SECURITIES AND EXCHANGE COMMISSION
Form 10-Q
_______________
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | ||
For the quarterly period ended |
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: 000-50250
MasterCard Incorporated
Delaware | ||
(State or other jurisdiction of | ||
incorporation or organization) | 13-4172551 (IRS Employer Identification Number) | |
2000 Purchase Street | ||
Purchase, NY | ||
(Address of principal executive offices) | 10577 (Zip Code) |
(914) 249-2000
(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]þ No [ ]o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class | Outstanding at | |||
April 29, 2005 | ||||
Class A redeemable common stock, par value $.01 per share | 84,000,000 | |||
Class B convertible common stock, par value $.01 per share | 16,000,000 |
MASTERCARD INCORPORATED
FORM 10-Q
TABLE OF CONTENTS
Page | ||||||||
No. | ||||||||
PART I — FINANCIAL INFORMATION | ||||||||
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) | ||||||||
3 | ||||||||
4 | ||||||||
5 | ||||||||
6 | ||||||||
6 | ||||||||
7 | ||||||||
| ||||||||
EX-31.1: CERTIFICATION | ||||||||
EX-31.2: CERTIFICATION | ||||||||
EX-32.1: CERTIFICATION | ||||||||
EX-32.2: CERTIFICATION |
2
MASTERCARD INCORPORATED
September 30, | December 31, | March 31, | December 31, | |||||||||||||
2004 | 2003 | 2005 | 2004 | |||||||||||||
(In thousands, except share data) | (In thousands, except share data) | |||||||||||||||
ASSETS | ||||||||||||||||
Cash and cash equivalents | $ | 578,802 | $ | 374,169 | $ | 359,992 | $ | 328,996 | ||||||||
Investment securities, at fair value: | ||||||||||||||||
Trading | 25,925 | 30,761 | 23,139 | 27,407 | ||||||||||||
Available-for-sale | 511,501 | 505,580 | 701,617 | 781,486 | ||||||||||||
Accounts receivable | 284,944 | 259,429 | 299,320 | 293,292 | ||||||||||||
Settlement due from members | 199,620 | 210,014 | 280,190 | 223,738 | ||||||||||||
Restricted security deposits held for members | 89,743 | 60,524 | 107,146 | 87,300 | ||||||||||||
Prepaid expenses | 116,965 | 92,189 | 111,778 | 124,595 | ||||||||||||
Other current assets | 64,929 | 77,184 | 36,699 | 35,982 | ||||||||||||
Total Current Assets | 1,872,429 | 1,609,850 | 1,919,881 | 1,902,796 | ||||||||||||
Property, plant and equipment, at cost (less accumulated depreciation of $322,108 and $288,259) | 232,654 | 258,520 | ||||||||||||||
Property, plant and equipment, at cost (less accumulated depreciation of $340,149 and $329,877) | 233,682 | 242,358 | ||||||||||||||
Deferred income taxes | 248,272 | 223,908 | 233,366 | 235,023 | ||||||||||||
Goodwill | 203,718 | 187,881 | 207,982 | 217,654 | ||||||||||||
Other intangible assets (less accumulated amortization of $206,232 and $158,938) | 313,869 | 327,630 | ||||||||||||||
Other intangible assets (less accumulated amortization of $241,573 and $227,738) | 313,819 | 328,984 | ||||||||||||||
Municipal bonds held-to-maturity | 195,295 | 196,141 | 194,855 | 195,295 | ||||||||||||
Other assets | 110,963 | 96,975 | 143,464 | 142,560 | ||||||||||||
Total Assets | $ | 3,177,200 | $ | 2,900,905 | $ | 3,247,049 | $ | 3,264,670 | ||||||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||||||||||
Bank overdraft | $ | 7,642 | $ | — | ||||||||||||
Accounts payable | 168,777 | 202,604 | $ | 199,152 | $ | 187,035 | ||||||||||
Settlement due to members | 150,114 | 176,144 | 207,466 | 186,858 | ||||||||||||
Restricted security deposits held for members | 89,743 | 60,524 | 107,146 | 87,300 | ||||||||||||
Obligations under U.S. merchant lawsuit and other legal settlements — current (Notes 11 and 13) | 133,408 | 155,780 | ||||||||||||||
Obligations under U.S. merchant lawsuit and other legal settlements — current (Notes 7 and 8) | 114,222 | 129,047 | ||||||||||||||
Accrued expenses | 589,518 | 555,165 | 524,456 | 648,019 | ||||||||||||
Other current liabilities | 58,585 | 38,641 | 81,397 | 63,103 | ||||||||||||
Total Current Liabilities | 1,197,787 | 1,188,858 | 1,233,839 | 1,301,362 | ||||||||||||
Deferred income taxes | 67,271 | 64,125 | 68,974 | 73,227 | ||||||||||||
Obligations under U.S. merchant lawsuit and other legal settlements (Notes 11 and 13) | 555,353 | 516,686 | ||||||||||||||
Obligations under U.S. merchant lawsuit and other legal settlements (Notes 7 and 8) | 479,993 | 468,547 | ||||||||||||||
Long-term debt | 229,508 | 229,574 | 229,536 | 229,569 | ||||||||||||
Other liabilities | 196,525 | 198,321 | 191,960 | 212,393 | ||||||||||||
Total Liabilities | 2,246,444 | 2,197,564 | 2,204,302 | 2,285,098 | ||||||||||||
Commitments and Contingencies (Notes 10 and 13) | ||||||||||||||||
Commitments and Contingencies (Notes 6 and 8) | ||||||||||||||||
Minority interest | 4,620 | 4,620 | 4,620 | 4,620 | ||||||||||||
Stockholders’ Equity | ||||||||||||||||
Class A redeemable common stock, $.01 par value; authorized 275,000,000 shares, issued and outstanding 84,000,000 shares | 840 | 840 | 840 | 840 | ||||||||||||
Class B convertible common stock, $.01 par value; authorized 25,000,000 shares, issued and outstanding 16,000,000 shares | 160 | 160 | 160 | 160 | ||||||||||||
Additional paid-in capital | 967,368 | 967,368 | 967,368 | 967,368 | ||||||||||||
Retained earnings (accumulated deficit) | (122,474 | ) | (359,264 | ) | (27,910 | ) | (121,204 | ) | ||||||||
Accumulated other comprehensive income, net of tax: | ||||||||||||||||
Cumulative foreign currency translation adjustments | 76,301 | 83,210 | 100,305 | 127,481 | ||||||||||||
Net unrealized gain on investment securities available-for-sale | 5,216 | 9,476 | ||||||||||||||
Net unrealized (loss) gain on investment securities available-for-sale | (1,506 | ) | 3,804 | |||||||||||||
Net unrealized loss on derivatives accounted for as hedges | (1,275 | ) | (3,069 | ) | (1,130 | ) | (3,497 | ) | ||||||||
Total accumulated other comprehensive income, net of tax | 80,242 | 89,617 | 97,669 | 127,788 | ||||||||||||
Total Stockholders’ Equity | 926,136 | 698,721 | 1,038,127 | 974,952 | ||||||||||||
Total Liabilities and Stockholders’ Equity | $ | 3,177,200 | $ | 2,900,905 | $ | 3,247,049 | $ | 3,264,670 | ||||||||
The accompanying notes are an integral part of these consolidated financial statements.
3
MASTERCARD INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months | Nine Months | |||||||||||||||
Ended September 30, | Ended September 30, | |||||||||||||||
2004 | 2003 | 2004 | 2003 | |||||||||||||
(In thousands, except per share data) | ||||||||||||||||
Revenues, net | $ | 667,841 | $ | 594,169 | $ | 1,909,426 | $ | 1,663,277 | ||||||||
Operating Expenses: | ||||||||||||||||
General and administrative | 284,923 | 255,281 | 846,417 | 813,128 | ||||||||||||
Advertising and market development | 190,078 | 183,046 | 586,398 | 530,740 | ||||||||||||
U.S. merchant lawsuit and other legal settlements (Notes 11 and 13) | 14,112 | 8,759 | 18,008 | 729,759 | ||||||||||||
Depreciation | 12,379 | 12,758 | 38,816 | 39,405 | ||||||||||||
Amortization | 16,798 | 15,425 | 53,303 | 49,160 | ||||||||||||
Total operating expenses | 518,290 | 475,269 | 1,542,942 | 2,162,192 | ||||||||||||
Operating income (loss) | 149,551 | 118,900 | 366,484 | (498,915 | ) | |||||||||||
Other Income (Expense): | ||||||||||||||||
Investment income, net | 11,205 | 12,121 | 32,814 | 39,859 | ||||||||||||
Interest expense | (17,792 | ) | (18,722 | ) | (52,205 | ) | (42,814 | ) | ||||||||
Minority interest in losses of subsidiaries | 54 | 77 | 71 | 99 | ||||||||||||
Other (expense) income, net | (2,303 | ) | (936 | ) | (2,494 | ) | (2,075 | ) | ||||||||
Total other (expense) income | (8,836 | ) | (7,460 | ) | (21,814 | ) | (4,931 | ) | ||||||||
Income (loss) before income taxes | 140,715 | 111,440 | 344,670 | (503,846 | ) | |||||||||||
Income tax expense (benefit) | 43,200 | 37,041 | 107,880 | (180,232 | ) | |||||||||||
Income (loss) before cumulative effect of accounting change | 97,515 | 74,399 | 236,790 | (323,614 | ) | |||||||||||
Cumulative effect of accounting change, net of tax | — | — | — | 4,949 | ||||||||||||
Net Income (Loss) | $ | 97,515 | $ | 74,399 | $ | 236,790 | $ | (318,665 | ) | |||||||
Net Income (Loss) per Share (Basic and Diluted): | ||||||||||||||||
Income (loss) before cumulative effect of accounting change | $ | .98 | $ | .74 | $ | 2.37 | $ | (3.24 | ) | |||||||
Cumulative effect of accounting change, net of tax | — | — | — | .05 | ||||||||||||
Net Income (Loss) per Share (Basic and Diluted) | $ | .98 | $ | .74 | $ | 2.37 | $ | (3.19 | ) | |||||||
Three Months | ||||||||
Ended March 31, | ||||||||
2005 | 2004 | |||||||
(In thousands, except per share data) | ||||||||
Revenues, net | $ | 658,238 | $ | 594,310 | ||||
Operating Expenses | ||||||||
General and administrative | 306,616 | 276,834 | ||||||
Advertising and market development | 171,679 | 167,496 | ||||||
U.S. merchant lawsuit and other legal settlements (Notes 7 and 8) | — | — | ||||||
Depreciation | 12,194 | 13,361 | ||||||
Amortization | 16,236 | 18,147 | ||||||
Total operating expenses | 506,725 | 475,838 | ||||||
Operating income | 151,513 | 118,472 | ||||||
Other Income (Expense) | ||||||||
Investment income, net | 10,049 | 12,319 | ||||||
Interest expense | (16,856 | ) | (17,729 | ) | ||||
Minority interest in (losses) income of subsidiaries | (21 | ) | 44 | |||||
Other (expense) income, net | (490 | ) | 674 | |||||
Total other (expense) income | (7,318 | ) | (4,692 | ) | ||||
Income before income taxes | 144,195 | 113,780 | ||||||
Income tax expense | 50,901 | 40,212 | ||||||
Net Income | $ | 93,294 | $ | 73,568 | ||||
Net Income per Share (Basic and Diluted) | $ | .93 | $ | .74 | ||||
Weighted average shares outstanding (Basic and Diluted) | 100,000 | 100,000 | ||||||
The accompanying notes are an integral part of these consolidated financial statements.
4
MASTERCARD INCORPORATED
Nine Months | Three Months | |||||||||||||||
Ended September 30, | Ended March 31, | |||||||||||||||
2004 | 2003 | 2005 | 2004 | |||||||||||||
(In thousands) | (In thousands) | |||||||||||||||
Operating Activities | ||||||||||||||||
Net income (loss) | $ | 236,790 | $ | (318,665 | ) | |||||||||||
Adjustments to reconcile net income (loss) to net cash provided by operating activities: | ||||||||||||||||
Net income | $ | 93,294 | $ | 73,568 | ||||||||||||
Adjustments to reconcile net income to net cash (used in) provided by operating activities: | ||||||||||||||||
Depreciation | 38,816 | 39,405 | 12,194 | 13,361 | ||||||||||||
Amortization | 53,303 | 49,160 | 16,236 | 18,147 | ||||||||||||
Deferred income taxes | (3,940 | ) | (214,833 | ) | 6,555 | 10,026 | ||||||||||
Other | 5,550 | 4,350 | 1,833 | 569 | ||||||||||||
Changes in operating assets and liabilities: | ||||||||||||||||
Trading securities | 4,836 | (1,808 | ) | 4,268 | 976 | |||||||||||
Accounts receivable | (21,755 | ) | (10,199 | ) | (9,787 | ) | 31,037 | |||||||||
Settlement due from members | 7,598 | 28,976 | (66,866 | ) | 24,935 | |||||||||||
Prepaid expenses and other current assets | (24,481 | ) | (27,051 | ) | 7,327 | (7,066 | ) | |||||||||
Accounts payable | (33,682 | ) | (33,074 | ) | 14,930 | (34,815 | ) | |||||||||
Settlement due to members | (23,706 | ) | (28,943 | ) | 29,137 | (38,008 | ) | |||||||||
Legal settlement accruals, including accretion of imputed interest | 16,295 | 738,508 | (3,379 | ) | 6,301 | |||||||||||
Accrued expenses | 33,325 | (12,416 | ) | (118,272 | ) | (84,567 | ) | |||||||||
Net change in other assets and liabilities | 5,107 | (23,044 | ) | (1,676 | ) | (1,545 | ) | |||||||||
Net cash provided by operating activities | 294,056 | 190,366 | ||||||||||||||
Net cash (used in) provided by operating activities | (14,206 | ) | 12,919 | |||||||||||||
Investing Activities | ||||||||||||||||
Purchases of property, plant and equipment | (13,351 | ) | (59,025 | ) | (6,077 | ) | (726 | ) | ||||||||
Capitalized software | (33,223 | ) | (49,788 | ) | (11,680 | ) | (9,805 | ) | ||||||||
Purchases of investment securities available-for-sale | (172,191 | ) | (182,456 | ) | (583,682 | ) | (192,058 | ) | ||||||||
Proceeds from sales and maturities of investment securities available-for-sale | 156,943 | 177,942 | 653,460 | 261,714 | ||||||||||||
Acquisition of businesses, net of cash acquired | (29,861 | ) | — | — | (18,866 | ) | ||||||||||
Other investing activities | (4,426 | ) | (2,943 | ) | 82 | (5,792 | ) | |||||||||
Net cash used in investing activities | (96,109 | ) | (116,270 | ) | ||||||||||||
Financing Activities | ||||||||||||||||
Bank overdraft | 7,642 | — | ||||||||||||||
Net cash provided by financing activities | 7,642 | — | ||||||||||||||
Net cash provided by investing activities | 52,103 | 34,467 | ||||||||||||||
Effect of exchange rate changes on cash and cash equivalents | (956 | ) | 4,066 | (6,901 | ) | (2,534 | ) | |||||||||
Net increase in cash and cash equivalents | 204,633 | 78,162 | 30,996 | 44,852 | ||||||||||||
Cash and cash equivalents — beginning of period | 374,169 | 336,474 | 328,996 | 248,119 | ||||||||||||
Cash and cash equivalents — end of period | $ | 578,802 | $ | 414,636 | $ | 359,992 | $ | 292,971 | ||||||||
Supplemental Cash Flows: | ||||||||||||||||
Cash paid for income taxes | $ | 16,119 | $ | 1,460 | ||||||||||||
Cash paid for interest | 5,745 | 5,776 |
The accompanying notes are an integral part of these consolidated financial statements.
