National Processing 10-Q 2001 Q3 Quarterly report

TABLE OF CONTENTS

Part I. Financial Information
	Item 1. Consolidated Financial Statements (unaudited)
		Consolidated Balance Sheets Unaudited
		Consolidated Statements of Income Unaudited
		Consolidated Statement of Changes in Shareholders’ Equity Unaudited
		Consolidated Statements of Cash Flows Unaudited
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Unaudited
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosure of Market Risk
Part II — Other Information
SIGNATURES

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 September 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 (State or other jurisdiction of incorporation or organization)	61-1303983 (I.R.S. Employer Identification No.)
1231 Durrett Lane Louisville, Kentucky (Address of principal executive offices)	40213-2008 (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 October 31, 2001 was 51,546,000.

NATIONAL PROCESSING, INC.

INDEX

Part I. Financial Information

			Page No.
	Item 1.	Consolidated Financial Statements (unaudited)
		Consolidated Balance Sheets — September 30, 2001 and December 31, 2000	3
		Consolidated Statements of Income — Three and Nine Months Ended September 30, 2001 and 2000	4
		Consolidated Statement of Changes in Shareholders’ Equity — Nine Months Ended September 30, 2001	5
		Consolidated Statements of Cash Flows - Nine Months Ended September 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 of Market Risk	18
Part II		Other Information
	Item 1.	Legal Proceedings (None)	19
	Item 2.	Changes in Securities and Use of Proceeds (None)	19
	Item 3.	Defaults Upon Senior Securities (None)	19
	Item 4.	Submission of Matters to a Vote of Security Holders (None)	19
	Item 5.	Other Information (None)	19
	Item 6.	Exhibits and Reports on Form 8-K	19
Signatures			20

2

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

		September 30			December 31
		2001			2000
Assets
Current assets:
	Cash and cash equivalents	$	156,631		$	68,590
	Eurodollar deposits		—			56,000
	Accounts receivable — trade		88,986			128,627
	Restricted deposits — customer funds		25,329			31,543
	Deferred tax assets		2,348			2,283
	Other current assets		7,687			9,901
Total current assets			280,981			296,944
Property and equipment:
	Furniture and equipment		53,017			69,417
	Building and leasehold improvements		11,204			19,231
	Software		27,193			24,418
	Property leased from affiliate		4,173			4,173
	Land and improvements		442			2,390
			96,029			119,629
Less: Accumulated depreciation and amortization			48,514			58,675
Property and equipment, net			47,515			60,954
Other assets:
	Goodwill, net of accumulated amortization of $7,490 in 2001 and $6,939 in 2000		92,021			79,399
	Other intangible assets, net of accumulated amortization of $13,020 in 2001 and $10,902 in 2000		44,040			29,697
	Deferred tax assets		19,007			4,149
	Other assets		6,553			6,328
Total other assets			161,621			119,573
Total assets		$	490,117		$	477,471
Liabilities and shareholders’ equity
Current liabilities:
	Restricted deposits — customer funds	$	25,329		$	31,543
	Accounts payable — trade		16,941			15,243
	Accrued bankcard assessments		22,527			24,458
	Income tax payable		12,890			7,865
	Other accrued liabilities		33,588			33,630
Total current liabilities			111,275			112,739
Obligation under property leased from affiliate			1,895			1,993
Deferred tax liabilities			—			1,181
Total liabilities			113,170			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; 51,538,112 and 50,935,460 shares issued and outstanding in 2001 and 2000, respectively		1			1
	Contributed capital		188,757			178,729
	Unearned compensation		(530	)		—
	Retained earnings		188,719			182,828
Total shareholders’ equity			376,947			361,558
Total liabilities and shareholders’ equity		$	490,117		$	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				Nine Months Ended
	September 30				September 30
	2001		2000		2001		2000
Revenue	$	122,376	$	108,632	$	349,297	$	311,012
Operating expense		88,374		77,262		254,838		224,479
General and administrative expense		5,457		7,066		18,115		21,042
Depreciation and amortization		5,124		5,376		15,488		16,076
Impairment, restructuring, and related expense		—		—		6,250		1,500
Operating profit		23,421		18,928		54,606		47,915
Net interest income		1,477		2,231		5,590		5,924
Income before provision for income taxes and minority interest		24,898		21,159		60,196		53,839
Provision for income taxes		9,345		8,175		25,186		20,831
Income before minority interest		15,553		12,984		35,010		33,008
Minority interest		519		—		519		—
Net income	$	15,034	$	12,984	$	34,491	$	33,008
Basic income per common share	$	0.29	$	0.26	$	0.67	$	0.65
Diluted income per common share	$	0.29	$	0.25	$	0.66	$	0.65

