182,766 336,771
 
 
Merchant Corporate
Card Outsourcing Consolidated
Services Solutions Corporate Total
For the six months ended June 30, 2001
Revenue $ 180,704 $ 46,217 $ — $ 226,921
Impairment, restructuring and related expense — 6,250 — 6,250
Operating profit (loss) 32,249 (1,064 ) — 31,185
Depreciation and amortization 7,019 3,345 — 10,364
Net interest income 3,481 632 — 4,113
Net operating assets 146,919 49,315 162,355 358,589
For the six months ended June 30, 2000
Revenue $ 147,015 $ 55,365 $ — $ 202,380
Impairment, restructuring and related expense — 1,500 — 1,500
Operating profit 22,856 6,131 — 28,987
Depreciation and amortization 6,743 3,957 — 10,700
Net interest income 2,783 910 — 3,693
Net operating assets 103,004 51,001 182,766 336,771
     
8. RECENT ACCOUNTING PRONOUNCEMENTS
 
     In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting, and broadens the criteria for recording intangible assets separate from goodwill. The provisions of SFAS No. 142 are effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests in accordance with the Statements. Other intangible assets will continue to be amortized over their useful lives. During 2002, the Company will perform the first of the required impairment tests of goodwill and indefinite lived intangible assets as of January 1, 2002 and has not yet determined what the effect of these tests will be on the earnings and financial position of the Company.

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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

Components of Revenue and Expenses

      Revenue.

      The Company’s Merchant Card Services revenue is primarily derived from fees paid by merchants for the authorization, processing and settlement of credit and debit card transactions. Fees are earned either on a “per transaction” basis or on a “discount” basis, which is a percent of dollar volume processed. Revenue is recorded net of interchange fees charged by the credit card associations as such costs are not controlled by the Company.

      Corporate Outsourcing Solutions revenue is generated from a variety of financial and administrative processing solutions provided to customers. These solutions include financial settlement, image scanning, data capture, storage and retrieval, and value-added customer reporting. A portion of Corporate Outsourcing Solutions revenue is earned from an exclusive long-term contract with the Airlines Reporting Corporation under which the Company is compensated on a “cost-plus” basis.

      A small portion of total revenue is derived from earnings on customer cash balances, which are maintained pursuant to contractual terms.

      Expenses.

      Expenses include costs of providing services to customers including wages and personnel costs, assessment fees, authorization fees, data processing costs, and general and administrative expenses.

Results of Operations

      The Company’s operating results are presented below in the manner in which they are viewed by management. The Company has exited or committed to divest certain business units during 2000 and 2001 in order to focus on its core business lines which are those that perform electronic payment settlement. Accordingly, the segment results presented below segregate the operating performance for the remaining core business lines from those that were exited or will be exited. The segment operating results as shown below exclude certain nonrecurring items. Certain prior year amounts have been reclassified to conform with the 2001 presentation.

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Three Months Ended June 30, 2001 Compared to Three Months Ended June 30, 2000

                                                         
2001 2000 Change
% of % of
(Dollars in thousands) Amount Revenue Amount Revenue Amount %
Revenue:
Merchant Services $ 95,364 81 $ 76,104 73 $ 19,260 25
Corporate Outsourcing Solutions 7,179 6 8,996 9 (1,817 ) (20 )
Total Core Revenue 102,543 87 85,100 81 17,443 20
Divested Business Lines 15,333 13 19,413 19 (4,080 ) (21 )
Total Revenue 117,876 100 104,513 100 13,363 13
Expenses:
Merchant Services 76,718 80 63,909 84 12,809 20
Corporate Outsourcing Solutions 5,968 83 6,645 74 (677 ) (10 )
Core Operating Expenses 82,686 81 70,554 83 12,132 17
Divested Business Lines 14,187 93 17,103 88 (2,916 ) (17 )
Total Expenses 96,873 82 87,657 84 9,216 11
Operating Profit:
Merchant Services 18,646 20 12,195 16 6,451 53
Corporate Outsourcing Solutions 1,211 17 2,351 26 (1,140 ) (48 )
Total Core Operating Profit 19,857 19 14,546 17 5,311 37
Divested Business Lines 1,146 7 2,310 12 (1,164 ) (50 )
Total Operating Profit 21,003 18 16,856 16 4,147 25
Net Interest Income 1,893 2 1,878 2 15 1
Income Before Taxes and Nonrecurring Items 22,896 19 18,734 18 4,162 22
Nonrecurring Items:
Impairment, Restructuring and Related Expenses (6,250 ) (5 ) (1,500 ) (1 ) (4,750 ) NM
Income Before Taxes 16,646 14 17,234 16 (588 ) (3 )
Provision for Income Taxes 8,728 7 6,758 6 1,970 29
Net Income $ 7,918 7 $ 10,476 10 $ (2,558 ) (24 )
NM — Not Meaningful
                                                       