5
MASTERCARD INCORPORATED
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)
Accumulated | |||||||||||||||||||||||||||||||||||||||||||||||||
Accumulated | Retained | Other | |||||||||||||||||||||||||||||||||||||||||||||||
Retained Earnings | Other Comprehensive | Common Shares | Additional | Earnings | Comprehensive | Additional | |||||||||||||||||||||||||||||||||||||||||||
(Accumulated | Income (Loss), | Paid-in | (Accumulated | Income (Loss), | Common Shares | Paid-in | |||||||||||||||||||||||||||||||||||||||||||
Total | Deficit) | Net of Tax | Class A | Class B | Capital | Total | Deficit) | Net of Tax | Class A | Class B | Capital | ||||||||||||||||||||||||||||||||||||||
(In thousands) | (In thousands) | ||||||||||||||||||||||||||||||||||||||||||||||||
Balance at January 1, 2004 | $ | 698,721 | $ | (359,264 | ) | $ | 89,617 | $ | 840 | $ | 160 | $ | 967,368 | ||||||||||||||||||||||||||||||||||||
Balance at January 1, 2005 | $ | 974,952 | $ | (121,204 | ) | $ | 127,788 | $ | 840 | $ | 160 | $ | 967,368 | ||||||||||||||||||||||||||||||||||||
Net income | 236,790 | 236,790 | — | — | — | — | 93,294 | 93,294 | — | — | — | — | |||||||||||||||||||||||||||||||||||||
Other comprehensive loss, net of tax | (9,375 | ) | — | (9,375 | ) | — | — | — | (30,119 | ) | — | (30,119 | ) | — | — | — | |||||||||||||||||||||||||||||||||
Balance at September 30, 2004 | $ | 926,136 | $ | (122,474 | ) | $ | 80,242 | $ | 840 | $ | 160 | $ | 967,368 | ||||||||||||||||||||||||||||||||||||
Balance at March 31, 2005 | $ | 1,038,127 | $ | (27,910 | ) | $ | 97,669 | $ | 840 | $ | 160 | $ | 967,368 | ||||||||||||||||||||||||||||||||||||
MASTERCARD INCORPORATED
CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED)
Three Months | Nine Months | |||||||||||||||
Ended September 30, | Ended September 30, | |||||||||||||||
2004 | 2003 | 2004 | 2003 | |||||||||||||
(In thousands) | ||||||||||||||||
Net Income (Loss) | $ | 97,515 | $ | 74,399 | $ | 236,790 | $ | (318,665 | ) | |||||||
Other comprehensive income (loss), net of tax: | ||||||||||||||||
Foreign currency translation adjustments | 3,697 | 3,177 | (6,909 | ) | 30,469 | |||||||||||
Net unrealized gain (loss) on investment securities available-for-sale | 3,757 | (643 | ) | (4,260 | ) | (2,077 | ) | |||||||||
Net unrealized gain (loss) on derivatives accounted for as hedges | 239 | 4,170 | 1,794 | (1,199 | ) | |||||||||||
Other comprehensive income (loss), net of tax | 7,693 | 6,704 | (9,375 | ) | 27,193 | |||||||||||
Comprehensive Income (Loss) | $ | 105,208 | $ | 81,103 | $ | 227,415 | $ | (291,472 | ) | |||||||
Three Months | ||||||||
Ended March 31, | ||||||||
2005 | 2004 | |||||||
(In thousands) | ||||||||
Net Income | $ | 93,294 | $ | 73,568 | ||||
Other comprehensive income, net of tax: | ||||||||
Foreign currency translation adjustments | (27,176 | ) | (11,848 | ) | ||||
Net unrealized loss on investment securities available-for-sale | (5,310 | ) | (523 | ) | ||||
Net unrealized gain on derivatives accounted for as hedges | 2,367 | 2,236 | ||||||
Other comprehensive loss, net of tax | (30,119 | ) | (10,135 | ) | ||||
Comprehensive Income | $ | 63,175 | $ | 63,433 | ||||
The accompanying notes are an integraliCntegral part of these consolidated financial statements.
6
MASTERCARD INCORPORATED
Note 1. Summary of Significant Accounting Policies
Organization— MasterCard Incorporated and its consolidated subsidiaries, including MasterCard International Incorporated (“MasterCard International”) and MasterCard Europe sprl (“MasterCard Europe”) (together, “MasterCard” or the “Company”), provide transaction processing and related services to customers principally in support of their credit, deposit access (debit), electronic cash and Automated Teller Machine (“ATM”) payment programs, and travelers cheque programs. The common stock of MasterCard Incorporated is privately owned by certain of the Company’s customers. MasterCard enters into transactions with its customers in the normal course of business and operates a system for payment processing among its customers.
Consolidation and basis of presentation— The Company follows accounting principles generally accepted in the United States of America. Certain prior period amounts have been reclassified to conform to 20042005 classifications. The consolidated financial statements include the accounts of MasterCard and its majority-owned orand controlled entities.entities, including the Company’s variable interest entity. Intercompany transactions are eliminated in consolidation.
The Company consolidates majority-owned or controlled entities, including variable interest entities. Minority interest is recorded for consolidated entities in which the Company owns less than 100% of the interest. Minority interest represents the equity interest not owned by the Company.
The consolidated financial statements for the three and nine months ended September 30,March 31, 2005 and 2004 and 2003 and as of September 30, 2004March 31, 2005 are unaudited, and in the opinion of management include allnormal recurring adjustments that are necessary to present fairly the results for interim periods. The balance sheet as of December 31, 2004 was derived from the audited consolidated financial statements as of December 31, 2004. Due to seasonal fluctuations and other factors, the results of operations for the three and nine months ended September 30, 2004March 31, 2005 are not necessarily indicative of the results to be expected for the full year.
The accompanying unaudited consolidated financial statements are presented in accordance with the requirements of Quarterly Reports on Form 10-Q and, consequently, do not include all of the disclosures required by accounting principles generally accepted in the United States of America. Reference should be made to the Company’s 20032004 Annual Report on Form 10-K for additional disclosures, including a summary of the Company’s significant accounting policies.
Note 2. Supplemental Cash FlowsGoodwill and Other Intangible Assets
The carrying amount of goodwill as of March 31, 2005 was $207,982 compared to $217,654 as of December 31, 2004. The change in the balance is primarily related to the foreign currency translation of the goodwill relating to the acquisition of MasterCard Europe.
The following table includes supplemental cash flow disclosures:sets forth net intangible assets, other than goodwill:
Nine Months | ||||||||
Ended September 30, | ||||||||
2004 | 2003 | |||||||
Cash paid for income taxes | $ | 35,522 | $ | 2,273 | ||||
Cash paid for interest | 14,063 | 14,117 | ||||||
Non-cash investing and financing activities: | ||||||||
Consolidation of variable interest entity: | ||||||||
Municipal bonds held-to-maturity | — | (154,000 | ) | |||||
Long-term debt | — | 149,380 | ||||||
Minority interest | — | 4,620 | ||||||
Sale-leaseback transaction: | ||||||||
Capital lease obligation | — | 32,627 | ||||||
Bonds held-to-maturity | — | (32,627 | ) |
March 31, 2005 | December 31, 2004 | |||||||||||||||||||||||
Gross | Net | Gross | Net | |||||||||||||||||||||
Carrying | Accumulated | Carrying | Carrying | Accumulated | Carrying | |||||||||||||||||||
Amount | Amortization | Amount | Amount | Amortization | Amount | |||||||||||||||||||
Amortized intangible assets: | ||||||||||||||||||||||||
Capitalized software | $ | 336,682 | $ | (220,954 | ) | $ | 115,728 | $ | 327,733 | $ | (207,371 | ) | $ | 120,362 | ||||||||||
Trademarks and tradenames | 23,343 | (17,335 | ) | 6,008 | 24,061 | (17,728 | ) | 6,333 | ||||||||||||||||
Other | 6,442 | (3,284 | ) | 3,158 | 6,442 | (2,639 | ) | 3,803 | ||||||||||||||||
Total | 366,467 | (241,573 | ) | 124,894 | 358,236 | (227,738 | ) | 130,498 | ||||||||||||||||
Unamortized intangible assets: | ||||||||||||||||||||||||
Customer relationships | 188,925 | — | 188,925 | 198,486 | — | 198,486 | ||||||||||||||||||
Total | $ | 555,392 | $ | (241,573 | ) | $ | 313,819 | $ | 556,722 | $ | (227,738 | ) | $ | 328,984 | ||||||||||
On January 1, 2003, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation Number No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”) and consolidated the MasterCard International O’Fallon 1999 Trust (the “Trust”) on the Company’s consolidated balance sheet, which resulted in recording $154,000 in municipal bonds held by the Trust, $149,380 in long-term debt and $4,620 of minority interest relating to the equity in the Trust held by a third party. The Trust financed the Company’s global technology and operations facility located in O’Fallon, Missouri, named Winghaven, through a combination of a third party equity investment and the issuance of 7.36 percent Series A Senior Secured Notes (the “Secured Notes”) in the amount of $149,380 due September 1, 2009. The redemption value of the minority interest approximates its carrying value. The minority interest will be redeemed by the minority interest holders upon the maturity of the Secured Notes. MasterCard
7
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share and percent data)
International has guaranteed 85.15 percent of the Secured Notes outstanding, totaling $127,197 at September 30, 2004. Additionally, upon the occurrence of specific events of default, MasterCard International guarantees repayment of the total outstanding principal and interest on the Secured Notes and would own the facility.
Note 3. Net Income (Loss) Per Share
The following table sets forth the computation of net income (loss) per share (basic and diluted):
Three Months | Nine Months | |||||||||||||||
Ended September 30, | Ended September 30, | |||||||||||||||
2004 | 2003 | 2004 | 2003 | |||||||||||||
Numerator for net income (loss) per share (basic and diluted): | ||||||||||||||||
Income (loss) before cumulative effect of accounting change | $ | 97,515 | $ | 74,399 | $ | 236,790 | $ | (323,614 | ) | |||||||
Cumulative effect of accounting change, net of tax | — | — | — | 4,949 | ||||||||||||
Net income (loss) | $ | 97,515 | $ | 74,399 | $ | 236,790 | $ | (318,665 | ) | |||||||
Denominator for net income (loss) per share (basic and diluted): | ||||||||||||||||
Weighted average shares outstanding | 100,000 | 100,000 | 100,000 | 100,000 | ||||||||||||
Income (loss) per share before cumulative effect of accounting change | $ | .98 | $ | .74 | $ | 2.37 | $ | (3.24 | ) | |||||||
Cumulative effect of accounting change per share, net of tax | — | — | — | .05 | ||||||||||||
Net income (loss) per share (basic and diluted) | $ | .98 | $ | .74 | $ | 2.37 | $ | (3.19 | ) | |||||||
Note 4. Acquisition of Europay International (“EPI”)
On June 28, 2002, MasterCard Incorporated issued 23,760 shares of its common stock to the shareholders of EPI and MasterCard Europay U.K. Limited (“MEPUK”), in return for directly and indirectly acquiring 100% of the shares of EPI not previously owned by MasterCard International. However, of the 23,760 shares issued, only 17,610 were considered to be issued unconditionally. The purchase price for EPI was based on the estimated value of the unconditional shares only, and this estimated value was determined on the basis of an independent valuation. Considering this valuation and the 17,610 unconditional shares issued, the purchase price of EPI was $267,856, excluding estimated acquisition costs of $10,486 that were incurred by the Company.
In calculating the purchase price of EPI, the Company considered only the unconditional shares issued to the former shareholders of EPI and MEPUK because the agreement relating to the EPI acquisition provides that the number of shares allocated to these shareholders will potentially increase or decrease at the end of a three-year transition period as a result of the application of a global proxy formula for the third year of the transition period. Of the 23,760 shares attributable to the exchange of EPI and MEPUK shares, 6,150 shares are conditional shares subject to reallocation at the end of the transition period. EPI and MEPUK shareholders therefore received 17,610 unconditional shares at closing.
Since former EPI and MEPUK shareholders would retain or receive additional shares of MasterCard Incorporated at the end of the transition period without remitting any additional consideration, any shares retained or received by them that are above their minimum allocation at that time would constitute a part of the purchase price. Any such additional shares will be valued at that time based upon the fair value of the stock of MasterCard Incorporated. Any such reallocation of shares to former EPI and MEPUK shareholders will increase the purchase price for EPI and, accordingly, the amount of goodwill and additional paid-in capital recorded.
8
MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and percent data)
Included in the liabilities assumed in the acquisition was a liability for exit costs relating to the integrationA portion of the Company and EPI (now MasterCard Europe). The changes in the liability for exit costs are summarized as follows:
Europay | Redundant Computer | |||||||||||||||
Brand/Logo | Systems/Technology | Workforce | ||||||||||||||
Elimination | Elimination | Reduction | Total | |||||||||||||
Balance as of December 31, 2003 | $ | 10,452 | $ | 9,810 | $ | 1,042 | $ | 21,304 | ||||||||
Utilization | (9,459 | ) | (4,999 | ) | (21 | ) | (14,479 | ) | ||||||||
Change in estimate | — | — | (248 | ) | (248 | ) | ||||||||||
Change due to currency translation | (219 | ) | (109 | ) | (77 | ) | (405 | ) | ||||||||
Balance as of September 30, 2004 | $ | 774 | $ | 4,702 | $ | 696 | $ | 6,172 | ||||||||
Note 5. Goodwill
The changes in the carrying amount of goodwill since December 31, 2003 are as follows:
Balance as of December 31, 2003 | $ | 187,881 | ||
Acquisition of businesses | 20,225 | |||
Impairment loss | (1,676 | ) | ||
Foreign currency translation | (2,548 | ) | ||
Other | (164 | ) | ||
Balance as of September 30, 2004 | $ | 203,718 | ||
In February 2004, the Company acquired a research and advisory firm focused exclusively on the global financial services industry. In May 2004, the Company acquired a consulting firm specializing in the optimization of customer relationships. During the three months ended September 30, 2004, the Company identified and recorded impairment losses of $2,011 for one of the acquisitions above (goodwill of $1,676 and otherCompany’s intangible assets of $335), which is reflected within General and Administrative expenses in the Consolidated Statements of Operations.
Note 6. Other Intangible Assets
The following table sets forth gross and net intangible assets, other than goodwill:
September 30, 2004 | December 31, 2003 | |||||||||||||||||||||||
Gross | Net | Gross | Net | |||||||||||||||||||||
Carrying | Accumulated | Carrying | Carrying | Accumulated | Carrying | |||||||||||||||||||
Amount | Amortization | Amount | Amount | Amortization | Amount | |||||||||||||||||||
Amortizable intangible assets: | ||||||||||||||||||||||||
Capitalized software | $ | 309,607 | $ | (188,995 | ) | $ | 120,612 | $ | 283,217 | $ | (148,408 | ) | $ | 134,809 | ||||||||||
Trademarks and tradenames | 22,664 | (14,707 | ) | 7,957 | 20,204 | (9,802 | ) | 10,402 | ||||||||||||||||
Other | 7,941 | (2,530 | ) | 5,411 | 728 | (728 | ) | — | ||||||||||||||||
Total amortizable intangible assets | 340,212 | (206,232 | ) | 133,980 | 304,149 | (158,938 | ) | 145,211 | ||||||||||||||||
Unamortizable intangible assets: | ||||||||||||||||||||||||
Customer relationships | 179,889 | — | 179,889 | 182,419 | — | 182,419 | ||||||||||||||||||
Total | $ | 520,101 | $ | (206,232 | ) | $ | 313,869 | $ | 486,568 | $ | (158,938 | ) | $ | 327,630 | ||||||||||
Additions to capitalized software primarily relate to internal projects associated with system enhancements or infrastructure improvements adjusted for the translation of capitalized software denominated in foreign currency. As discussed in Note 5 herein, MasterCard’s acquisitions during the nine months ended September 30, 2004 resulted in an increase in trademarks and tradenames in the amount of $2,650 and an increase in other amortizable intangible assets, including covenants not to compete, customer lists and a research library, in the amount of $7,213.
9
MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share and percent data)
Amortizable trademarks and tradenames and unamortizable customer relationships include assets which are denominated in foreign currency.currencies. As such, a component of the net change in these intangible assets is attributable to foreign currency translation. In particular, for the nine months ended September 30, 2004,unamortized customer relationships and trademarks assumed inrelate to the acquisition of EPI on June 28, 2002MasterCard Europe and decreased by $2,530 and $190, respectively.$9,561.
Amortization and impairment expense on the assets above amounted towas $16,236 and $18,147 for the following:
For the Three Months | For the Nine Months | |||||||||||||||
Ended September 30, | Ended September 30, | |||||||||||||||
2004 | 2003 | 2004 | 2003 | |||||||||||||
Amortization | $ | 16,798 | $ | 15,425 | $ | 53,303 | $ | 49,160 | ||||||||
Impairment | 425 | 1,062 | 892 | 2,562 |
three months ended March 31, 2005 and 2004, respectively. Impairment expense was nominal in both periods. The following table sets forth the estimated future amortization expense on amortizable intangible assets:assets for the periods ending:
For the three months ending December 31, 2004 | $ | 19,251 | ||
For the year ending December 31, 2005 | 55,339 | |||
For the year ending December 31, 2006 | 36,829 | |||
For the year ending December 31, 2007 | 17,313 | |||
For the year ending December 31, 2008 | 2,629 | |||
For the year ending December 31, 2009 and thereafter | 2,619 |
Remainder of 2005 | $ | 44,954 | ||
December 31, 2006 | $ | 44,821 | ||
December 31, 2007 | $ | 26,221 | ||
December 31, 2008 | $ | 5,945 | ||
December 31, 2009 and thereafter | $ | 2,953 |
Note 7.3. Pension Plans
The Company maintains a noncontributory defined benefit pension plan with a cash balance feature covering substantially all of its U.S. employees. Additionally, the Company has an unfunded nonqualified supplemental executive retirement plan that provides certain key employees with supplemental retirement benefits in excess of limits imposed on qualified plans by U.S. tax laws.
