National Processing 10-Q 2001 Q2 Quarterly report

TABLE OF CONTENTS

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

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the transition period from________________to___________

Commission File Number: 1-11905

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

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

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

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

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

NATIONAL PROCESSING, INC.

INDEX

Part I Financial Information

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

2

National Processing, Inc.
Consolidated Balance Sheets
Unaudited
(Dollars in thousands)

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

See notes to consolidated financial statements

3

National Processing, Inc.
Consolidated Statements of Income
Unaudited
(In thousands, except per share amounts)

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

See notes to consolidated financial statements

4

National Processing, Inc.
Consolidated Statement of Changes in Shareholders’ Equity
Unaudited
(In thousands)

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

See notes to consolidated financial statements

5

National Processing, Inc.
Consolidated Statements of Cash Flows
Unaudited
(In thousands)

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

See notes to consolidated financial statements

6

NATIONAL PROCESSING, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Unaudited

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

7

	Divested business units also include the Company’s Springfield remittance operation sold in August 2000 and the Denver collections operation discontinued in March 2001.
	For the three months ended June 30, 2001 and 2000, the divested business units had revenue of $15.3 million and $19.4 million, respectively, and operating profit (loss) of $(5.1) million and $0.8 million, respectively. For the six months ended June 30, 2001 and 2000, the divested business units had revenue of $31.4 million and $37.3 million, respectively, and operating profit (loss) of $(3.8) million and $2.3 million, respectively. Operating profit (loss) includes impairment and restructuring charges related to the divested business units totaling $6.3 million in the second quarter of 2001 and $1.5 million in the second quarter of 2000.
	The effective tax rates for the three and six months ended June 30, 2001 were 52.4% and 44.9%, respectively. The effective tax rates were higher than prior year due to additional provisions related to the sale of the BPO business units. These additional provisions were for nondeductible losses, repatriation of previously untaxed earnings in foreign countries, and dividends from foreign subsidiaries.
3.	ASSETS HELD FOR SALE
	At June 30, 2001, assets held for sale totaled $38.9 million related to the divestiture of the BPO business units. These assets have been classified as current assets on the consolidated balance sheet and are summarized as follows (in thousands):

Accounts receivable	$	11,526
Other current assets		412
Property and equipment, net		18,249
Goodwill, net		9,602
Other intangible assets, net		2,740
Account payable — trade		(632	)
Other accrued liabilities		(3,028	)
Total net assets	$	38,869

4.

ACQUISITIONS

On June 28, 2001, the Company acquired a 70 percent interest in ABN AMRO Merchant Services, LLC (AAMS) for $48.5 million, which was settled on July 2, 2001 using existing cash balances. Under the terms of the agreement, the Company will provide AAMS with all merchant-processing services including both authorization and settlement of all card-based transactions. The Company expects AAMS to generate approximately $38 million in annual revenue. The acquisition, accounted for as a purchase, increased the Company’s goodwill by approximately $27 million, to be amortized on a straight-line basis over 20 years. The remainder of the purchase price was allocated to other identifiable intangibles, primarily acquired merchant contracts, which are being amortized on a straight-line basis over 10 years. The results of operations of AAMS have been included in the consolidated financial statements since the date of its acquisition.

8

	On January 8, 2001, the Company purchased the merchant services business units from several of National City Corporation’s (National City) banking subsidiaries for $44.0 million in cash. This acquisition included merchant contracts and additional sales personnel. National Processing also assumed responsibility for all merchant processing sales efforts throughout National City’s 1,200 branch network via an exclusive multi-year marketing agreement. The Company already provided the authorization and settlement processing for these merchants via a third party processing contract with National City. For the three and six months ended June 30, 2001, the Company recorded $3.8 million and $7.9 million, respectively, of incremental revenue as a result of this acquisition. The acquisition was accounted for as a transaction among entities under common control and was recorded at the historical cost bases of National City. The excess of the cash paid over the historical cost bases was recorded as a reduction in shareholders’ equity, net of income taxes. The results of operations of the National City merchant services business units have been included in the consolidated financial statements since the date of acquisition.
5.	COMMITMENTS AND CONTINGENCIES
	In the normal course of business, the Company is involved in litigation from time to time. In the opinion of management, the ultimate liability, if any, arising from this litigation is not expected to have a material adverse effect on the Company’s financial condition, results of operations or liquidity.
6.	NET INCOME PER COMMON SHARE
	The calculation of net income per common share follows (in thousands, except per share amounts):