2001 2000 Change
(Dollars in thousands, except per
share amounts) Amount % Amount % Amount %
Excluding Nonrecurring Items:
Pre-Tax Income $ 22,896 100 $ 18,734 100 $ 4,162 22
Taxes 8,828 39 7,283 39 1,545 21
Net Income $ 14,068 61 $ 11,451 61 $ 2,617 23
Per Share — Diluted $ 0.27 $ 0 .22 $ 0.05 20
Nonrecurring Items:
Pre-Tax Income (Loss) $ (6,250 ) 100 $ (1,500 ) 100 $ (4,750 ) NM
Taxes (100 ) 2 (525 ) 35 425 NM
Net Income (Loss) $ (6,150 ) 98 $ (975 ) 65 $ (5,175 ) NM
Per Share — Diluted $ (0.12 ) $ (0.02 ) $ (0.10 ) NM
Total:
Pre-Tax Income $ 16,646 100 $ 17,234 100 $ (588 ) (3 )
Taxes 8,728 52 6,758 39 1,970 29
Net Income $ 7,918 48 $ 10,476 61 $ (2,558 ) (24 )
Per Share — Diluted $ 0.15 $ 0.21 $ (0.06 ) (26 )

NM — Not Meaningful

Merchant Card Services

      Revenue for the three months ended June 30, 2001 increased 25% to $95.4 million from $76.1 million in 2000. Revenue increased primarily due to increases in transaction and dollar volume processed of 23% and 24%, respectively, and as a result the acquisition of National City’s merchant business units on January 8, 2001. This acquisition contributed $3.8 million of incremental revenue in the second quarter of 2001. The volume increases were primarily due to the addition of new national customers, strong execution in the regional sales channels, and continued expansion in new vertical markets.

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      Expenses for the three months ended June 30, 2001 increased 20% to $76.7 million from $63.9 million in 2000 primarily due to increased processing volume. Operating margins as a percentage of revenue increased to 20% from 16%, primarily due to economies of scale from increased volume and the addition of National City’s merchant business units. Operating profit for the quarter ended June 30, 2001 increased 53% to $18.6 million from $12.2 million in the 2000 second quarter due primarily to the factors outlined above.

Corporate Outsourcing Solutions

      Revenue for the core Corporate Outsourcing Solutions business lines for the three months ended June 30, 2001 decreased 20% to $7.2 million from $9.0 million in 2000. Revenue decreased primarily due to decreased volume from the Company’s Airlines Reporting Corporation contract.

      Expenses for the core Corporate Outsourcing Solutions business lines for the three months ended June 30, 2001 decreased 10% to $6.0 million from $6.6 million in 2000 due primarily to decreased volume and staff reductions. Operating profit for the quarter ended June 30, 2001 decreased 48% to $1.2 million from $2.4 million in the 2000 first quarter as a result of the items discussed above.

Divested Business Units and Nonrecurring Items

      In June 2001, the Company committed to a formal plan to dispose of its Business Process Outsourcing (BPO) business units. These business units primarily process healthcare claims, credit card applications, and airline lift tickets. In conjunction with the formal plan of disposal in June 2001 the Company recorded a $6.3 million pre-tax charge primarily related to an impairment associated with the divestiture. The charge totaled $6.2 million, after-tax, or $0.12 per share. On July 11, 2001 the Company signed a definitive agreement with Affiliated Computer Services (ACS), whereby ACS will acquire the BPO business units for $43 million in cash. This transaction is expected to close in August 2001.