Net For both plans, net periodic pension cost is as follows:
Three Months | Nine Months | Three Months | ||||||||||||||||||||||
Ended September 30, | Ended September 30, | Ended March 31, | ||||||||||||||||||||||
2004 | 2003 | 2004 | 2003 | 2005 | 2004 | |||||||||||||||||||
Service cost | $ | 4,038 | $ | 4,214 | $ | 12,114 | $ | 12,642 | $ | 4,579 | $ | 4,038 | ||||||||||||
Interest cost | 2,449 | 2,119 | 7,347 | 6,357 | 2,584 | 2,449 | ||||||||||||||||||
Expected return on plan assets | (2,580 | ) | (2,165 | ) | (7,740 | ) | (6,495 | ) | (3,192 | ) | (2,580 | ) | ||||||||||||
Amortization of prior service credit | (79 | ) | (79 | ) | (237 | ) | (237 | ) | ||||||||||||||||
Amortization of prior service cost | (75 | ) | (79 | ) | ||||||||||||||||||||
Recognized actuarial loss | 318 | 890 | 954 | 2,670 | 344 | 318 | ||||||||||||||||||
Net periodic pension cost | $ | 4,146 | $ | 4,979 | $ | 12,438 | $ | 14,937 | $ | 4,240 | $ | 4,146 | ||||||||||||
The funded status of the qualified plan exceeds minimum funding requirements. In the fourth quarter ofDecember 2004, the Company elected to make a voluntary $15,000 contribution and in April 2005, the Company contributed $5,000 to its qualified plan. The Company expects to make a contribution to its defined benefit pension plan. The amount of the contribution may be up to $40,000 depending on market conditions.additional voluntary contributions totaling $20,000 before September 15, 2005.
Note 8.4. Postretirement Health and Life Insurance Benefits
The Company maintains a postretirement plan providing health coverage and life insurance benefits for substantially all of its U.S. employees and retirees.
In May 2004, the FASB issued FASB Staff Position No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP 106-2”). FSP 106-2 requires (a) that the effects of the federal subsidy be considered an actuarial gain and recognized in the same manner as other actuarial gains and losses and (b) certain
10
MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share and percent data)
disclosures for employers that sponsor postretirement benefit plans that provide prescription drug benefits. The Company has determined that the enactment of the Medicare Modernization Act was not a significant event with respect to its plans, and accordingly, as required by FSP 106-2, the effects of the Act will be incorporated into the Company’s December 31, 2004 measurement of the plan’s benefit obligations.
Net periodic postretirement benefit cost is as follows:
Three Months | Nine Months | Three Months | ||||||||||||||||||||||
Ended September 30, | Ended September 30, | Ended March 31, | ||||||||||||||||||||||
2004 | 2003 | 2004 | 2003 | 2005 | 2004 | |||||||||||||||||||
Service cost | $ | 774 | $ | 644 | $ | 2,322 | $ | 1,932 | $ | 797 | $ | 774 | ||||||||||||
Interest cost | 741 | 557 | 2,223 | 1,671 | 858 | 741 | ||||||||||||||||||
Amortization of prior service cost | 17 | 17 | 51 | 51 | 17 | 17 | ||||||||||||||||||
Amortization of transition obligation | 145 | 145 | 435 | 435 | 145 | 145 | ||||||||||||||||||
Recognized actuarial gain | — | (38 | ) | — | (114 | ) | ||||||||||||||||||
Recognized actuarial loss | 65 | — | ||||||||||||||||||||||
Net periodic postretirement benefit cost | $ | 1,677 | $ | 1,325 | $ | 5,031 | $ | 3,975 | $ | 1,882 | $ | 1,677 | ||||||||||||
The Company funds its postretirement benefits as payments are required through cash flows from operations.
8
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and percent data)
Note 9. Credit Facility5. Accrued Expenses
On June 18, 2004, the Company entered into a committed unsecured $1,950,000 revolving credit facility (the “Credit Facility”) with certain financial institutions, which expires on June 17, 2005. Borrowings under the facility are available to provide liquidity in the event of one or more settlement failures by MasterCard International members and, subject to a limit of $300,000, for general corporate purposes. The Credit Facility replaced MasterCard Incorporated’s prior $1,200,000 credit facility which expired on June 18, 2004. Interest on borrowings under the Credit Facility is charged at the London Interbank Offered Rate plus 28 basis points. An additional 10 basis points would be applied if the aggregate borrowings under the Credit Facility were to exceed 33%Accrued expenses consist of the commitments. MasterCard agreed to pay a facility fee which varies based on MasterCard’s credit rating and is currently equal to 7 basis points on the total commitment. MasterCard was in compliance with the Credit Facility covenants as of September 30, 2004. There were no borrowings under the Credit Facility at September 30, 2004. The majority of Credit Facility lenders are members or affiliates of members of MasterCard International.following:
March 31, | December 31, | |||||||
2005 | 2004 | |||||||
Accrued personnel costs | $ | 113,206 | $ | 190,114 | ||||
Accrued customer incentives | 159,508 | 163,278 | ||||||
Accrued advertising | 82,363 | 136,107 | ||||||
Accrued taxes | 86,121 | 63,940 | ||||||
Other | 83,258 | 94,580 | ||||||
$ | 524,456 | $ | 648,019 | |||||
In July 2004, MasterCard Europe and European Payment System Services sprl, subsidiaries of MasterCard, reduced a multi-purpose uncommitted credit facility with a bank from 35,000 euros to a 1,000 euro overdraft facility for MasterCard Europe and European Payment System Services sprl and a 1,000 euro guarantee facility for MasterCard Europe. Additionally, MasterCard Europe has canceled an uncommitted credit agreement totaling 30,000 euros as of June 30, 2004.
Note 10.6. Commitments and Contingent Liabilities
The future minimum payments under non-cancelable operating or capital leases for office buildings and equipment, sponsorships, and licensing and other agreements at September 30, 2004March 31, 2005 are as follows:
Sponsorships, | Sponsorship, | |||||||||||||||||||||||||||||||
Capital | Operating | Licensing & | Capital | Operating | Licensing and | |||||||||||||||||||||||||||
Total | Leases | Leases | Other | Total | Leases | Leases | Other | |||||||||||||||||||||||||
The remainder of 2004 | $ | 98,377 | $ | 2,967 | $ | 10,467 | $ | 84,943 | ||||||||||||||||||||||||
2005 | 226,050 | 6,965 | 31,705 | 187,380 | ||||||||||||||||||||||||||||
The remainder of 2005 | $ | 237,678 | $ | 6,253 | $ | 28,823 | $ | 202,602 | ||||||||||||||||||||||||
2006 | 189,184 | 4,267 | 27,134 | 157,783 | 213,888 | 4,783 | 30,210 | 178,895 | ||||||||||||||||||||||||
2007 | 94,981 | 3,319 | 23,007 | 68,655 | 125,415 | 3,852 | 25,432 | 96,131 | ||||||||||||||||||||||||
2008 | 62,845 | 2,284 | 16,585 | 43,976 | 63,597 | 2,360 | 17,823 | 43,414 | ||||||||||||||||||||||||
2009 | 30,880 | 1,901 | 11,445 | 17,534 | ||||||||||||||||||||||||||||
Thereafter | 80,877 | 43,962 | 12,107 | 24,808 | 50,234 | 42,294 | 1,798 | 6,142 | ||||||||||||||||||||||||
Total | $ | 752,314 | $ | 63,764 | $ | 121,005 | $ | 567,545 | $ | 721,692 | $ | 61,443 | $ | 115,531 | $ | 544,718 | ||||||||||||||||
11
MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share The table above excludes obligations from performance based agreements with our customers and percent data)
merchants due to their contingent nature. Included in the table above are capital leases with imputed interest expense of $17,094$15,416 and a net present value of minimum lease payments of $46,670. In addition, at September 30, 2004, $24,275$46,027. At March 31, 2005, $18,642 of the future minimum payments in the table above for operating leases, sponsorships andsponsorship, licensing and other agreements was accrued.
included in accounts payable or accrued expenses. Consolidated rental expense for the Company’s office space was approximately $7,537$7,805 and $7,434$7,875 for the three months ended September 30,March 31, 2005 and 2004, and 2003, respectively, and $23,454 and $21,755 for the nine months ended September 30, 2004 and 2003, respectively. Consolidated lease expense for automobiles, computer equipment and office equipment was $2,150$1,987 and $2,146$2,544 for the three months ended September 30,March 31, 2005 and 2004, and 2003, respectively, and $7,416 and $6,751 for the nine months ended September 30, 2004 and 2003, respectively.
MasterCard licenses certain software to its customers. The license agreements contain guarantees under which the Company indemnifies licensees from any adverse judgments arising from claims of intellectual property infringement by third parties. The terms of the guarantees are equal to the terms of the license to which they relate. The amount of the guarantees are limited to damages, losses, costs, expenses or other liabilities incurred by the licensee as a result of any intellectual property rights claims. The Company does not generate significant revenues from software licensing. The fair value of the guarantees is estimated to be negligible.
Note 11.7. U.S. Merchant Lawsuit and Other Legal Settlements
DuringIn 2003, MasterCard settled the U.S. merchant lawsuit described in Note 138 herein and contract disputes with certain customers. MasterCard International signed a Memorandum of Understanding (“MOU”) with plaintiffs in the U.S. merchant lawsuit on April 30, 2003. On June 4, 2003, MasterCard International and plaintiffs signed a settlement agreement (the “Settlement Agreement”) embodying the terms originally set forth in the MOU. The Settlement Agreementwhich required the Company to pay $125,000 in 2003 and requires it to pay $100,000 annually ineach December from 2004 through 2012. In addition, the Company adopted rules which permit U.S. merchants to elect not to accept MasterCard branded debit (or credit) cards, implemented programs to allow merchants to identify debit cards, provided signage to merchants and established a separate debit interchange rate for a required period. For a description of interchange, see the text under the heading “Global Interchange Proceedings” in Note 138 herein.
In connection with the signing of the MOU, MasterCard recorded a pre-tax charge of $721,000 ($469,000 after-tax) Also in the three months ended March 31, 2003, consisting of (i) the monetary amount of the U.S. merchant lawsuit settlement (discounted at 8 percent over the payment term), (ii) certain additional costs in connection with,several other lawsuits were initiated and in order to comply with, other requirements of the U.S. merchant lawsuit settlement, and (iii) costs to address thesettled by merchants who opted not to participate in the plaintiff class in the U.S. merchant lawsuit. As noted above
9
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and described further in Note 13 herein, several lawsuits have been commenced by merchants who have opted not to participate in the plaintiff percent data)
class in the U.S. merchant lawsuit. The “opt out”“opt-out” merchant lawsuits are not covered by the terms of the Settlement Agreement. The $721,000 pre-tax charge amount was an estimate, which was subsequently revised based onDuring the approval of the Settlement Agreement by the court, and other factors. If necessary, future refinements will also be made.
During 2004,three months ended March 31, 2005, total liabilities for the U.S. merchant lawsuit and other legal settlements changed as follows:
Balance as of December 31, 2003 | $ | 672,466 | ||
Other legal settlements and revisions of merchant opt-out estimate | 18,008 | |||
Interest accretion | 38,029 | |||
Payments | (39,742 | ) | ||
Balance as of September 30, 2004 | $ | 688,761 | ||
Balance as of December 31, 2004 | $ | 597,594 | ||
Interest accretion | 11,446 | |||
Payments | (14,825 | ) | ||
Balance as of March 31, 2005 | $ | 594,215 | ||
Interest accretion of $12,933 and $14,161 for the three months ended September 30, 2004 and 2003, respectively, and $38,029 and $28,240 for the nine months ended September 30, 2004 and 2003, respectively, are included in interest expense.
Note 12. Income Tax
The effective tax rate for the three and nine months ended September 30, 2004 was 30.7% and 31.3%, respectively, compared to 33.2% and 35.8% for the three and nine months ended September 30, 2003, respectively. The decrease in the rate in 2004 is primarily attributable to discrete items that occurred in the second and third quarters of 2004. The primary discrete item in the third quarter was an increase in the Company’s deferred state tax assets as a result of a change in the taxation of our state and local income. The primary
12
MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share and percent data)
discrete items in the second quarter that, together with the third quarter discrete items resulted in the decrease in the nine-month effective tax rate were the favorable settlement and reassessment of various tax controversies and the filing and recognition of refund claims, partially offset by an increase in the valuation allowance for the future realization of a benefit from a capital loss carryover. Absent the discrete items the Company’s effective tax rate for the three and nine month periods ended September 30, 2004 would have been 36.8% and 36.3%, respectively, compared to 33.2% and 33.1% for the three and nine month periods ended September 30, 2003, respectively. The increase in the 2004 rates before discrete items is primarily attributable to a decrease in the percentage of tax exempt interest income and other favorable permanent tax items as a percent of pretax income, as well as a change in the geographic distribution of pretax income from taxable jurisdictions with lower rates to those with higher rates.
Note 13.8. Legal Proceedings
MasterCard is a party to legal proceedings with respect to a variety of matters in the ordinary course of business. Except as described below, MasterCard does not believe that any legal proceedings to which it is a party would have a material impact on its results of operations, financial position, or cash flows.
Department of Justice Antitrust Litigation and Related Private LitigationLitigations
In October 1998, the United States Department of Justice (“DOJ”) filed suit against MasterCard International, Visa U.S.A., Inc. and Visa International Corp. in the U.S. District Court for the Southern District of New York alleging that both MasterCard’s and Visa’s governance structure and policies violated U.S. federal antitrust laws. First, the DOJ claimed that “dual governance” — the situation where a financial institution has a representative on the board of directors of MasterCard or Visa while a portion of its card portfolio is issued under the brand of the other association — was anti-competitive and acted to limit innovation within the payment card industry. At the same time, the DOJ conceded that “dual issuance” — a term describing the structure of the bank card industry in the United States in which a single financial institution can issue both MasterCard and Visa-branded cards — was pro-competitive. Second, the DOJ challenged MasterCard’s Competitive Programs Policy (“CPP”) and a Visa bylaw provision that prohibit financial institutions participating in the respective associations from issuing competing proprietary payment cards (such as American Express or Discover). The DOJ alleged that MasterCard’s CPP and Visa’s bylaw provision acted to restrain competition.
A bench trial concerning the DOJ’s allegations was concluded on August 22, 2000. On October 9, 2001, the District Court judge issued an opinion upholding the legality and pro-competitive nature of dual governance. In so doing, the judge specifically found that MasterCard and Visa have competed vigorously over the years, that prices to consumers have dropped dramatically, and that MasterCard has fostered rapid innovations in systems, product offerings and services.
However, the judge also held that MasterCard’s CPP and the Visa bylaw constitute unlawful restraints of trade under the federal antitrust laws. The judge found that the CPP and Visa bylaw weakened competition and harmed consumers by preventing competing proprietary payment card networks such as American Express and Discover from entering into agreements with banks to issue cards on their networks. In reaching this decision, the judge found that two distinct markets — a credit and charge card issuing market and a network services market — existed in the United States, and that both MasterCard and Visa had market power in the network market. MasterCard strongly disputes these findings and believes that the DOJ failed, among other things, to demonstrate that U.S. consumers have been harmed by the CPP.
On November 26, 2001, the judge issued a final judgment that ordersordered MasterCard to repeal the CPP insofar as it applies to issuers and enjoinsenjoined MasterCard from enacting or enforcing any bylaw, rule, policy or practice that prohibits its issuers from issuing general purpose credit or debit cards in the United States on any other general purpose card network. The judge also concluded that during the period in which the CPP was in effect, MasterCard was able to “lock up” certain members by entering into long-term agreements with them pursuant to which the members committed to maintain a certain percentage of their general purpose card volume, new card issuance or total number of cards in force in the United States on MasterCard’s network. Accordingly, the final judgment also provides that there will be a period (commencing onfrom the effective date of the final judgment and ending on the later of two years from that date or two years from the resolution of any final appeal) during whichuntil October 15, 2006, MasterCard will beis required to permit any issuer with which it entered into such an agreement prior to the effective date of the final judgment to terminate that agreement without penalty, provided that the reason for the termination is to permit the issuer to enter into an agreement with American Express or Discover. MasterCard would be free to apply to the District Court to recover funds paid but not yet earned under any terminated agreement. The final judgment
13
MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share and percent data)
imposes parallel requirements on Visa. The judge explicitly provided that MasterCard and Visa would be free to enter into new partnership or member business agreements in the future.
MasterCard appealed the judge’s ruling with respect to the CPP and on February 6, 2002, the judge issued an order granting MasterCard’s and Visa’s motion to stay the final judgment pending appeal.CPP. On September 17, 2003 a three-judge panel of the Second Circuit issued its decision upholding the District Court’s decision. On May 10, 2004, MasterCard filed a petition for certiorari with the Supreme Court. On October 4, 2004, the Supreme Court denied MasterCard’s petition for certiorari, thereby exhausting all avenues for further appeal in this case. The Second Circuit issued its mandate onThereafter, the parties agreed that October 15, 2004. MasterCard will treat2004 would serve as the effective date of the final judgment as effective as of October 15, 2004.judgment.