		Three Months Ended				Six Months Ended
		June 30				June 30
		2001		2000		2001		2000
BASIC
	Net income	$	7,918	$	10,476	$	19,457	$	20,024
	Average common shares outstanding		51,255		50,799		51,107		50,792
	Net income per common share – basic	$	0.15	$	0.21	$	0.38	$	0.39
DILUTED
	Net income	$	7,918	$	10,476	$	19,457	$	20,024
	Average common shares outstanding		51,255		50,799		51,107		50,792
	Stock option adjustment		798		166		703		106
	Average common shares outstanding – diluted		52,053		50,965		51,810		50,898
	Net income per common share – diluted	$	0.15	$	0.21	$	0.38	$	0.39

7.	SEGMENT REPORTING
	The Company operates two business segments – Merchant Card Services and Corporate Outsourcing Solutions. Merchant Card Services authorizes, processes, and settles credit and debit card transactions. Corporate Outsourcing Solutions provides financial settlement, image scanning, data capture, storage and retrieval, and value-added customer reporting services.
	The accounting policies of the reportable segments are the same as those of the Company. Prior period amounts have been classified to conform to the current line of business reporting structure.

9

     General and administrative expense is allocated to the segments based upon various methods determined by the nature of the expenses. There are no intersegment revenues. Depreciation and amortization expense for corporate fixed assets is allocated to the segments. Corporate net operating assets are comprised primarily of cash, Eurodollar deposits, and income tax balances.

(Dollars in thousands)

	Merchant		Corporate
	Card		Outsourcing					Consolidated
	Services		Solutions			Corporate		Total
For the three months ended June 30, 2001
Revenue	$	95,364	$	22,512		$	—	$	117,876
Impairment, restructuring and related expense		—		6,250			—		6,250
Operating profit (loss)		18,646		(3,893	)		—		14,753
Depreciation and amortization		3,527		1,657			—		5,184
Net interest income		1,664		229			—		1,893
Net operating assets		146,919		49,315			162,355		358,589
For the three months ended June 30, 2000
Revenue	$	76,104	$	28,409		$	—	$	104,513
Impairment, restructuring and related expense		—		1,500			—		1,500
Operating profit		12,195		3,161			—		15,356
Depreciation and amortization		3,372		1,953			—		5,325
Net interest income		1,364		514			—		1,878
Net operating assets		103,004		51,001			182,766		336,771
	Merchant		Corporate
	Card		Outsourcing					Consolidated
	Services		Solutions			Corporate		Total
For the six months ended June 30, 2001
Revenue	$	180,704	$	46,217		$	—	$	226,921
Impairment, restructuring and related expense		—		6,250			—		6,250
Operating profit (loss)		32,249		(1,064	)		—		31,185
Depreciation and amortization		7,019		3,345			—		10,364
Net interest income		3,481		632			—		4,113
Net operating assets		146,919		49,315			162,355		358,589
For the six months ended June 30, 2000
Revenue	$	147,015	$	55,365		$	—	$	202,380
Impairment, restructuring and related expense		—		1,500			—		1,500
Operating profit		22,856		6,131			—		28,987
Depreciation and amortization		6,743		3,957			—		10,700
Net interest income		2,783		910			—		3,693
Net operating assets		103,004		51,001			182,766		336,771

8.

RECENT ACCOUNTING PRONOUNCEMENTS

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

10

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

Components of Revenue and Expenses

      Revenue.

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

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

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

      Expenses.