      In the second quarter of 2000, a pre-tax charge of $1.5 million was recorded for site consolidation initiatives related to the BPO business units. The charge totaled $1.0 million after-tax, or $0.02 per share, and related primarily to the write-off of leasehold improvements and the accrual of future contractual rent payments on abandoned facilities.

      Divested business units also include the Company’s Springfield remittance operation sold in August 2000 and the Denver collections operation discontinued in March 2001.

      For the three months ended June 30, 2001 and 2000, the divested business units had revenue of $15.3 million and $19.4 million, respectively, and operating profit (loss) of $(5.1) million and $0.8 million, respectively. Operating profit (loss) includes impairment and restructuring charges related to the divested business units totaling $6.3 million in the second quarter of 2001 and $1.5 million in the second quarter of 2000.

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Net Interest Income

      Net interest income for the three months ending June 30, 2001, was $1.9 million consistent with prior year.

Provision for Income Taxes

      The overall effective tax rate for the second quarter of 2001 was 52.4% compared to 39.2% for the same quarter a year ago. The increase in the effective tax rate was due to additional provisions related to the sale of the BPO business units for nondeductible losses, repatriation of previously untaxed earnings in foreign countries, and dividends from foreign subsidiaries.

Six Months Ended June 30, 2001 Compared to Six Months Ended June 30, 2000

                                                         
2001 2000 Change
% of % of
(Dollars in thousands) Amount Revenue Amount Revenue Amount %
Revenue:
Merchant Services $ 180,704 80 $ 147,015 73 $ 33,689 23
Corporate Outsourcing Solutions 14,809 7 18,098 9 (3,289 ) (18 )
Total Core Revenue 195,513 86 165,113 82 30,400 18
Divested Business Lines 31,408 14 37,267 18 (5,859 ) (16 )
Total Revenue 226,921 100 202,380 100 24,541 12
Expenses:
Merchant Services 148,455 82 124,159 84 24,296 20
Corporate Outsourcing Solutions 12,027 81 14,262 79 (2,235 ) (16 )
Core Operating Expenses 160,482 82 138,421 84 22,061 16
Divested Business Lines 29,004 92 33,472 90 (4,468 ) (13 )
Total Operating Expenses 189,486 84 171,893 85 17,593 10
Operating Profit:
Merchant Services 32,249 18 22,856 16 9,393 41
Corporate Outsourcing Solutions 2,782 19 3,836 21 (1,054 ) (27 )
Total Core Operating Profit 35,031 18 26,692 16 8,339 31
Divested Business Lines 2,404 8 3,795 10 (1,391 ) (37 )
Total Operating Profit 37,435 16 30,487 15 6,948 23
Net Interest Income 4,113 2 3,693 2 420 11
Income Before Taxes and Nonrecurring Items 41,548 18 34,180 17 7,368 22
Nonrecurring Items:
Impairment, Restructuring and Related Expenses (6,250 ) (3 ) (1,500 ) (1 ) (4,750 ) NM
Income Before Taxes 35,298 16 32,680 16 2,618 8
Provision for Income Taxes 15,841 7 12,656 6 3,185 25
Net Income $ 19,457 9 $ 20,024 10 $ (567 ) (3 )
                                                       
2001 2000 Change
(Dollars in thousands, except per Amount % Amount % Amount %
share amounts)
 
Excluding Nonrecurring Items:
Pre-Tax Income $ 41,548 100 $ 34,180 100 $ 7,368 22
Taxes 15,941 38 13,181 39 2,760 21
Net Income $ 25,607 62 $ 20,999 61 $ 4,608 22
Per Share — Diluted $ 0.49 $ 0.41 $ 0.08 20
Nonrecurring Items:
Pre-Tax Income (Loss) $ (6,250 ) 100 $ (1,500 ) 100 $ (4,750 ) NM
Taxes (100 ) 2 (525 ) 35 425 NM
Net Income (Loss) $ (6,150 ) 98 $ (975 ) 65 $ (5,175 ) NM
Per Share — Diluted $ (0.12 ) $ (0.02 ) $ (0.10 ) NM
Total:
Pre-Tax Income $ 35,298 100 $ 32,680 100 $ 2,618 8
Taxes 15,841 45 12,656 39 3,185 25
Net Income $ 19,457 55 $ 20,024 61 $ (567 ) (3 )
Per Share — Diluted $ 0.38 $ 0.39 $ (0.01 ) (5 )