In addition, onOn September 18, 2003, MasterCard filed a motion before the District Court judge in this casethe DOJ litigation seeking to enjoin Visa, pending completion of the appellate process, from enforcing a newly-enacted bylaw requiring Visa’s 100 largest issuers of debit cards in the United States to pay a so-called “settlement service” fee if they reduce their Visa debit volume by more than 10%. This bylaw was later modified to clarify that the settlement service fee would only be imposed if an issuer shifted its portfolio of debit cards to MasterCard. Visa implemented this bylaw provision following the settlement of the U.S. merchant lawsuit described under the heading “U.S. Merchant Opt Out and Consumer Litigations” below. MasterCard believes that this bylaw is punitive and inconsistent with the final judgment in the DOJ litigation. On December 8, 2003, the District Court judge ruled that the District Court lacked jurisdiction to issue an injunction, but held that the court would have the authority to rescind contracts entered into by issuers with Visa during the time that the settlement service fee was in effect if the court’s final judgment is upheld on appeal and the court finds that the settlement service fee violates the final judgment. In lightAs a result of the Supreme Court’s denial of certiorari, MasterCard maythe District Court now renew its challengehas jurisdiction over issues related to the bylawfinal judgment in the DOJ litigation. On January 10, 2005, MasterCard moved before the District Court.Court to enforce the terms of the final judgment and sought an order enjoining Visa from enforcing or maintaining its settlement service fee bylaw. In addition, MasterCard requested that the Court permit
10
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and percent data)
Visa’s largest 100 debit issuers to rescind any debit issuance agreements they entered into with Visa while the settlement service fee was in effect. The motion is scheduled to be fully briefed on May 16, 2005. At this time it is not possible to determine the ultimate resolution of this matter.
On October 4, 2004, Discover Financial Services, Inc., filed a complaint against MasterCard, Visa U.S.A., Inc. and Visa International Incorporated. The complaint was filed in the U.S. District Court for the Southern District of New York and was designated as a related case to the DOJ litigation, and preliminarily assigned to the same judge. The complaint alleges that the implementation and enforcement of MasterCard’s CPP and Visa’s bylaw provision as well as MasterCard’s “Honor All Cards” rule (and a similar Visa rule), which require merchants who accept MasterCard cards to accept for payment every validly presented MasterCard card, violated Sections 1 and 2 of the Sherman Act as well as California’s Unfair Competition Act. The complaint also challenged MasterCard’s “no surcharge rule” (and a similar Visa rule) under the same statutes. On December 10, 2004, MasterCard moved to dismiss the complaint in its entirety for failure to state a claim. In lieu of filing its opposition papers to MasterCard’s motion, Discover filed an amended complaint on January 7, 2005. In the amended complaint, Discover dropped some of its claims, including its challenge against the no surcharge rule and its claims under California’s Unfair Competition Act, but continues to allege that the implementation and enforcement of the Company’s CPP, Visa’s bylaw provision and the Honor All Cards rules are in violation of Sections 1 and 2 of the Sherman Act. Discover requests that the District Court apply collateral estoppel with respect to its final judgment in the DOJ litigation and enter an order that the CPP and Visa’s bylaw provision have injured competition and caused injury to Discover. Discover seeks treble damages in an amount to be proved at trial along with attorneys’ fees and costs. MasterCard’s timeOn February 7, 2005, MasterCard moved to dismiss Discover’s amended complaint in whichits entirety for failure to respondstate a claim. On April 14, 2005, the Court denied Discover’s request to give collateral estoppel effect to the complaint is currently running.findings in the DOJ litigation. In addition, the Court denied MasterCard’s motion to dismiss the majority of Discover’s claims. However, the Court reserved ruling with respect to MasterCard’s motion to dismiss those portions of Discover’s claims that are based on MasterCard’s Honor All Cards rule as well those claims under Section 2 of the Sherman Act. At this time it is not possible to determine the ultimate resolution of this matter. At the time of this report, American Express has not initiated a similar private lawsuit against MasterCard although its executives have made public comments that they are currently considering such an action. No provision for losses has been provided in connection with the Discover litigation.
On November 15, 2004, American Express filed a complaint against MasterCard, Visa and eight member banks, including J.P. Morgan Chase & Co., Bank of America Corp., Capital One Financial Corp., U.S. Bancorp, Household International Inc., Wells Fargo & Co., Providian Financial Corp. and USAA Federal Savings Bank. The complaint, which was filed in the U.S. District Court for the Southern District of New York, was designated as a related case to the DOJ litigation and was assigned to the same judge. The complaint alleges that the implementation and enforcement of MasterCard’s CPP and Visa’s bylaw provision violated Sections 1 and 2 of the Sherman Act. American Express seeks treble damages in an amount to be proved at trial, along with attorneys’ fees and costs. On January 14, 2005, MasterCard filed a motion to dismiss the complaint for failure to state a claim. On April 14, 2005, the District Court denied American Express’ request to give collateral estoppel effect to the findings in the DOJ litigation. In addition, the Court denied MasterCard’s motion to dismiss the majority of American Express’ claims. However, the Court reserved ruling with respect to MasterCard’s motion to dismiss those portions of American Express’ claims that are based on MasterCard’s Honor All Cards rule as well those claims under Section 2 of the Sherman Act. At this time it is not possible to determine the ultimate resolution of this matter. No provision for losses has been provided in connection with the American Express litigation.
Currency Conversion Litigations
MasterCard International, together with Visa U.S.A., Inc. and Visa International Corp., are defendants in a state court lawsuit in California. The lawsuit alleges that MasterCard and Visa wrongfully imposed an asserted one percent currency conversion “fee” on every credit card transaction by U.S. MasterCard and Visa cardholders involving the purchase of goods or services in a foreign country, and that such alleged “fee” is unlawful. This action, titled Schwartz v. Visa Int’l Corp., et al., was brought in the Superior Court of California in February 2000, purportedly on behalf of the general public. Trial of the Schwartz matter commenced on May 20, 2002 and concluded on November 27, 2002. The Schwartz action claims that the alleged “fee” grossly exceeds any costs the defendants might incur in connection with currency conversions relating to credit card purchase transactions made in foreign countries and is not properly disclosed to cardholders. Plaintiffs seek to prevent defendants from continuing to engage in, use or employ the alleged practice of charging and collecting the asserted one percent currency conversion “fee” and from charging any type of purported currency conversion “fee” without providing a clear, obvious and comprehensive notice that a fee will be charged. Plaintiffs also request an order (1) requiring defendants to fund a corrective advertising campaign; and (2) awarding restitution of the monies allegedly wrongfully acquired by imposing the purported currency conversion “fee”. MasterCard denies these allegations.allegations.
11
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and percent data)
On April 8, 2003, the trial court judge issued a final decision in the Schwartz matter. In his decision, the trial judge found that MasterCard’s currency conversion process does not violate the Truth in Lending Act or regulations, nor is it unconscionably priced under California law. However, the judge found that the practice is deceptive under California law, and ordered that MasterCard mandate that members disclose the currency conversion process to cardholders in cardholder agreements, applications, solicitations
14
MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share and percent data)
and monthly billing statements. As to MasterCard, the judge also ordered restitution to California cardholders. The judge issued a decision on restitution on September 19, 2003, which requires a traditional notice and claims process in which consumers have approximately six months to submit their claims. The court issued its final judgment on October 31, 2003. On December 29, 2003, MasterCard appealed the judgment. The final judgment and restitution process have been stayed pending MasterCard’s appeal. On August 6, 2004 the court awarded plaintiff’s attorneys’ fees in the amount of $28,224 to be paid equally by MasterCard and Visa. Accordingly, during the three months ended September 30, 2004, MasterCard accrued amounts totaling $14,112 which are included in U.S. Merchant Lawsuit and Other Legal Settlements in the Consolidated Statements of Operations (see Note 11)7). MasterCard subsequently filed a notice of appeal on the attorneys’ fee award on October 1, 2004. With respect to restitution, MasterCard believes that it is likely to prevail on appeal. At this time it is not possible to determine the ultimate resolution of this matter. Other than as set forth above, no provision for losses has been provided in connection with this matter.
In addition, MasterCard has been served with complaints in state courts in New York, Arizona, Texas, Florida, Arkansas, Kentucky, Illinois, Tennessee, Michigan, Pennsylvania, Ohio, Minnesota and Missouri seeking to, in effect, extend the judge’s decision in the Schwartz matter to MasterCard cardholders outside of California. Some of these cases have been transferred to the U.S. District Court for the Southern District of New York and combined with the federal complaints in MDL No. 1409 discussed below. In other state court cases, MasterCard has moved to dismiss the claims. On December 12, 2003, the action in Kentucky was dismissed. On July 28, 2004,February 1, 2005 a New York stateMichigan action was dismissed without prejudice.with prejudice and on April 12, 2005, the plaintiff agreed to withdraw his appeal of that decision. MasterCard has also been served with complaints in state courts in California and Texas alleging it wrongfully imposed an asserted one percent currency conversion “fee” in every debit card transaction by U.S. MasterCard cardholders involving the purchase of goods or services in a foreign country and that such alleged “fee” is unlawful. Visa USA, Inc. and Visa International Corp. have been named as co-defendants in the California cases. One such Texas case was dismissed voluntarily by plaintiffs, however a new complaint is expected to be filed. At this time, it is not possible to determine the ultimate resolution of these matters.matters and no provision for losses has been provided in connection with them.
MasterCard International, Visa U.S.A., Inc., Visa International Corp., several member banks including Citibank (South Dakota), N.A., Citibank (Nevada), N.A., Chase Manhattan Bank USA, N.A., Bank of America, N.A. (USA), MBNA, and Diners Club are also defendants in a number of federal putative class actions that allege, among other things, violations of federal antitrust laws based on the asserted one percent currency conversion “fee”. Pursuant to an order of the Judicial Panel on Multidistrict Litigation, the federal complaints have been consolidated in MDL No. 1409 before Judge William H. Pauley III in the U.S. District Court for the Southern District of New York. In January 2002, the federal plaintiffs filed a Consolidated Amended Complaint (“MDL Complaint”) adding MBNA Corporation and MBNA America Bank, N.A. as defendants. This pleading asserts two theories of antitrust conspiracy under Section 1 of the Sherman Act: (i) an alleged “inter-association” conspiracy among MasterCard (together with its members), Visa (together with its members) and Diners Club to fix currency conversion “fees” allegedly charged to cardholders of “no less than 1% of the transaction amount and frequently more;” and (ii) two alleged “intra-association” conspiracies, whereby each of Visa and MasterCard is claimed separately to have conspired with its members to fix currency conversion “fees” allegedly charged to cardholders of “no less than 1% of the transaction amount” and “to facilitate and encourage institution — and collection — of second tier currency conversion surcharges.” The MDL Complaint also asserts that the alleged currency conversion “fees” have not been disclosed as required by the Truth in Lending Act and Regulation Z.
Defendants have moved to dismiss the MDL Complaint. On July 3, 2003, Judge Pauley issued a decision granting MasterCard’s motion to dismiss in part. Judge Pauley dismissed the Truth in Lending claims in their entirety as against MasterCard, Visa and several of the member bank defendants. Judge Pauley did not dismiss the antitrust claims. DiscoveryFact discovery in this matter has closed but expert discovery is expected to close on November 19, 2004.ongoing. On November 12, 2003 plaintiffs filed a motion for class certification, which was granted on October 15, 2004. On March 9, 2005, Judge Pauley issued a decision on defendants’ motion to reconsider the class certification decision. The Judge ruled that the arbitration provisions in the cardholder agreements of member bank defendants, Bank One, MBNA, Providian,
12
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and percent data)
Household and Bank of America are valid as to those respective banks and MasterCard and, consequently, cardholders of those banks can no longer participate in the class action certified in his earlier decision and must pursue any claims through arbitration. Plaintiffs have moved for further reconsideration. Judge Pauley declined to give effect to the arbitration clauses in the Citibank and Chase cardholder agreements; both banks have noticed an appeal of that decision. A trial date has been set for October 10, 2005. At this time, it is not possible to determine the ultimate resolution of this matter.
For the reasons set forth above, except as discussed above,matter and no provision for losses has been provided in connection with these currency conversion litigations.it.
Merchant Chargeback-Related Litigations
On May 12, 2003, a complaint alleging violations of federal and state antitrust laws, breach of contract, fraud and other theories was filed in the U.S. District Court for the Central District of California (Los Angeles) against MasterCard by a merchant aggregator whose customers include businesses selling adult entertainment content over the Internet. The complaint’s allegations focus on MasterCard’s past and potential future assessments on the plaintiff’s merchant bank (acquirer) for exceeding excessive chargeback
15
MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share and percent data)
standards in connection with the plaintiff’s transaction activity as well as the effect of MasterCard’s chargeback rules and other practices on “card-not-present” merchants. Chargebacks refer to a situation where a transaction is returned, or charged back, to an acquirer by an issuer at the request of cardholders or for other reasons. Prior to MasterCard filing any motion or responsive pleading, the plaintiff filed a voluntary notice of dismissal without prejudice on December 5, 2003. On the same date, the plaintiff filed a complaint in the U.S. District Court for the Eastern District of New York making similar allegations to those made in its initial California complaint. MasterCard moved to dismiss all of the claims in the complaint for failure to state a cause of action. On March 30, 2005 the judge granted MasterCard’s motion and dismissed all of the claims in the complaint. On April 11, 2005, the plaintiff filed a notice of appeal of the district court’s order. The Court has yet to schedule oral argument on the motion.time in which plaintiff may perfect its appeal is currently running.
In addition, on June 6, 2003, an action titled California Law Institute v. Visa U.S.A, et al. was initiated against MasterCard and Visa U.S.A., Inc. in the Superior Court of California, purportedly on behalf of the general public. Plaintiffs seek disgorgement, restitution and injunctive relief for unlawful and unfair business practices in violation of California Unfair Trade Practices Act Section 17200, et. seq. Plaintiffs purportedly allege that MasterCard’s (and Visa’s) chargeback fees are unfair and punitive in nature. Plaintiffs seek injunctive relief preventing MasterCard from continuing to engage in its chargeback practices and requiring MasterCard to provide restitution and/or disgorgement for monies improperly obtained by virtue of them. On August 13, 2003,November 19, 2004, MasterCard made motions seekingmoved for judgment on the grounds that recent amendments to dismiss the complaint in its entirety or, in the alternative, to narrow the scopesections 17203 and 17204 of the proceedingCalifornia Business and add necessary parties. Oral argument onProfessions Code by the motions was held on October 27, 2003. TheCalifornia State Ballot Initiative Proposition 64 mandate that the California Law Institute, as an unaffected plaintiff, does not have standing to pursue this action. By order dated December 29, 2004, the Court denied the motions.motion but certified the question presented as appropriate for appellate resolution. On April 22, 2005, the California Supreme Court denied MasterCard’s petition for appellate review. Initial, but limited, discovery is now proceeding in this matter.
On September 20, 2004, MasterCard was served with a complaint titled PSW Inc. v. Visa U.S.A, Inc,Inc., MasterCard International Incorporated, et. al., No. 04-347, in the District Court of Rhode Island. The plaintiff, as alleged in the complaint, provided credit card billing services primarily for adult content web sites. The plaintiff alleges defendants’ excessive chargeback standards, exclusionary rules, merchant registration programs, cross-border acquiring rules and interchange pricing to internet merchants violate federal and state antitrust laws as well as state contract and tort law. The plaintiff seeks $60,000 in compensatory damages as well as $180,000 in punitive damages. On November 24, 2004, MasterCard moved to dismiss the complaint. Prior to the Court ruling on MasterCard’s motion to dismiss, plaintiffs filed an amended complaint on April 6, 2005. This complaint generally mirrors the original complaint but includes additional causes of action based on the purported deprivation of plaintiff’s rights under the First Amendment of the U.S. Constitution. MasterCard’s time in which to respond to the amended complaint is currently running.
At this time it is not possible to determine the outcome of the merchant chargeback-related litigations. For reasons set forth above, noNo provision for losses has been provided in connection with these litigations.