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

Results of Operations

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

11

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

					2001						2000						Change
								% of						% of
(Dollars in thousands)					Amount			Revenue			Amount			Revenue			Amount			%
Revenue:
	Merchant Services				$	95,364			81		$	76,104			73		$	19,260			25
	Corporate Outsourcing Solutions					7,179			6			8,996			9			(1,817	)		(20	)
			Total Core Revenue			102,543			87			85,100			81			17,443			20
	Divested Business Lines					15,333			13			19,413			19			(4,080	)		(21	)
			Total Revenue			117,876			100			104,513			100			13,363			13
Expenses:
	Merchant Services					76,718			80			63,909			84			12,809			20
	Corporate Outsourcing Solutions					5,968			83			6,645			74			(677	)		(10	)
				Core Operating Expenses		82,686			81			70,554			83			12,132			17
	Divested Business Lines					14,187			93			17,103			88			(2,916	)		(17	)
				Total Expenses		96,873			82			87,657			84			9,216			11
Operating Profit:
	Merchant Services					18,646			20			12,195			16			6,451			53
	Corporate Outsourcing Solutions					1,211			17			2,351			26			(1,140	)		(48	)
				Total Core Operating Profit		19,857			19			14,546			17			5,311			37
	Divested Business Lines					1,146			7			2,310			12			(1,164	)		(50	)
				Total Operating Profit		21,003			18			16,856			16			4,147			25
Net Interest Income						1,893			2			1,878			2			15			1
Income Before Taxes and Nonrecurring Items						22,896			19			18,734			18			4,162			22
Nonrecurring Items:
		Impairment, Restructuring and Related Expenses				(6,250	)		(5	)		(1,500	)		(1	)		(4,750	)		NM
Income Before Taxes						16,646			14			17,234			16			(588	)		(3	)
Provision for Income Taxes						8,728			7			6,758			6			1,970			29
Net Income					$	7,918			7		$	10,476			10		$	(2,558	)		(24	)
NM — Not Meaningful

				2001					2000					Change
(Dollars in thousands, except per
share amounts)				Amount			%		Amount			%		Amount			%
Excluding Nonrecurring Items:
	Pre-Tax Income			$	22,896			100	$	18,734			100	$	4,162			22
	Taxes				8,828			39		7,283			39		1,545			21
		Net Income		$	14,068			61	$	11,451			61	$	2,617			23
			Per Share — Diluted	$	0.27				$	0 .22				$	0.05			20
Nonrecurring Items:
	Pre-Tax Income (Loss)			$	(6,250	)		100	$	(1,500	)		100	$	(4,750	)		NM
	Taxes				(100	)		2		(525	)		35		425			NM
			Net Income (Loss)	$	(6,150	)		98	$	(975	)		65	$	(5,175	)		NM
			Per Share — Diluted	$	(0.12	)			$	(0.02	)			$	(0.10	)		NM
Total:
	Pre-Tax Income			$	16,646			100	$	17,234			100	$	(588	)		(3	)
	Taxes				8,728			52		6,758			39		1,970			29
			Net Income	$	7,918			48	$	10,476			61	$	(2,558	)		(24	)
			Per Share — Diluted	$	0.15				$	0.21				$	(0.06	)		(26	)