NM — Not Meaningful

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Merchant Card Services

      Revenue for the six months ended June 30, 2001 increased 23% to $180.7 million from $147.0 million in 2000. Revenue increased primarily due to increases of 25% in both transaction and dollar volume processed over the prior year and the acquisition of National City’s merchant business units on January 8, 2001. This acquisition contributed $7.9 million of incremental revenue for the first six months of 2001. The volume increases were primarily due to the addition of new national customers, strong execution in the regional sales channels, and continued expansion in new vertical markets.

      Expenses increased 20% to $148.5 million from $124.2 million primarily due to increased processing volume. Operating margins as a percentage of revenue increased to 18% from 16%, primarily due to economies of scale from increased volume and the addition of National City’s merchant business units. Operating profit for the six months ended June 30, 2001 increased 41% to $32.2 million from $22.9 million for 2000 due primarily to the factors outlined above.

Corporate Outsourcing Solutions

      Revenue for the core Corporate Outsourcing Solutions business lines for the six months ended June 30, 2001 decreased 18% to $14.8 million from $18.1 million in 2000. Revenue decreased primarily due to decreased volume from the Company’s Airlines Reporting Corporation contract.

      Expenses for the core Corporate Outsourcing Solutions business lines decreased 16% to $12.0 million from $14.3 million due primarily to decreased volume and staff reductions. Operating profit for the six months ended June 30, 2001 decreased 27% to $2.8 million from $3.8 million for 2000 due primarily to the factors outlined above.

Divested Business Units and Nonrecurring Items

      In June 2001, the Company committed to a formal plan to dispose of its Business Process Outsourcing (BPO) business units. These business units primarily process healthcare claims, credit card applications, and airline lift tickets. In conjunction with the formal plan of disposal in June 2001 the Company recorded a $6.3 million pre-tax charge primarily related to an impairment associated with the divestiture. The charge totaled $6.2 million, after-tax, or $0.12 per share. On July 11, 2001 the Company signed a definitive agreement with Affiliated Computer Services (ACS) whereby ACS will acquire the BPO business units for $43 million in cash. This transaction is expected to close in August 2001.

      In the second quarter of 2000, a pre-tax charge of $1.5 million was recorded for site consolidation initiatives related to the BPO business units. The charge totaled $1.0 million after-tax, or $0.02 per share, and related primarily to the write-off of leasehold improvements and the accrual of future contractual rent payments on abandoned facilities.

      Divested business units also include the Company’s Springfield remittance operation sold in August 2000 and the Denver collections operation discontinued in March 2001.

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      For the six months ended June 30, 2001 and 2000, the divested business units had revenue of $31.4 million and $37.3 million, respectively, and operating profit (loss) of ($3.8) million and $2.3 million, respectively. Operating profit (loss) includes impairment and restructuring charges related to the divested business units totaling $6.3 million in the second quarter of 2001 and $1.5 million in the second quarter of 2000.

Net Interest Income

      Net interest income for the six months ending June 30, 2001, increased 11% to $4.1 million due to higher average interest rates and higher average cash balances.

Provision For Income Taxes

      The overall effective tax rate for the six months ended June 30, 2001 was 44.9% compared to 38.7% for the same period a year ago. The increase in the effective tax rate was due to additional provisions related to the sale of the BPO business units for nondeductible losses, repatriation of previously untaxed earnings in foreign countries, and dividends from foreign subsidiaries.

Recent Accounting Pronouncements

      In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting, and broadens the criteria for recording intangible assets separate from goodwill. The provisions of SFAS No. 142 are effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests in accordance with the Statements. Other intangible assets will continue to be amortized over their useful lives. During 2002, the Company will perform the first of the required impairment tests of goodwill and indefinite lived intangible assets as of January 1, 2002 and has not yet determined what the effect of these tests will be on the earnings and financial position of the Company.

Seasonality

      The Company experiences seasonality in its businesses and typically realizes higher revenue in the third and fourth quarters, reflecting increased transaction volume in the summer and holiday months.