13
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and percent data)
U.S. Merchant Opt Out and Consumer Litigations
Commencing in October 1996, several class action suits were brought by a number of U.S. merchants against MasterCard International and Visa U.S.A., Inc. challenging certain aspects of the payment card industry under U.S. federal antitrust law. Those suits were later consolidated in the U.S. District Court for the Eastern District of New York. The plaintiffs challenged MasterCard’s “Honor All Cards” rule (andand a similar Visa rule), which required merchants who accept MasterCard cards to accept for payment every validly presented MasterCard card.rule. Plaintiffs claimed that MasterCard and Visa unlawfully tied acceptance of debit cards to acceptance of credit cards. In essence, the merchants desired the ability to reject off-line, signature-based debit transactions (for example, MasterCard card transactions) in favor of other payment forms including on-line, PIN-based debit transactions (for example, Maestro or regional ATM network transactions) which generally impose lower transaction costs for merchants. The plaintiffs also claimed that MasterCard and Visa conspired to monopolize what they characterized as the point-of-sale debit card market, thereby suppressing the growth of regional networks such as ATM payment systems. Plaintiffs alleged that the plaintiff class had been forced to pay unlawfully high prices for debit and credit card transactions as a result of the alleged tying arrangement and monopolization practices. On June 4, 2003, MasterCard International signed the Settlement Agreement to settle the claims brought by the plaintiffs in this matter, which the Court approved on December 19, 2003. A number of class members have appealed the district court’sDistrict Court’s approval of the settlement to the Second Circuit Court of Appeals.settlement. These appeals are largely focused on the court’sCourt’s attorneys’ fees award as well on the court’sCourt’s ruling on the scope of the release. Therelease set forth in the Settlement Agreement. On January 4, 2005, the Second Circuit heard oral argumentsCourt of Appeals issued an order affirming the District Court’s approval of the U.S. merchant Settlement Agreement. The time for which class members may seek certiorari of the Second Circuit’s decision with the Supreme Court expires on these appeals on August 25, 2004 and a decision is currently pending.May 31, 2005. For a further description of the U.S. merchant lawsuit settlement and its impact on MasterCard’s financial results, see Note 11.
Several lawsuits have been commenced by merchants who have opted not to participate in the plaintiff class in the U.S. merchant lawsuit, including Best Buy Stores, CVS, Giant Eagle, Home Depot, Toys “R” Us and Darden Restaurants. The majority of these cases were filed in the U.S. District Court for the Eastern District of New York and we expect that all of these cases will be tried in that Court for, at minimum, pretrial issues. On March 19, 2004, the opt out merchants amended their complaints to include allegations, among other things: (i) that MasterCard’s (and Visa’s) interchange fees contravene the Sherman Act and (ii) that the opt out merchants
16
MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share and percent data)
were harmed by MasterCard’s CPP. MasterCard filed its response to the amended complaints on April 21, 2004. MasterCard has entered into separate settlement agreements with CVS, Home Depot and Darden Restaurants resolving those opt out merchants’ claims against MasterCard. The District Court has entered orders dismissing with prejudice the respective merchants’ complaints against MasterCard. MasterCard continues to be involved in court-ordered mediation with the remaining opt out merchant plaintiffs while discovery continues to proceed.7.
In addition, individual or multiple complaints have been brought in 19 different states and the District of Columbia under state unfair competition statutes against MasterCard International (and Visa) on behalf of putative classes of consumers. The claims in these actions mirror the allegations made in the U.S. merchant lawsuit and assert that merchants, faced with excessive merchant discount fees, have passed these overcharges to consumers in the form of higher prices on goods and services sold. While these actions are in their early stages, MasterCard has filed motions to dismiss the complaints in a number of state courts for failure to state a cause of action. Courts in Arizona, Iowa, New York, Michigan, Minnesota, Nebraska, Maine, North Dakota, Kansas, North Carolina, and South Dakota, Vermont, Wisconsin and the District of Columbia have granted MasterCard’s motions and dismissed the complaints with prejudice. The plaintiffs in the New York, Maine and Michigan casesPlaintiffs have filed a noticeappealed several of appeal and the time in which the plaintiffs in the other states may appeal is currently running.these decisions. The plaintiffs in Minnesota have filed a revised complaint on behalf of a purported class of Minnesota consumers who made purchases with debit cards rather than on behalf of all consumers, MasterCard's time in whichconsumers. On January 6, 2005, MasterCard moved to responddismiss the Minnesota complaint for failure to this complaint is currently running.state a claim. In addition, the courts in Tennessee and California have granted MasterCard’s motion to dismiss the respective state unfair competition claims but have denied MasterCard’s motions with respect to unjust enrichment claims in Tennessee and Section 17200 claims for unlawful, unfair, and/or fraudulent business practices in California. MasterCard hasThe Tennessee decisions are expected to be appealed the court’s decision in Tennessee on the unjust enrichment claims and plaintiffs have filed a motion for reconsideration of the court’s dismissal of their antitrust claims. The time in which MasterCard and plaintiff may appeal the California ruling is currently running.by both parties. MasterCard is awaiting decisions on its motions to dismiss in the other state courts.
On March 14, 2005, MasterCard was served with a complaint that was filed in Ohio state court on behalf of a putative class of consumers under Ohio state unfair competition law. The claims in this action mirror those in the consumer actions described above but also name as co-defendants a purported class of merchants who were class members in the U.S. merchant lawsuit. Plaintiffs allege that Visa, MasterCard and the class members of the U.S. merchant lawsuit conspired to attempt to monopolize the debit card market by tying debit card acceptance to credit card acceptance. MasterCard’s time in which to respond to the complaint is currently running.
At this time, it is not possible to determine the outcome of these consumer cases. Neither thecases and no provision for losses has been provided in connection with them. The consumer class actions nor the “opt out” merchant litigations are not covered by the terms of the Settlement Agreement in the U.S. merchant lawsuit.
Global Interchange Proceedings
Interchange fees represent a sharing of payment system costs among the financial institutions participating in a four-party payment card system such as MasterCard’s. Generally,Typically, interchange fees are paid by the merchant bank (the “acquirer”) to the cardholder bank (the “issuer”) in connection with transactions initiated with the payment system’s cards. These fees reimburse the issuer for a portion of the costs incurred by it in providing services which are of benefit to all participants in the system, including acquirers and merchants. MasterCard establishesor its members establish a multilateral interchange fee (“MIF”) in certain circumstances as a default fee that applies when there is no other interchange fee arrangement between the issuer and the acquirer. MasterCard establishes a variety of MIF rates depending on such considerations as the location and the type of transaction, and collects the MIF on behalf of the institutions entitled to receive it. As described more fully below, MasterCard’s or its members’ MIFs are subject
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and percent data)
to regulatory or legal review and/or challenges in a number of jurisdictions. At this time, it is not possible to determine the ultimate resolution of any of the interchange proceedings described below. Accordingly, no provision for losses has been provided in connection with them.
European Union.In September 2000, the European Commission issued a “Statement of Objections” challenging Visa International’s cross-border MIF under European Community competition rules. On July 24, 2002, the European Commission announced its decision to exempt the Visa MIF from these rules based on certain changes proposed by Visa to its MIF. Among other things, in connection with the exemption order, Visa agreed to adopt a cost-based methodology for calculating its MIF similar to the methodology employed by MasterCard, which considers the costs of certain specified services provided by issuers, and to reduce its MIF rates for debit and credit transactions to amounts at or below certain specified levels.
On September 25, 2003, the European Commission issued a Statement of Objections challenging MasterCard Europe’s cross-border MIF. MasterCard Europe filed its response to this Statement of Objections on January 5, 2004. MasterCard Europe is engaged in discussions with the European Commission in order to determine under what conditions, if any, the European Commission would issue a favorable ruling regarding MasterCard Europe’s MIF. If MasterCard is unsuccessful in obtaining a favorable ruling, the European Commission could issue a prohibition decision ordering MasterCard to change the manner in which it calculates its cross-border MIF. MasterCard could appeal such a decision to the European Court of Justice. Because the cross-border MIF constitutes an essential element of MasterCard Europe’s operations, changes to it could significantly impact MasterCard International’s European members and the MasterCard business in Europe. At this time, it is not possibleIn addition, a negative decision by the European Commission could lead to determine the ultimate resolutionfiling of this matter.
17
MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share and percent data)private actions against MasterCard by merchants seeking substantial damages.
United Kingdom Office of Fair Trading.On September 25, 2001, the Office of Fair Trading of the United Kingdom (“OFT”) issued a Rule 14 Notice under the U.K. Competition Act 1998 challenging the MasterCard MIF, the fee paid by acquirers to issuers in connection with point of sale transactions, and multilateral service fee (“MSF”), the fee paid by issuers to acquirers when a customer uses a MasterCard-branded card in the United Kingdom either at an ATM or over the counter to obtain a cash advance. TheUntil November 2004 (see below), the MIF and MSF arewere established by MasterCard U.K. Members Forum Limited (formerly MEPUK) (“MMF”) for domestic credit card transactions in the United Kingdom. The notice contained preliminary conclusions to the effect that the MasterCard U.K. MIF and MSF may infringe U.K. competition law and do not qualify for an exemption in their present forms. In January 2002, MasterCard, MEPUK and several MasterCard U.K. members responded to the notice. On February 11, 2003, the OFT issued a supplemental Rule 14 Notice, which also contained preliminary conclusions challenging MasterCard’s U.K. MIF under the Competition Act. On May 2, 2003, MasterCard and MMF responded to the supplemental notice. TheOn November 10, 2004, the OFT has given writtenissued a third notice that it will issue(now called a Statement of Objection inObjections) claiming that the MIF infringes U.K. competition law. In February 2005, MasterCard and MMF responded to the Statement of Objections. An oral hearing was held on March 2, 2005. The OFT is expected to reach a decision later this year.
On November 2004.
If18, 2004, MasterCard’s board of directors adopted a resolution withdrawing the authority of the U.K. members to set domestic MIFs and MSFs and conferring such authority exclusively on MasterCard’s President and Chief Executive Officer. As a result, if MasterCard and MMF are unsuccessful in obtaining a favorable ruling in the current proceeding, the OFT could issuewould have to commence a prohibition decisionnew proceeding for the purpose of ordering MasterCard to change the manner in which it calculates its U.K. MIF. The OFT has informed MasterCard that, if it issues a prohibition decision in the current proceedings, it is likely to commence a new proceeding challenging MasterCard’s setting of MIFs. Because the MIF constitutes an essential element of MasterCard’s U.K. operations, a negative decisiondecisions by the OFT in the current or any future proceedings could have a significant adverse impact on MasterCard’s U.K. members and on MasterCard’s competitive position and overall business in the U.K. In addition, a negative decision by the OFT could lead to the filing of private actions against MasterCard by merchants seeking substantial damages. In the event of a negative decision by the OFT in the current proceeding, MasterCard intendsand MMF intend to appeal to the Competition Appeals Tribunal and possibly to seek interim relief. Similarly, it is likely that MasterCard would appeal a negative decision by the OFT in any future proceeding to the Competition Appeals Tribunal and to seek interim relief. At this time, it is not possible to determine the ultimate resolution of this matter.
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MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and percent data)
United States.In July 2002, a purported class action lawsuit was filed by a group of merchants in the U.S. District Court for the Northern District of California against MasterCard International, Visa U.S.A., Inc., Visa International Corp. and several member banks in California alleging, among other things, that MasterCard’s and Visa’s interchange fees contravene the Sherman Act. The suit seeks treble damages in an unspecified amount, attorney’s fees and injunctive relief, including the divestiture of bank ownership of MasterCard and Visa, and the elimination of MasterCard and Visa marketing activities. On March 4, 2004, the court dismissed the lawsuit with prejudice in reliance upon the approval of the Settlement Agreement in the U.S. merchant lawsuit by the U.S. District Court for the Eastern District of New York, which held that the settlement and release in that case extinguished the claims brought by the merchant group in the present case. The plaintiffs have appealed the U.S. District Court for the Eastern District of New York’s approval of the U.S. merchant lawsuit settlement and release to the Second Circuit Court of Appeals and have also appealed the U.S. District Court for the Northern District of California’s dismissal of the present lawsuit to the Ninth Circuit Court of Appeals. Oral argument was held inOn January 4, 2005, the Second Circuit Court of Appeals on August 25, 2004,issued an order affirming the District Court’s approval of the U.S. merchant lawsuit settlement agreement, including the District Court’s finding that the settlement and arelease extinguished such claims. Plaintiffs’ time in which to seek certiorari of the Second Circuit’s decision with the U.S. Supreme Court is currently pending. At this time itrunning. The appeal to the Ninth Circuit is not possible to determine the outcome of this proceeding.currently pending.
On October 8, 2004, a new purported class action lawsuit was filed by a group of merchants in the U.S. District Court for the Northern District of California against MasterCard International, Visa U.S.A., Inc., Visa International Corp. and several member banks in California alleging, among other things, that MasterCard’s and Visa’s interchange fees contravene the Sherman Act and the Clayton Act. The complaint appears to contain substantivelycontains similar claimsallegations to those brought in the interchange case described in the preceding paragraph, and plaintiffs have designated it as a related case. The plaintiffs seek damages and an injunction against MasterCard (and Visa) setting interchange and engaging in “joint marketing activities,” which plaintiffs allege include the purported negotiation of merchant discount rates with certain merchants. On November 19, 2004, MasterCard filed an answer to the complaint. On March 29, 2005, the Court granted MasterCard’s time in whichrequest for permission to respond is currently running.file a motion for partial summary judgment, and the Court scheduled oral argument on that motion for July 8, 2005. Plaintiffs filed an amended complaint on April 25, 2005.
Other Jurisdictions.
In Spain, the competition tribunal issued a decision in April 2005 denying the interchange fee exemption applications of two of the three domestic credit and debit card processing systems and beginning the process to revoke the exemption it had previously granted to the third such system. In addition, the tribunal expressed views as to the appropriate manner for setting domestic interchange fees which, if implemented, would result in substantial reductions in credit and debit card interchange fees in Spain. This could have a material impact on MasterCard’s business in Spain.
MasterCard is aware that regulatory authorities in certain other jurisdictions, including Poland, Spain, New Zealand, Portugal, Mexico, Colombia, South Africa and Switzerland are reviewing MasterCard’s and/or its members’ interchange fees and/or related practices and may seek to regulate the establishment of such fees and/or such practices. At this time it is not possible to determine the outcome of these proceedings.
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MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and percent data)
Note 14.9. Settlement and Travelers Cheque Risk Management
Settlement risk is the legal exposure due to the difference in timing between the payment transaction date and subsequent final settlement. Settlement risk is estimated using the average daily card charges during the quarter multiplied by the estimated number of days to settle. The Company has global risk management policies and procedures, which include risk standards to provide a framework for managing the Company’s settlement exposure. MasterCard International’s rules generally guarantee the payment of MasterCard transactions and certain Cirrus and Maestro transactions between principal members. The term and amount of the guarantee are unlimited. Member-reported transaction data and the transaction clearing data underlying the settlement risk exposure calculation may be revised in subsequent reporting periods.
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MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share and percent data)
In the event that MasterCard International effects a payment on behalf of a failed member, MasterCard International may seek an assignment of the underlying receivables. Subject to approval by the Board of Directors, members may be assessed for the amount of any settlement loss.
MasterCard requires certain members that are not in compliance with the Company’s risk standards in effect at the time of review to post collateral, typically in the form of letters of credit and bank guarantees. This requirement is based on management review of the individual risk circumstances for each member that is out of compliance. In addition to these amounts, MasterCard holds collateral to cover:cover variability and future growth in member programs; the possibility that it may choose to pay merchants to protect brand integrity in the event of merchant bank (acquirer)bank/acquirer failure, although it is not contractually obligated to do so; and Cirrus and Maestro related risk. MasterCard monitors its credit risk portfolio on a regular basis to estimate potential concentration risks and the adequacy of collateral on hand. Additionally, from time to time, the Company reviews its risk management methodology and standards. As such, the amounts of uncollateralized estimated settlement exposure relating to non-compliant members are revised as necessary.
Estimated settlement exposure, and the portion of the Company’s uncollateralized settlement exposure for MasterCard-branded transactions that relates to members that are deemed not to be in compliance with, or that are under review in connection with, the Company’s risk management standards at September 30, 2004 and December 31, 2003 were as follows:
September 30, | December 31, | |||||||||||||||
2004 | 2003 | March 31, 2005 | December 31, 2004 | |||||||||||||
MasterCard-branded transactions: | ||||||||||||||||
Gross legal settlement exposure | $ | 12,691,503 | $ | 11,880,152 | $ | 13,021,047 | $ | 14,055,973 | ||||||||
Collateral held for legal settlement exposure | (1,423,032 | ) | (1,344,621 | ) | (1,213,315 | ) | (1,482,319 | ) | ||||||||
Net uncollateralized settlement exposure | $ | 11,268,471 | $ | 10,535,531 | $ | 11,807,732 | $ | 12,573,654 | ||||||||
Uncollateralized settlement exposure attributable to non-compliant members | $ | 265,721 | $ | 250,984 | $ | 363,072 | $ | 299,995 | ||||||||
Cirrus and Maestro transactions: | ||||||||||||||||
Gross legal settlement exposure | $ | 889,666 | $ | 591,317 | $ | 1,333,028 | $ | 1,294,145 | ||||||||
Although MasterCard holds collateral at the member level, the Cirrus and Maestro estimated settlement exposures are calculated at the regional level. Therefore, these settlement exposures are reported on a gross basis, rather than net of collateral.
MasterCard’s estimated settlement exposure under the MasterCard brand, net of collateral, had concentrations of 57%54% and 58%56% in North America and 22%23% and 22%23% in Europe at September 30, 2004March 31, 2005 and December 31, 2003,2004, respectively.
A significant portion of the uncollateralized settlement exposure attributable to non-compliant members is concentrated in five members ($235,092) and three members ($127,425 and $157,955 for September 30, 2004163,786) at March 31, 2005 and December 31, 2003, respectively).2004, respectively.