NM — Not Meaningful

Merchant Card Services

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

12

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

Corporate Outsourcing Solutions

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

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

Divested Business Units and Nonrecurring Items

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

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

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

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

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Net Interest Income

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

Provision for Income Taxes

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

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

					2001						2000						Change
								% of						% of
(Dollars in thousands)					Amount			Revenue			Amount			Revenue			Amount			%
Revenue:
	Merchant Services				$	180,704			80		$	147,015			73		$	33,689			23
	Corporate Outsourcing Solutions					14,809			7			18,098			9			(3,289	)		(18	)
			Total Core Revenue			195,513			86			165,113			82			30,400			18
	Divested Business Lines					31,408			14			37,267			18			(5,859	)		(16	)
			Total Revenue			226,921			100			202,380			100			24,541			12
Expenses:
	Merchant Services					148,455			82			124,159			84			24,296			20
	Corporate Outsourcing Solutions					12,027			81			14,262			79			(2,235	)		(16	)
				Core Operating Expenses		160,482			82			138,421			84			22,061			16
	Divested Business Lines					29,004			92			33,472			90			(4,468	)		(13	)
				Total Operating Expenses		189,486			84			171,893			85			17,593			10
Operating Profit:
	Merchant Services					32,249			18			22,856			16			9,393			41
	Corporate Outsourcing Solutions					2,782			19			3,836			21			(1,054	)		(27	)
				Total Core Operating Profit		35,031			18			26,692			16			8,339			31
	Divested Business Lines					2,404			8			3,795			10			(1,391	)		(37	)
				Total Operating Profit		37,435			16			30,487			15			6,948			23
Net Interest Income						4,113			2			3,693			2			420			11
Income Before Taxes and Nonrecurring Items						41,548			18			34,180			17			7,368			22
Nonrecurring Items:
		Impairment, Restructuring and Related Expenses				(6,250	)		(3	)		(1,500	)		(1	)		(4,750	)		NM
Income Before Taxes						35,298			16			32,680			16			2,618			8
Provision for Income Taxes						15,841			7			12,656			6			3,185			25
Net Income					$	19,457			9		$	20,024			10		$	(567	)		(3	)

				2001					2000					Change
(Dollars in thousands, except per				Amount			%		Amount			%		Amount			%
share amounts)
Excluding Nonrecurring Items:
	Pre-Tax Income			$	41,548			100	$	34,180			100	$	7,368			22
	Taxes				15,941			38		13,181			39		2,760			21
		Net Income		$	25,607			62	$	20,999			61	$	4,608			22
			Per Share — Diluted	$	0.49				$	0.41				$	0.08			20
Nonrecurring Items:
	Pre-Tax Income (Loss)			$	(6,250	)		100	$	(1,500	)		100	$	(4,750	)		NM
	Taxes				(100	)		2		(525	)		35		425			NM
			Net Income (Loss)	$	(6,150	)		98	$	(975	)		65	$	(5,175	)		NM
			Per Share — Diluted	$	(0.12	)			$	(0.02	)			$	(0.10	)		NM
Total:
	Pre-Tax Income			$	35,298			100	$	32,680			100	$	2,618			8
	Taxes				15,841			45		12,656			39		3,185			25
			Net Income	$	19,457			55	$	20,024			61	$	(567	)		(3	)
			Per Share — Diluted	$	0.38				$	0.39				$	(0.01	)		(5	)

NM — Not Meaningful

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Merchant Card Services

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

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

Corporate Outsourcing Solutions

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

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

Divested Business Units and Nonrecurring Items

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

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

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

15

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

Net Interest Income

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

Provision For Income Taxes

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

Recent Accounting Pronouncements

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

Seasonality

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

Liquidity and Capital Resources

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

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

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

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

      As the Company does not carry significant amounts of inventory and historically has experienced short collection periods for its accounts receivable, it does not require substantial working capital to support revenue growth. Working capital requirements will vary depending upon future acquisition activity. Increases in working capital needs are expected to be financed through operating cash flow and current cash balances.

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

Forward-Looking Statements and Risk Factors

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

Item 3. Quantitative and Qualitative Disclosure About Market Risk

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

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Part II — Other Information

Item 1. Legal Proceedings (None)

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

Item 3. Defaults Upon Senior Securities (None)

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

On May 10, 2001, at the Annual Shareholders Meeting of the Registrant, the shareholders took the following actions:

1. Elected as directors all nominees designated in the proxy statement dated March 30, 2001 as follows:

	Number of Votes
	For		Withheld
Paul G. Clark		50,275,828		678,547
Preston B. Heller, Jr.		50,812,659		141,716
Robert G. Siefers		50,797,009		157,366

2.	Approved the National Processing, Inc. 2001 Restricted Stock Plan: 47,800,466 votes cast for, 3,029,645 votes cast against, and 124,264 votes withheld.
3.	Approved the selection of Ernst & Young LLP as independent auditors for the Registrant for 2001: 50,882,711 votes cast for, 68,864 votes cast against, and 2,800 votes withheld.

Item 5. Other Information (None)

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

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

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

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SIGNATURES

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

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

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