Liquidity and Capital Resources

      The Company’s primary uses of capital include capital expenditures, working capital, and acquisitions. Future business acquisitions may be funded through current liquidity, borrowed funds, and/or issuances of common stock.

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      The Company’s capital expenditures include amounts paid for computers, external and internally developed software, scanning and other document processing equipment and improvements to operating facilities. During the six months ended June 30, 2001, the Company’s capital expenditures totaled $8.9 million. Such expenditures were financed from operating cash flow, which totaled $68.5 million for the six month period of 2001. Operating cash flow and capital expenditures during the six months ended June 30, 2000 totaled $42.9 million and $6.2 million, respectively. Operating cash flow increased in the 2001 period compared to 2000 due to strong operating results from the Merchant Card Services business segment. It is anticipated future capital expenditures will be funded with operating cash flow.

      On January 8, 2001, the Company acquired the merchant services business units from several National City banking subsidiaries for $44.0 million.

      On June 28, 2001, the Company acquired a 70 percent interest in AAMS for $48.5 million, which was settled on July 2, 2001 using existing cash balances of the Company.

      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 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 balances.

      The Company maintains restricted cash balances held on behalf of clients pending distribution to vendors, which are shown on the balance sheet as assets and equivalent offsetting liabilities. These cash balances totaled $36.1 million and $31.5 million as of June 30, 2001 and December 31, 2000, respectively.

Forward-Looking Statements and Risk Factors

      The section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains certain forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995). Although management believes the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially. Please refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000 for risks and uncertainties that could cause actual results to differ materially.

Item 3. Quantitative and Qualitative Disclosure About Market Risk

      There have been no material changes in market risk as disclosed in the Company’s 2000 Annual Report on Form 10-K.

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Part II — Other Information

Item 1. Legal Proceedings (None)

Item 2. Changes in Securities and Use of Proceeds (None)

Item 3. Defaults Upon Senior Securities (None)

Item 4. Submission of Matters to a Vote of Security Holders

     
On May 10, 2001, at the Annual Shareholders Meeting of the Registrant, the shareholders took the following actions:
     
1. Elected as directors all nominees designated in the proxy statement dated March 30, 2001 as follows:
                 
Number of Votes
For Withheld
Paul G. Clark 50,275,828 678,547
Preston B. Heller, Jr. 50,812,659 141,716
Robert G. Siefers 50,797,009 157,366
     
2. Approved the National Processing, Inc. 2001 Restricted Stock Plan: 47,800,466 votes cast for, 3,029,645 votes cast against, and 124,264 votes withheld.
 
3. Approved the selection of Ernst & Young LLP as independent auditors for the Registrant for 2001: 50,882,711 votes cast for, 68,864 votes cast against, and 2,800 votes withheld.

Item 5. Other Information (None)

Item 6. Exhibits and Reports on Form 8-K:

     
a. Exhibits
 
10.41 National Processing, Inc. 2001 Restricted Stock Plan (filed as Exhibit A to National Processing, Inc.’s Proxy Statement on Form 14A #001-11905 dated March 30, 2001 and incorporated herein by reference).
10.42 National Processing, Inc.’s U.S. Asset Purchase Agreement dated July 11, 2001 (filed as Exhibit 10.42).
10.43 National Processing, Inc.’s Mexico Asset Purchase Agreement dated July 11, 2001 (filed as Exhibit 10.43).
10.44 National Processing, Inc.’s Stock Purchase Agreement dated July 11, 2001 (filed as Exhibit 10.44).
10.45 National Processing, Inc.’s Limited Liability Company Interest Purchase Agreement dated June 28, 2001 (filed as Exhibit 10.45).
 
b. Reports on Form 8-K

      April 30, 2001: On April 19, 2001, the Registrant issued a press release reporting earnings for the quarter ended March 31, 2001.

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SIGNATURES

      Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

             
NATIONAL PROCESSING, INC.
 
Date: August 13, 2001 By: /s/ Thomas A. Wimsett
 
Thomas A. Wimsett
President and Chief Executive Officer
(Duly Authorized Signer)
 
By: /s/ David E. Fountain
 
David E. Fountain
Senior Vice President and Chief Financial Officer
(Principal Financial Officer)

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