17
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and percent data)
MasterCard guarantees the payment of MasterCard-branded travelers cheques in the event of issuer default. The guarantee estimate is based on all outstanding MasterCard-branded travelers cheques, reduced by an actuarial determination of cheques that are not anticipated to be presented for payment. The term and amount of the guarantee are unlimited. MasterCard calculated its MasterCard-branded travelers cheques exposure under this guarantee as $1,185,500$1,078,882 and $1,205,921$1,172,533 at September 30, 2004March 31, 2005 and December 31, 2003,2004, respectively.
A significant portion of the Company’s credit risk is concentrated in one MasterCard travelers cheque issuer. MasterCard has obtained an unlimited guarantee estimated at $984,934$885,131 and $996,927$969,593 at September 30, 2004March 31, 2005 and December 31, 2003,2004, respectively, from a financial institution that is a member, to cover all of the exposure of outstanding travelers cheques with respect to that issuer. In addition, MasterCard has obtained guarantees estimated at $28,833$27,449 and $32,101$28,592 at September 30, 2004March 31, 2005 and December 31, 2003,2004, respectively, from financial institutions that are members in order to cover the exposure of outstanding travelers cheques with respect to another issuer. These guarantee amounts have also been reduced by an actuarial determination of cheques that are not anticipated to be presented for payment.
Based on the Company’s ability to assess its members for settlement and travelers cheque losses, the effectiveness of the Company’s global risk management policies and procedures, and the historically low level of losses that the Company has experienced, management believes the probability of future payments for settlement and travelers cheque losses in excess of existing
19
MASTERCARD INCORPORATEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(In thousands, except per share and percent data)
reserves is negligible. However, if circumstances in the future change, the Company may need to reassess whether it would be necessary to record an obligation for the fair value of some or all of its settlement and travelers cheque guarantees.
Note 15.10. Foreign Exchange Risk Management
The Company enters into foreign exchangecurrency forward contracts to minimize risk associated with anticipated receipts and disbursements denominated in foreign currencies. The Company also enters into contracts to offsetcurrencies and the possible changes in value due to foreign exchange fluctuations of assets and liabilities denominated in foreign currencies. MasterCard’s forward contracts are classified by functional currency as summarized below:
U.S. Dollar Functional Currency
September 30, 2004 | December 31, 2003 | March 31, 2005 | December 31, 2004 | |||||||||||||||||||||||||||||
Estimated | Estimated | Estimated | Estimated | |||||||||||||||||||||||||||||
Forward Contracts | Notional | Fair Value | Notional | Fair Value | Notional | Fair Value | Notional | Fair Value | ||||||||||||||||||||||||
Commitments to purchase foreign currency | $ | 38,348 | $ | (241 | ) | $ | 64,147 | $ | 595 | $ | 69,911 | $ | 61 | $ | 40,981 | $ | 1,854 | |||||||||||||||
Commitments to sell foreign currency | 18,920 | (355 | ) | 60,162 | (46 | ) | $ | 43,802 | $ | (153 | ) | 20,226 | (655 | ) |
Euro Functional Currency
September 30, 2004 | December 31, 2003 | March 31, 2005 | December 31, 2004 | |||||||||||||||||||||||||||||
Estimated | Estimated | Estimated | Estimated | |||||||||||||||||||||||||||||
Forward Contracts | Notional | Fair Value | Notional | Fair Value | Notional | Fair Value | Notional | Fair Value | ||||||||||||||||||||||||
Commitments to purchase foreign currency | $ | 55,708 | $ | (1,445 | ) | $ | 178,030 | $ | (5,112 | ) | $ | 144,584 | $ | (1,676 | ) | $ | 128,253 | $ | (6,494 | ) |
The currencies underlying the foreign currency forward contracts consist primarily of euro, U.K. pounds sterling, Swiss francs, Japanese yen, Australian dollar, and U.K. pounds sterling.Mexican peso. The fair value of the foreign currency forward contracts generally reflects the estimated amounts that the Company would receive or (pay), on a pre-tax basis, to terminate the contracts at the reporting date based on broker quotes for the same or similar instruments. The terms of the foreign currency forward contracts are generally less than 18 months. The Company has deferred $1,275$1,130 and $3,069$3,497 of net losses, after tax, in accumulated other comprehensive income as of September 30, 2004March 31, 2005 and December 31, 2003,2004, respectively, all of which areis expected to be reclassified to earnings within the next threenine months to provide an economic offset to the earnings impact of the anticipated cash flows hedged.
The Company’s derivative financial instruments are subject to both credit and market risk. Credit risk is the risk of loss due to failure of athe counterparty to perform its obligations in accordance with contractual terms. Market risk
18
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — Continued
(In thousands, except per share and percent data)
is the potential change in an investment’s value caused by fluctuations in interest and currency exchange rates, credit spreads or other variables. Credit and market risk related to derivative instruments were not material at September 30, 2004March 31, 2005 and December 31, 2003.2004.
Generally, the Company does not obtain collateral related to forward contracts because of the high credit ratings of the counter-partiescounterparties that are members. The amount of accounting loss the Company would incur if the counterparties failed to perform according to the terms of the contracts is not considered material.
20Note 11. Acquisition of MasterCard Europe
On June 28, 2002, MasterCard Incorporated issued 23,760 shares of its common stock to the shareholders of Europay International (“EPI”), now MasterCard Europe, and MasterCard Europay U.K. Limited (“MEPUK”), in return for directly and indirectly acquiring 100% of the shares of EPI not previously owned by MasterCard International. Of the 23,760 shares attributable to the exchange of EPI and MEPUK shares, 6,150 shares are conditional shares subject to reallocation at the end of the three-year transition period as a result of the application of a global proxy formula for the third year of the transition period. In calculating the purchase price of EPI, the Company considered only the unconditional shares issued to the former shareholders of EPI and MEPUK. Since former EPI and MEPUK shareholders would retain or receive additional shares without remitting any additional consideration, any conditional shares retained or received by them would constitute a part of the purchase price. Any conditional shares would be valued based upon the fair value of the stock of MasterCard Incorporated as of June 28, 2005, would increase the purchase price for EPI and, accordingly, the amount of goodwill and additional paid-in capital initially recorded.
19
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the consolidated financial statements and notes of MasterCard Incorporated and its consolidated subsidiaries, including MasterCard International Incorporated (“MasterCard International”) and MasterCard Europe sprl (“MasterCard Europe”)(together, “MasterCard” or the “Company”) included elsewhere in this report. References to “we”, “our” and similar terms in the following discussion are references to the Company.
Forward-Looking Statements
This Report on Form 10-Q contains forward-looking statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. When used in this Report, the words “believe,” “expect,” “could,” “may,” “would”, “will” and similar words are intended to identify forward-looking statements. These statements relate to our future prospects, developments and business strategies. Many factors and uncertainties relating to our operations and business environment, all of which are difficult to predict and many of which are outside of our control, influence whether any forward-looking statements can or will be achieved. Any one of those factors could cause our actual results to differ materially from those expressed or implied in writing in any forward-looking statements made by MasterCard or on its behalf. We believe there are certain risk factors that are important to our business, and these could cause actual results to differ from our expectations. Please seeReference should be made to the Company’s 2004 Annual Report on Form 10-K for a complete discussion of these risk factors under the caption “Risk Factors” in Item 1 — Business of the Annual Report on Form 10-K of MasterCard for the year ended December 31, 2003.Business.
Overview
We achieved double-digit revenue growth of 12%11% in the first three months of 2005 from the comparable period in 2004, of which 1% was due to the impact of favorable foreign currency fluctuation against the euro. The increase in revenue was due to higher gross dollar volume (“GDV”) and more transactions being processed by MasterCard, primarily from the expansion of our customer relationships and higher cross-border travel. Rebates and incentives were 19% and 15% of our gross revenues in the three months ended September 30,March 31, 2005 and 2004, respectively, and 15%accordingly, are moderating our revenue growth. In addition, in the ninefirst three months ended September 30, 2004 from the comparable periods in 2003. Of these increases, 2% in each period was due to the weakening of the U.S. dollar against the euro in 2004 versus the comparable period in 2003, which created a favorable foreign currency translation. Increased usage of MasterCard products spurred by economic recovery in many of the countries in which2005, we do business resulted in higher gross dollar volume and more transactions processed by MasterCard. In addition, the conflict in Iraq, threat of terrorism, and SARS negatively impacted cross-border travel in the beginning of 2003. As international travel returned to more normal levels in 2004, our cross-border transactions and related revenue have increased significantly.
Our cost control initiatives have taken effect. Excluding the impact of the U.S. merchant lawsuit and other legal settlements,reduced our operating expenses as a percentage of totalnet revenues declined to 76% from 79%77% compared to 80% for the same period in 2004. As a result, our net income increased 26% in the first three months ended September 30, 2004, and to 80% from 86% for the nine months ended September 30, 2004, in each case fromof 2005 versus the comparable period in 2003. Excluding2004.
We believe revenue growth was positively impacted by the impactworldwide trend in which payments are migrating from paper-based forms to electronic forms such as payment cards. This trend has helped drive our volume and revenue growth for a number of the U.S. merchant lawsuit and other legal settlements,years. However, our operating expenses increased 8%net revenue growth in 2005 will be moderated by pricing arrangements with certain large customers. These pricing arrangements reflect enhanced competition in the three months ended September 30, 2004 and 6% for the nine months ended September 30, 2004, in each case from the comparable period in 2003. In each of the periods 1% of the increase was due to the weakening of the U.S. dollar against the euro, creating an unfavorable currency translation.
As theglobal payments industry and the continued consolidation and globalization of our key customers and merchants.
Our financial position continues to evolve, we face increased competition, consolidationreflect strong liquidity. We have $1.1 billion in cash, cash equivalents and globalization.available-for-sale securities and $1 billion in stockholders’ equity as of March 31, 2005. We are,have begun to implement strategic initiatives by hiring additional resources and will continuedeveloping sales personnel to be, significantly dependent on our relationships with our issuers and acquirers and their further relationships with cardholders and merchants to support our programs and services. Most ofimprove our relationships with our customers are not exclusive and may be terminated at the convenience ofmerchants that accept our cards. We will seek to leverage our expertise in payment programs, consulting services, brand marketing, technology and processing to expand the value-added services we provide our customers. The consolidation or merger of one or more ofWe expect our customers with financial institutions aligned with our competitors could have a material adverse impact on our revenues.
In recent years, our corporate strategy has been to focus on our key customers toefforts will drive our business growth; to strengthen our brands, technology and acceptance network; and to differentiate MasterCard from our competition by developing innovative payment solutions and customized consulting services. In 2004, we remain committed to this strategic direction and have begun to implement initiatives to expand our customer-focused approach to a broader group of customers, as well as to further develop relationships with merchants that accept our cards. In addition, we will continueintend to focus resources on proactively addressingaddress the legal, regulatory and regulatoryother industry risks that impact our business, as described more fully below.business. We believe our resources are sufficient to fund our initiatives in 2005 and beyond.
2120
Legal and Regulatory Results of Operations
Percent | ||||||||||||
For the three | Increase | |||||||||||
months ended | (Decrease) | |||||||||||
March 31, | 2005 vs. | |||||||||||
2005 | 2004 | 2004 | ||||||||||
(In millions, except per share and GDV amounts) | ||||||||||||
Operations fees | $ | 412 | $ | 372 | 10.8 | |||||||
Assessments | 246 | 222 | 10.8 | |||||||||
Revenue | 658 | 594 | 10.8 | |||||||||
General and administrative | 307 | 277 | 10.8 | |||||||||
Advertising and market development | 172 | 167 | 3.0 | |||||||||
U.S. merchant lawsuit and other legal settlements | — | — | — | |||||||||
Depreciation and amortization | 28 | 32 | (12.5 | ) | ||||||||
Total operating expenses | 507 | 476 | 6.5 | |||||||||
Operating income | 151 | 118 | 28.0 | |||||||||
Total other income (expense) | (7 | ) | (4 | ) | (75.0 | ) | ||||||
Income before income tax expense | 144 | 114 | 26.3 | |||||||||
Income tax expense | 51 | 40 | 27.5 | |||||||||
Net income | $ | 93 | $ | 74 | 25.7 | |||||||
Net income per share (basic and diluted) | $ | .93 | $ | .74 | 25.7 | |||||||
Weighted average shares outstanding (basic and diluted) | 100 | 100 | — | |||||||||
Effective income tax rate | 35.3 | % | 35.3 | % | — | |||||||
Gross dollar volume (“GDV”) on a U.S. dollar converted basis (in billions) | 379.6 | 334.3 | 13.5 | |||||||||
Processed transactions | 3,112.4 | 2,794.8 | 11.4 |
Impact on our Businessof Foreign Currency Rates
Our financial results have been and will continueoperations are impacted by changes in foreign currency exchange rates. Quarterly assessment fees are calculated based on local dollar volume which is converted to be significantly influenced byU.S. dollar volume using average exchange rates for the legal and regulatory environmentquarter. In 2005, the increase in which we operate our business. MasterCard isGDV of 14% on a party to several legal and regulatory proceedings, as discussedU.S. dollar converted basis exceeded local currency GDV growth of 11%, resulting in Note 13increased assessment revenues due to the Consolidated Financial Statements included herein, which could have a material adverse impact on our business. In particular, any of the following outcomes to our legal and regulatory proceedings could adversely affect our results of operations and liquidity:
See Note 13 to the Consolidated Financial Statements included herein for a discussion of these and other legal and regulatory proceedings to which we are a party.
We earn a portion of our revenues in connection with MasterCard-branded offline debit cards issued in the United States. Following the settlementdevaluation of the U.S. merchant lawsuit in 2003, Visa U.S.A., Inc. implemented a bylaw requiring Visa’s 100 largest issuers of debit cards in the United States to pay a fee if they reduce their debit volume by more than 10%. If Visa is permitted to enforce this bylaw, it would penalize Visa members seeking to do debit business with MasterCard and effectively prevent them from converting their debit cards to the MasterCard brand. MasterCard has challenged the validity of this bylaw provision.dollar. In addition, underconsumer behavior, particularly international transactions, may vary with changes in foreign currency exchange rates.
We are especially impacted by the Settlement Agreement in the U.S. merchant lawsuit, merchants have the right to reject MasterCard-branded debit cards in the United States, while still accepting other MasterCard-branded cards and vice versa. These scenarios may be detrimental to MasterCard’s ability to maintain and grow its debit card business in the United States.
As a resultmovements of the U.S. Supreme Court’s denial of our petition for certiorari with respecteuro to the U.S. Department of Justice litigation described in Note 13 to the Consolidated Financial Statements included herein.dollar since MasterCard will be required to repeal its Competitive Programs Policy, which prohibited its members from issuing credit cards on competing proprietary networks (such as American Express and Discover). Furthermore, for a period of two years from the entry of the final judgment, members will be permitted to terminate without penalty, agreements that they entered into with MasterCard prior to the effective date of the final judgment, whereby the member agreed to long-term commitments to the MasterCard brand, provided that the reason for such termination is to permit the member to enter into an agreement with American Express or Discover. Repeal of the Competitive Programs Policy and/or termination of certain member business agreements could cause members to reduce, or reduce the growth of, their MasterCard-branded card volumes, which could have an adverse impact on our business. On January 29, 2004, MBNA Corporation announced its intention to offer American Express credit cards to its customers.
22
Results of Operations
Key selected financial and operating data for the three and nine months ended September 30, 2004 and 2003 is included in the table below:
Percent | Percent | |||||||||||||||||||||||
Three Months | Increase | Nine Months | Increase | |||||||||||||||||||||
Ended September 30, | (Decrease) 2004 vs. | Ended September 30, | (Decrease) 2004 vs. | |||||||||||||||||||||
2004 | 2003 | 2003 | 2004 | 2003 | 2003 | |||||||||||||||||||
(in millions, except per share amounts and percentages) | ||||||||||||||||||||||||
Operations fees | $ | 419 | $ | 373 | 12 | % | $ | 1,188 | $ | 1,041 | 14 | % | ||||||||||||
Assessments | 249 | 221 | 13 | % | 722 | 622 | 16 | % | ||||||||||||||||
Revenue | 668 | 594 | 12 | % | 1,910 | 1,663 | 15 | % | ||||||||||||||||
General and administrative | 285 | 255 | 12 | % | 846 | 813 | 4 | % | ||||||||||||||||
Advertising and market development | 190 | 183 | 4 | % | 587 | 530 | 11 | % | ||||||||||||||||
U.S. merchant lawsuit and other legal settlements | 14 | 9 | 56 | % | 18 | 730 | (98 | %) | ||||||||||||||||
Depreciation and amortization | 29 | 28 | 4 | % | 92 | 89 | 3 | % | ||||||||||||||||
Total operating expenses | 518 | 475 | 9 | % | 1,543 | 2,162 | (29 | %) | ||||||||||||||||
Operating income (loss) | 150 | 119 | 26 | % | 367 | (499 | ) | 174 | % | |||||||||||||||
Total other income (expense) | (9 | ) | (8 | ) | 13 | % | (22 | ) | (5 | ) | 340 | % | ||||||||||||
Income (loss) before income tax expense (benefit) and cumulative effect of accounting change | 141 | 111 | 27 | % | 345 | (504 | ) | 168 | % | |||||||||||||||
Income tax expense (benefit) | 43 | 37 | 16 | % | 108 | (180 | ) | 160 | % | |||||||||||||||
Cumulative effect of accounting change, net of tax | — | — | — | — | 5 | (100 | %) | |||||||||||||||||
Net income (loss) | $ | 98 | $ | 74 | 32 | % | $ | 237 | $ | (319 | ) | 174 | % | |||||||||||
Net income (loss) per share (basic and diluted) | $ | .98 | $ | .74 | 32 | % | $ | 2.37 | $ | (3.19 | ) | 174 | % | |||||||||||
Weighted average shares outstanding (basic and diluted) | 100 | 100 | — | 100 | 100 | — | ||||||||||||||||||
Effective tax rate | 30.7 | % | 33.2 | % | — | 31.3 | % | 35.8 | % | — | ||||||||||||||
Gross dollar volume (“GDV”) on a U.S. dollar converted basis (in billions). | $ | 366 | $ | 324 | 13 | % | $ | 1,049 | $ | 926 | 13 | % | ||||||||||||
Processed transactions | 2,833 | 2,528 | 12 | % | 7,991 | 7,130 | 12 | % |
Our functional currency is primarily the U.S. dollar except for MasterCard Europe, whoseEurope’s functional currency is the euro. Accordingly, our resultsThe devaluation of operations have been impacted by movements of the euro against the U.S. dollar. As the euro strengthened against the U.S. dollar duringagainst the threeeuro and nine months ended September 30, 2004 compared to the same periods in 2003,impact of the translation of MasterCard Europe’s revenue and expenses increased as a result of translationoperating results into U.S. dollar amounts. In addition, we assess our members for foreign currency denominated transactions based on the equivalent U.S. dollar volume of their card programs. Since the U.S. dollar devalued against most major currencies, our revenues increased accordingly.dollars are summarized below:
For the three months | ||||||||
ended March 31, | ||||||||
2005 | 2004 | |||||||
Euro to U.S. dollar average exchange rate | $ | 1.30834 | $ | 1.24365 | ||||
Devaluation of U.S. dollar to euro | 5 | % | ||||||
Revenue growth attributable to translation of MasterCard Europe revenues to U.S. dollars | 1 | % | ||||||
Operating expense growth attributable to translation of MasterCard Europe expenses to U.S. dollars | 1 | % |
2321
Revenues
Our revenues are generated from the fees that we charge our customers for providing transaction processing and other payment services, and from assessments calculated on the dollar volume of activity on cards carrying our brands. We establish standards and procedures for the acceptance and settlement of our customers’customer’s transactions on a global basis. We do not issue cards, set fees, or determine the interest rates consumers will be charged on MasterCard-branded cards.cards carrying our brands. Our issuing customers have the responsibility for determining these and most other competitive card features. Our revenues are based upon transactional information accumulated by our systems and/or reported by our customers. Certain revenues are estimated based upon aggregate transaction information and historical and projected customer performance.
MasterCard hasenters into business agreements with certain customers thatand merchants to provide for fee rebates when the customers meet certainGDV-based and other performance based criteria.rebates and incentives. Such rebates and incentives are calculated on a monthly basis based upon estimated performance and the contracted discount rates for the services provided. In addition, MasterCard enters into agreements with certain customers and merchants to provide GDV-based and support incentives.related business agreements. Rebates and incentives are recorded as a reduction of revenue in the same periodsperiod as the revenue is earned.earned or the performance has occurred.
The U.S. remains our largest geographic market based on revenues. However, internationalapproximately 56% of total revenues grew at a faster rate than U.S. revenues for the three and nine months ended September 30, 2004, particularly in the European region. U.S. revenues have been negatively impacted by the increasing demand from our customers to receive better pricing and greater incentives than in the past. Accordingly, revenuebeing generated in the U.S. was approximately 58% and 61%in each of total revenues for the three months ended September 30, 2004March 31, 2005 and 2003, respectively, and 58% and 63% of total revenues for the nine months ended September 30, 2004 and 2003, respectively. The growth in the European region is primarily due to new assessment revenue streams and increased transactions. The European region generated revenues of approximately 20% and 18% of total revenues for the three months ended September 30, 2004 and 2003, respectively, and 20% and 16% of total revenues for the nine months ended September 30, 2004 and 2003, respectively.2004. No individual country, other than the U.S., generated more than 10% of total revenues in either period.
Operations Fees
Operations fees primarily represent user fees for authorization, clearing, settlement and other payment services that facilitate transaction and information management among our customers on a global basis. Operations fees increased $46$40 million or 12% and $147 million or 14%11% in the three and nine months ended September 30, 2004, respectively,March 31, 2005 compared to the same periodsperiod in 2003.2004. The significant changes in operations fees were as follows:
Change in Revenue | ||||||||
Increase (Decrease) | ||||||||
(in millions) | ||||||||
Three Months | Nine Months | |||||||
Ended September 30, | Ended September 30, | |||||||
2004 vs. 2003 | 2004 vs. 2003 | |||||||
Authorization, settlement and switch | $ | 27 | $ | 96 | ||||
Currency conversion | 12 | 37 | ||||||
Warning bulletins | (1 | ) | (5 | ) | ||||
Rebates | (13 | ) | (24 | ) | ||||
Excessive chargeback fees | 2 | (7 | ) | |||||
Consulting | 5 | 11 | ||||||
Other operations fees | 14 | 39 | ||||||
$ | 46 | $ | 147 | |||||
Change in | ||||
Revenue | ||||
Increase | ||||
(Decrease) | ||||
Three months | ||||
ended March 31, | ||||
2005 vs. 2004 | ||||
(In millions) | ||||
Authorization, settlement and switch | $ | 20 | ||
Currency conversion | 10 | |||
Consulting fees and research subscriptions | 5 | |||
Cardholder services | 5 | |||
Other operations fees | 15 | |||
Gross operations fees change | 55 | |||
Increase in rebates | (15) | |||
Net change in operations fees | $ | 40 | ||
• | Authorization, settlement and switch revenues increased $20 million, or 9% in the three months ended March 31, 2005 compared to the same period in 2004. These revenues are driven by the number of transactions processed through our systems, which increased 11% in the three months ended March 31, 2005 compared to the same period in 2004. | ||||
• | Currency conversion revenues increased $10 million in the three months ended March 31, 2005 compared to the same period in 2004. Our customers require currency conversion of international purchases made by their cardholders. Accordingly, these revenues fluctuate with the increase in cross-border transactions. | ||||
• | Consulting fees and research subscriptions which are primarily generated by MasterCard Advisors, our advisory services group. In the first and second quarter of 2004, MasterCard acquired two consulting firms. Accordingly, these revenues were greater in the three months ended March 31, 2005 compared to the same |
2422
• | Cardholder services include revenue earned for providing enhanced services to our customers or their cardholders. Examples of these services are telecommunication assistance, ATM locator and concierge programs. These revenues increased | |||
• | Other operations fees represent various revenue | |||
• | Rebates are primarily based on transactions and volumes and, accordingly, increase as these variables increase. Rebates to certain customers continued to increase due to ongoing consolidation of our customers and increasingly intense competition. Accordingly, rebates as a percentage of gross operations fees were 9% and 7% in the |
Assessments
Assessments are revenues that are calculated based primarily on our customers’ GDV of MasterCard transactions.GDV. GDV represents gross usage (purchase and cash disbursements) on MasterCard-branded cards carrying our brands for goods and services including balance transfers and convenience checks. In the three and nine months ended September 30, 2004,March 31, 2005, assessments revenue grew $28$24 million, or 13% and $100 million or 16% respectively, over11%, versus the same periodscomparable period in 2003.2004. GDV growth was 10% and 9%11% when measured in local currency terms in the three and nine months ended September 30, 2004 respectively, over the same periods in 2003 and 13% in each period14% when measured on a U.S. dollar converted basis.
In additionbasis in the three months ended March 31, 2005 compared to the increasesame period in GDV, assessments growth in 2004 was due to the following factors:2004.
Rebates and incentives provided to our customers and merchants reduce revenue and moderate assessments growth.increased $38 million in the three months ended March 31, 2005 versus the comparable period in 2004. These rebates and incentives reduce revenue, moderate assessments growth and are generally are based on card generated volumeGDV, as well as a fixed component for the issuance of new cards or the launch of new programs. In the three and nine months ended September 30, 2004, these rebates and incentives increased $15 million and $38 million, respectively, compared to the same periods in 2003. Rebates and incentives as a percentage of gross assessments increased to 39% from 37% forwere 32% in the three months ended September 30,March 31, 2005 versus 26% in the comparable period in 2004. In 2004, andwe entered into additional pricing arrangements with certain large customers which we expect to 36% from 35% formoderate net revenue growth in the nine months endedfuture.
2523
September 30, 2004, in each case, from the comparable periods in 2003. During 2004, MasterCard increased the incentives offered to certain customers and merchants to promote usage and acceptance of our brands.
Operating Expenses
Our operating expenses are comprised of general and administrative, advertising and market development, the U.S. merchant lawsuit and other legal settlements, and depreciation and amortization expenses. In the three months ended September 30, 2004,March 31, 2005, there was an increase in operating expenses of $43$31 million or 9% over7% compared to the same period in 2003. In the nine months ended September 30, 2004, there was a decrease in operating expenses of $619 million or 29% over the same period in 2003, or an increase of $93 million or 6% excluding the charges to earnings related to the U.S. merchant lawsuit and other legal settlements. Approximately $10 million and $18 million of these increases in the three and nine months ended September 30, 2004, respectively, related to the acquisition of the two consulting firms described in Note 5 to the Consolidated Financial Statements included herein.2004.
General and Administrative
General and administrative expenses consist primarily of personnel, professional fees, data processing, telecommunications and travel. TheseIn the three months ended March 31, 2005 and 2004 these activities accounted for approximately 43%47% of total revenues in each period. The major components of the three months ended September 30, 2004 and 2003, respectively, and 44% and 49% of total revenueschanges in the nine months ended September 30, 2004 and 2003, respectively. Generalgeneral and administrative expenses increased $30 million or 12% and $33 million or 4% in the three and nine months ended September 30, 2004, respectively, over the same periods in 2003 due to the following:are as follows:
Change | ||||
Increase | ||||
(Decrease) | ||||
Three months | ||||
ended March 31, | ||||
2005 vs. 2004 | ||||
(In millions) | ||||
Personnel | $ | 18 | ||
Professional fees | 8 | |||
Telecommunications | (3) | |||
Travel | 5 | |||
Other | 2 | |||
Net general and administrative change | $ | 30 | ||
• | Personnel expense increased | |||
• | Professional fees increased | |||
• | Telecommunications expense decreased | |||
• | Travel expenses are incurred primarily for travel to customer and regional meetings. In the three months ended March 31, 2005, there was more business activity which required travel than in the comparable period in 2004. | |||
• | Other includes rental expense for our facilities, foreign exchange gains and losses and other miscellaneous administrative expenses. |
Advertising and Market Development
Advertising and market development consists of expenses associated with advertising, marketing, promotions and sponsorships, which promote our brandsbrand and assist our customers to achievein achieving their goals by raising consumer awareness and usage of cards carrying our brands. TheseIn the three months ended March 31, 2005, these activities accounted for approximately 28% and 31%26% of total revenues compared to 28% in the three months ended September 30, 2004 and 2003, respectively, and 31% and 32% of total revenuessame period in the nine months ended September 30, 2004 and 2003, respectively.2004. Advertising and market development expenses increased $7$5 million or 4% and $57 million or 11%3% in the three and nine months ended September 30, 2004, respectively, over the same periods in 2003. These increases are primarily due to additional media advertising in our European region. Our Priceless campaign continues to be successful in 96 countries and 48 languages, and we plan to continue to invest significantly in this campaign.
MasterCard implemented a four-year plan in 2002 to accelerate our growth and to enhance the global position of MasterCard and its customers by significantly expanding its spending in advertising and market development. For the three months ended September 30, 2004 and 2003, we spent $30 million and $42 million, respectively, and in the nine months ended September 30, 2004 and 2003, we spent $108 million, in each case, on advertising and marketing relating to this plan. The primary focus of these initiatives is to build brand recognition, promote brand acceptance, and enhance the development of our programs and services in certain markets. We will continue to evaluate the extent of these initiatives in light of changing market conditions.March 31, 2005.
The MasterCard family ofOur brands, principally MasterCard, is aare valuable strategic assetassets which conveys a symbolconvey symbols that can be readily identified by our customers, as well as our cardholders, creating value for our business. Our advertising and marketing efforts are focused on ensuring that our services are identified, communicated and marketed in a clear, efficient and consistent manner, not only on a local level, but also on a global scale. We are committed to maintaining and enhancing our MasterCard brand reputation, image and ultimate value. Our “Priceless” campaign
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Merchant Lawsuithas run in 96 countries and Other Legal Settlements
48 languages and we continue to invest significantly in this campaign. In the first quarter of 2003,addition, we recorded a pre-tax charge of $721 million for settlement of the U.S. merchant lawsuit. The primary components of this charge were (i) the monetary amount of the U.S. merchant settlement (discounted at 8 percent over the payment term), (ii) certain additional costs in connection with, andundertake programs from time to time to focus our marketing efforts in order to comply with, other requirementsbuild brand recognition, to promote brand acceptance and enhance the development of our programs and services in certain markets. MasterCard also has corporate sponsorships and conducts promotions to generate usage of cards carrying our brands. Our sponsorships include the U.S. merchant lawsuit settlement,UEFA Champions League, certain National Football League teams, Major League Baseball, the Professional Golf Association and (iii) costs to address certain merchants who opted not to participate in the U.S. merchant lawsuit. This amount was an estimate, which was revised in subsequent periods based on approval of the Settlement Agreement by the court, and other factors. If necessary, future refinements will also be made. Relating to these settlements, payments of $29 million and $40 million were made during the three and nine months ended September 30, 2004, respectively. The Company recorded additional charges of $14 million and $18 million in the three and nine months ended September 30, 2004, respectively, principally related to the awarding of legal costs under an unrelated currency conversion case. See Note 13 to the Consolidated Financial Statements included herein.Universal Studios.
Depreciation and Amortization
Depreciation and amortization increased $1 million and $3expenses decreased $4 million in the three months ending March 31, 2005 versus the comparable period in 2004. This decrease was primarily related to the maturity of certain capital leases and nine months ended September 30, 2004, respectively, over the same periods in 2003. Our business is dependent on the technology that we use to process transactions, which is continuously updated and improved. Therefore, our investments in capitalized software and related amortization also continue to increase.certain assets becoming fully depreciated.
Other Income and Expense
Other income (expense) is comprised primarily of investment income and interest expense. Investment income decreased $1 million and $7$2 million in the three and nine months ended September 30, 2004, respectively, over the same periods in 2003 resulting fromMarch 31, 2005 due to a decline in the market value of theour trading securities portfolio, which had significant appreciation in the comparable periods in 2003.portfolio. Interest expense decreased $1 million and increased $9 million in the three and nine months ended September 30, 2004, respectively,March 31, 2005 primarily duerelated to the imputed interest on the U.S. merchant lawsuit settlement obligation.settlement.
Income Taxes
The effective income tax rate forwas 35.3% in each of the three and nine months ended September 30, 2004 was 30.7%March 31, 2005 and 31.3%, respectively, compared2004. MasterCard does not anticipate any substantial adjustments to 33.2% and 35.8% for the three and nine months ended September 30, 2003, respectively. The decrease in the rate in 2004 is primarily attributable to discrete items that occurred in the second and third quarters of 2004. The primary discrete item in the third quarter was an increase in our deferred state tax assets as a result of a change in the taxation of our state and local income. The primary discrete items in the second quarter that, together with the third quarter discrete items resulted in the decrease in the nine-month effective tax rate were the favorable settlement and reassessment of various tax controversies and the filing and recognition of refund claims, partially offset by an increase in the valuation allowance for the future realization of a benefit from a capital loss carryover. Absent the discrete items our effective tax rate for the three and nine months ended September 30, 2004 would have been 36.8% and 36.3%, respectively, compared to 33.2% and 33.1% for the three and nine months ended September 30, 2003, respectively. The increase in the 2004 rates before discrete items is primarily attributable to a decrease in the percentage of tax exempt interest income and other favorable permanent tax items as a percent of pretax income, as well as a change in the geographic distribution of pretax income from taxable jurisdictions with lower rates to those with higher rates.year ending December 31, 2005.
Liquidity
We believe our ability to generate cash from our operations to reinvest in our business is one of our fundamental financial strengths. We need capital resources and liquidity to fund our global development, to provide for credit and settlement risk, to finance capital expenditures, and any future acquisitions, and to service the payments of principal and interest on our outstanding debt and the settlement of the U.S. merchant lawsuit. At September 30,March 31, 2005 and December 31, 2004, we had $1.1 billion of liquid investmentscash, cash equivalents and available-for-sale securities with which to manage operations, compared to $880 million at December 31, 2003.operations. We expect that cash and cash equivalents,the cash generated from operations and our borrowing capacity will be sufficient to meet our operating, working capital and capital needs in 20042005 and beyond.thereafter. In addition, we believe that our resources are sufficient to fund our initiatives to accelerate our profitable growth and to enhance the global position of MasterCard in 20042005 and 2005.beyond. However, our liquidity could be negatively impacted by the outcome of any of the legal or regulatory proceedings to which we are a party. See “Legal, Regulatory and Other Industry Risks.”
Three Months | Dollar Change | |||||||||||
Ended March 31, | Increase (Decrease) | |||||||||||
2005 | 2004 | 2005 vs. 2004 | ||||||||||
(in millions) | ||||||||||||
Cash flow data: | ||||||||||||
Net cash (used in) provided by operating activities | $ | (14 | ) | $ | 13 | $ | (27 | ) | ||||
Net cash provided by investing activities | 52 | 34 | 18 |
March 31, 2005 | December 31, 2004 | |||||||
(in millions, except ratio) | ||||||||
Balance sheet data: | ||||||||
Current assets | $ | 1,920 | $ | 1,903 | ||||
Current liabilities | 1,234 | 1,301 | ||||||
Long-term liabilities | 970 | 984 | ||||||
Stockholders’ equity | 1,038 | 975 | ||||||
Working capital ratio | 1.56 | 1.46 |
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Nine Months | ||||||||||||
Ended September 30, | Percent Change | |||||||||||
2004 | 2003 | 2004 vs. 2003 | ||||||||||
(in millions, except percentages) | ||||||||||||
Cash flow data: | ||||||||||||
Net cash provided by operating activities | $ | 294 | $ | 190 | 55 | % | ||||||
Net cash used in investing activities | (96 | ) | (116 | ) | 17 | % | ||||||
Net cash provided in financing activities | 8 | — | 100 | % |
September 30, 2004 | December 31, 2003 | |||||||
(in millions, except ratios) | ||||||||
Balance sheet data: | ||||||||
Current assets | $ | 1,872 | $ | 1,610 | ||||
Current liabilities | 1,198 | 1,189 | ||||||
Long-term liabilities | 1,049 | 1,009 | ||||||
Stockholders’ equity | 926 | 699 | ||||||
Working capital ratio | 1.56 | 1.35 |
Net cash (used in) provided by operating activities in the three months ended March 31, 2005 and 2004 was generated$(14) million and $13 million, respectively. The decrease in cash from operations was principally by current period earnings exclusive of non-cash charges for depreciation and amortization and an increase in accrued expenses. These increases were offset by the payment of accounts payable that had increased at December 31, 2003 due to heavy fourth quarter 2003higher payments for personnel, rebates, incentives and advertising in 2005 as compared to 2004, as well as the timing of settlement activity versus the prior period. We believe that the liabilities related to the U.S. merchant lawsuit settlement and market development activity.
other legal settlements discussed in Note 7 to the Consolidated Financial Statements herein will be funded through existing cash and cash equivalents, investments, annual cash generated from operations and our borrowing capacity. The utilizationsource of cash byfrom investing activities in 2004the three months ended March 31, 2005 was primarily due to the purchasesale or maturity of or cost of internally developed, capitalized software and the acquisition of certain businesses as described in Note 5 to the Consolidated Financial Statements included herein. Our capitalized software is essential to providing payment card transaction processing to our customers through our proprietary global computer and telecommunications system. Our investing activities in 2003 included funding for a back-up center in Kansas City, Missouri, and associated equipment.available-for-sale securities.
In addition to our liquid investments, we provide for liquidity through a committed $1.95 billion revolving credit facility (the “Credit Facility”) with certain financial institutions which expires on June 17, 2005. TheWe intend to replace the Credit Facility replaced MasterCard Incorporated’s prior $1.2 billion credit facility which expired on June 18, 2004.upon its expiration. Borrowings under the facilityCredit Facility are available to provide liquidity in the event of one or more settlement failures by MasterCard International members and, subject to a limit of $300 million, for general corporate purposes. Interest on borrowings under the Credit Facility is charged at the London Interbank Offered Rate (“LIBOR”) plus 28 basis points. An additional 10 basis points would be applied if the aggregate borrowings under the Credit Facility exceed 33% of the commitments. MasterCard agreed to pay a facility fee which varies based on MasterCard’s credit rating and is currently equal to 7 basis points on the total commitment. MasterCard was in compliance with the Credit Facility covenants and all other debt covenants as of September 30, 2004.March 31, 2005. There were no borrowings under the Credit Facility at September 30, 2004.March 31, 2005. The majority of Credit Facility lenders are members or affiliates of members of MasterCard International.
28 Due to Standard & Poor’s assessment of MasterCard’s vulnerability to legal risk, on May 16, 2003, Standard & Poor’s lowered MasterCard’s counterparty credit rating to A-/A-2, subordinated debt rating to BBB+ and placed MasterCard on negative outlook. These ratings were reaffirmed in 2004. This rating has not materially impacted our liquidity.
Legal, Regulatory and Other Risks
Our business has many risks, most significantly the legal and regulatory environment in which we operate. These risks have increased in recent years, although we are proactively seeking to address them. Reference should be made to the Company’s 2004 Annual Report on Form 10-K for a complete discussion of these risk factors under the caption “Risk Factors” in Item 1 — Business. The following risks, among others, may have a material impact on our results of operations or financial condition:
• | Legal and Regulatory Proceedings — MasterCard is a party to several legal and regulatory proceedings, as discussed in Note 8 to the Consolidated Financial Statements herein, which could have a material adverse impact on our business. Many of the legal and regulatory proceedings to which we are subject are supported by merchants, who have a growing role in the global payments industry. | |||
• | Competition and Consolidation of Our Customers — We are, and will continue to be, significantly dependent on our relationships with our issuers, acquirers and merchants. Most of our relationships with our customers are not exclusive and may be terminated at the convenience of our customers. In addition, the consolidation and globalization of our customers has provided more intense competition and greater demand for rebates, incentives and reduced pricing for our services. The consolidation or merger of one or more of our customers with financial institutions aligned with our competitors could have a material adverse impact on our revenues. | |||
• | Economic — Our business is dependent on certain world economies and consumer behaviors. In the past, our revenues have been impacted by specific events such as the war in Iraq, the SARS outbreak and the September 11, 2001 terrorist attack. We continue to closely monitor the impact of the tsunami and recent geological incidents in Asia as the recovery evolves in 2005. |
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Future Obligations
The following table summarizes our obligations as of September 30, 2004March 31, 2005 our obligations that are expected to impact liquidity and cash flowsflow in future periods. We believe that we will be able to fund these obligations through cash generated from operations and our existing cash balances.
Payments Due by Period | ||||||||||||||||||||
More | ||||||||||||||||||||
1 Year | Than | |||||||||||||||||||
Total | or Less | 2-3 Years | 4-5 Years | 5 Years | ||||||||||||||||
(in millions) | ||||||||||||||||||||
Capital leases(a) | $ | 64 | $ | 3 | $ | 11 | $ | 6 | $ | 44 | ||||||||||
Operating leases(b) | 121 | 10 | 59 | 40 | 12 | |||||||||||||||
Sponsorship, licensing & other(c) | 568 | 85 | 345 | 113 | 25 | |||||||||||||||
U.S. merchant lawsuit and other legal settlements(d) | 933 | 133 | 200 | 200 | 400 | |||||||||||||||
Debt(e) | 250 | 5 | 11 | 234 | — | |||||||||||||||
Total | $ | 1,936 | $ | 236 | $ | 626 | $ | 593 | $ | 481 | ||||||||||
Payments Due by Period | ||||||||||||||||||||
Less Than | More Than | |||||||||||||||||||
Total | 1 Year | 2-3 Years | 4-5 Years | 5 Years | ||||||||||||||||
(In millions) | ||||||||||||||||||||
Capital leases (a) | $ | 61 | $ | 6 | $ | 9 | $ | 4 | $ | 42 | ||||||||||
Operating leases (b) | 116 | 29 | 56 | 29 | 2 | |||||||||||||||
Sponsorship, licensing & other (c) | 545 | 203 | 275 | 61 | 6 | |||||||||||||||
U.S. merchant lawsuit and other legal settlements (d) | 814 | 114 | 200 | 200 | 300 | |||||||||||||||
Debt (e) | 250 | 5 | 11 | 234 | — | |||||||||||||||
Total | $ | 1,786 | $ | 357 | $ | 551 | $ | 528 | $ | 350 | ||||||||||
(a) | Most capital leases relate to certain property, plant and equipment used in our business. Our largest capital lease relates to our Kansas City, Missouri co-processing facility. | |
(b) | We enter into operating leases in the normal course of business, including the lease on our facility in St. | |
(c) | Amounts primarily relate to sponsorships with certain organizations to promote the MasterCard brand. The amounts included are fixed and non-cancelable. In addition, these amounts include purchase obligations. Obligations which result from performance based agreements with our members and merchants have been excluded from the table due to their contingent nature. | |
(d) | Amounts due in accordance with legal settlements entered into during 2003 and | |
(e) | Debt primarily represents principal and interest owed on our subordinated notes due June 2008 and the principal owed on our Series A Senior Secured Notes due September 2009. We also have various credit facilities for which there were no outstanding balances at |
Recent Accounting Pronouncements
In May 2004, the FASB issued FASB Staff Position No. FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP 106-2”). FSP 106-2 requires (a) that the effects of the federal subsidy be considered an actuarial gain and recognized in the same manner as other actuarial gains and losses and (b) certain disclosures for employers that sponsor postretirement benefit plans that provide prescription drug benefits. The Company has determined that the enactment of the Medicare Modernization Act was not a significant event with respect to its plans, and accordingly, as required by FSP 106-2, the effects of the Act will be incorporated into our December 31, 2004 measurement of the plan’s benefit obligations.
In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” (“EITF 03-01”). EITF 03-01 addresses determining the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Investments” (“SFAS 115”) and investments accounted for under the cost method or the equity method. The EITF reached a consensus on a model for determining whether an investment within the scope of EITF 03-01 is other-than-temporarily impaired and reached a consensus that investors should provide certain disclosures related to investments that are within the scope of EITF 03-01. The consensus for evaluating whether an investment is other-than-temporarily impaired should be applied to evaluations made in reporting periods beginning after June 15, 2004. The consensus on additional disclosures for cost method investments is effective for
2927
fiscal years ending after June 15, 2004. The adoption of EITF 03-01 is not expected to have an impact on our financial position or results of operations.
In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 clarifies that companies may need to consolidate certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 applied immediately to variable interest entities created or in which an enterprise obtained an interest after January 31, 2003. The Company adopted FIN 46 on January 1, 2003 and therefore consolidated its variable interest entity as described in Note 1 and 2 to the Consolidated Financial Statements included herein. In December 2003, FIN 46 was revised. The adoption of the revisions to FIN 46 did not have an impact on our financial position or results of operations.
Item 3.Quantitative and Qualitative Disclosures About Market Risk
MarketMasterCard has limited exposure to market risk isor the potential for economic losses to be incurred on market risk sensitive instruments arising from adverse changes in market factors such as interest rates, foreign currency exchange rates, and equity price risk. We have limited exposure to market risk from changes in interest rates, foreign exchange rates, and equity price risk. Management establishes and oversees the implementation of policies, which have been approved by the Board of Directors, governing our funding, investments, and use of derivative financial instruments. We monitor aggregate risk exposures on an ongoing basis. There have been no material changes in our market risk exposures at September 30, 2004March 31, 2005 as compared to December 31, 2003.2004.
Item 4.Controls and Procedures
Evaluation of Disclosure Controls and Procedures
MasterCard Incorporated’s management, including the President and Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the Company’s disclosure controls and procedures (as defined in Rule 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Report. Based on that evaluation, the Company’s President and Chief Executive Officer and Chief Financial Officer concluded that MasterCard Incorporated had effective disclosure controls and procedures for (i) recording, processing, summarizing and reporting information that is required to be disclosed in its reports under the Securities Exchange Act of 1934, as amended, within the time periods specified in the Securities and Exchange Commission’s rules and forms and (ii) ensuring that information required to be disclosed in such reports is accumulated and communicated to MasterCard Incorporated’s management, including its President and Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure.
30Changes in Internal Control over Financial Reporting
In connection with the evaluation by the Company’s Chief Executive Officer and Chief Financial Officer of changes in internal control over financial reporting that occurred during the Company’s last fiscal quarter, no change in the Company’s internal control over financial reporting was identified that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
28
[PRICEWATERHOUSECOOPERS LETTERHEAD]
Report of Independent Registered Public Accounting Firm
To the Board of Directors and StockholdersOfof MasterCard Incorporated:
We have reviewed the accompanying consolidated balance sheet of MasterCard Incorporated and its subsidiaries as of September 30, 2004,March 31, 2005, and the related consolidated statements of operations and consolidated condensed statements of comprehensive income (loss)and the consolidated statements of cash flows for each of the three- and nine-monththree-month periods ended September 30,March 31, 2005 and 2004 and 2003 and the consolidated statement of cash flows for the nine-month period ended September 30, 2004 and 2003 and the consolidated statement of changes in stockholders’ equity for the nine-monththree-month period ended September 30, 2004.March 31, 2005. These interim financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2003,2004, and the related consolidated statements of operations, of comprehensive income (loss), of changes in stockholders’/members’ equity, and of cash flows for the year then ended, (not presented herein),management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004 and the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004; and in our report dated March 4, 20041, 2005, we expressed unqualified opinions thereon. Our report contained an unqualified opinion on thoseexplanatory paragraph for a change in accounting principle and the adoption of an accounting standard, as stated in the paragraph below. The consolidated financial statements.statements and management’s assessment of the effectiveness of internal control over financial reporting referred to above are not presented herein. In our opinion, the information set forth in the accompanying consolidated balance sheet information as of December 31, 2003,2004, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.
The Company changed its method for calculating the market-related value of pension plan assets used in determining the expected return on the assets component of annual pension cost in 2003 and the Company adopted the provisions of Financial Accounting Standards Board Interpretation No. 46R, “Consolidation of Variable Interest Entities”, which resulted in the consolidation of a special purpose entity in 2003.
PricewaterhouseCoopers LLP
New York, NYNovemberMay 9, 20042005
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MASTERCARD INCORPORATED
FORM 10-Q
PART II — OTHER INFORMATION
Item 1.Legal Proceedings
Refer to Notes 117 and 138 to the Consolidated Financial Statements included herein.
Item 6.Exhibits
Refer to the Exhibit Index included herein.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Date: May 9, 2005 | MASTERCARD INCORPORATED | |||||
(Registrant) | ||||||
Date: May 9, 2005 | By: | /s/ ROBERT W. SELANDER | ||||
Robert W. Selander | ||||||
President and Chief Executive Officer | ||||||
(Principal Executive Officer) | ||||||
Date: May 9, 2005 | By: | /s/ CHRIS A. MCWILTON | ||||
Chris A. McWilton | ||||||
Chief Financial Officer | ||||||
(Principal Financial Officer) | ||||||
Date: May 9, 2005 | By: | /s/ LISA WAGNER | ||||
Lisa Wagner | ||||||
Senior Vice President and Controller | ||||||
(Principal Accounting Officer) |
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EXHIBIT INDEX
Exhibit | ||
Number | Exhibit Description | |
3.1(a) | Amended and Restated Certificate of Incorporation of MasterCard Incorporated (incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K dated June 28, 2002 and filed July 12, 2002 (No. 333-67544)). | |
3.1(b) | Amended and Restated Bylaws of MasterCard Incorporated (incorporated by reference to Exhibit 3.1(b) to the Company’s Annual Report on Form 10-K filed March | |
3.2(a) | Amended and Restated Certificate of Incorporation of MasterCard International Incorporated (incorporated by reference to Exhibit 3.2(a) to the Company’s Quarterly Report on Form 10-Q filed August 14, 2002 (No. 333-67544)). | |
3.2(b) | Amended and Restated Bylaws of MasterCard International Incorporated (incorporated by reference to Exhibit 3.2(b) to the Company’s Quarterly Report on Form 10-Q filed August 14, 2002 (No. 333-67544)). | |
31.1 | Certification of Robert W. Selander, President and Chief Executive Officer, pursuant to Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
31.2 | Certification of Chris A. McWilton, Chief Financial Officer, pursuant to Rule 13a-14(a)/ 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
32.1 | Certification of Robert W. Selander, President and Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
32.2 | Certification of Chris A. McWilton, Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
34
* | The registrant has applied for confidential treatment of portions of this exhibit. Accordingly, portions have been omitted and filed separately with the Securities and Exchange Commission. |
32