See notes to consolidated financial statements

4

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

	Common		Common		Contributed		Unearned			Retained
	Shares		Stock		Capital		Compensation			Earnings			Total
Balance at January 1, 2001		50,935,460	$	1	$	178,729	$	—		$	182,828		$	361,558
Net income		—		—		—		—			34,491			34,491
Common control business unit purchase (Note 3)		—		—		—		—			(28,600	)		(28,600	)
Issuance of common shares under stock-based compensation plans, including related tax effects		602,652		—		10,028		(530	)		—			9,498
Balance at September 30, 2001		51,538,112	$	1	$	188,757	$	(530	)	$	188,719		$	376,947

See notes to consolidated financial statements

5

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

			Nine Months Ended
			September 30
			2001			2000
Operating Activities
	Net income		$	34,491		$	33,008
	Items not requiring cash currently:
		Depreciation and amortization		15,488			16,076
		Impairment, restructuring and related expense, net of cash paid		5,098			1,431
		Deferred income taxes		(704	)		632
		Loss on disposition of fixed assets		34			591
		Minority interest		519			—
	Change in current assets and liabilities:
		Accounts receivable – trade		30,145			21,303
		Accounts payable – trade		2,460			48
		Accrued bankcard assessments		(1,931	)		(836	)
		Income taxes payable		7,814			(11,037	)
		Other current assets/liabilities		(2,630	)		922
		Other, net		31			(486	)
	Net cash provided by operating activities			90,815			61,652
Investing Activities
	Capital expenditures			(14,813	)		(8,804	)
	Proceeds from sales of fixed assets			34			309
	Purchases of Eurodollar deposits			—			(76,000	)
	Proceeds from maturities of Eurodollar deposits			56,000			60,000
	Common control business unit purchase			(44,000	)		—
	Acquisitions, net of cash received			(48,500	)		(2,000	)
	Proceeds from sale of businesses			43,000			—
	Net cash used in investing activities			(8,279	)		(26,495	)
Financing Activities
	Principal payments under property leased from affiliate			(98	)		(98	)
	Issuance of common stock			5,603			595
	Net cash provided by financing activities			5,505			497
Net increase in cash and cash equivalents				88,041			35,654
Cash and cash equivalents, beginning of period				68,590			32,042
Cash and cash equivalents, end of period			$	156,631		$	67,696
Supplemental cash flow information:
	Taxes paid		$	17,718		$	29,417

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). Beginning June 29, 2001, the consolidated financial statements also include the Company’s 70% ownership interest in ABN AMRO Merchant Services, LLC (see Note 3). 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 and lower revenue in the first calendar quarter, reflecting increased transaction volume in the summer and holiday months.
	Although the consolidated 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 unit. This business unit primarily processed 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 impairment associated with the divestiture. The charge totaled $6.2 million after-tax, or $0.12 per diluted share. On July 11, 2001, the Company signed a definitive agreement with Affiliated Computer Services (ACS) to sell the BPO business unit for $43.0 million in cash. The sale of the BPO business unit was completed on August 29, 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 unit. The charge totaled $1.0 million after-tax, or $0.02 per diluted 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 September 30, 2001 and 2000, the divested business units had revenue of $9.8 million and $19.1 million, respectively, and operating profit of $1.2 million and $2.8 million, respectively. For the nine months ended September 30, 2001 and 2000, the divested business units had revenue of $41.1 million and $56.4 million, respectively, and operating profit (loss) of ($2.7) million and $5.1 million, respectively. Operating profit (loss) includes impairment and restructuring charges related to the BPO business unit totaling $6.3 million in the second quarter of 2001 and $1.5 million in the second quarter of 2000.
3.	ACQUISITIONS
	On June 28, 2001, the Company acquired a 70% ownership interest in ABN AMRO Merchant Services, LLC (AAMS) for $48.5 million 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 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. Incremental revenue as a result of this acquisition was $8.5 million for both the three and nine months ended September 30, 2001.
	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 had previously provided the authorization and settlement processing for these merchants via a third party processing contract with National City. For the three and nine months ended September 30, 2001, the Company recorded $3.8 million and $11.9 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.

8

4.	COMMITMENTS AND CONTINGENCIES
	Under the rules of VISA® and Mastercard®, when a merchant card services processor acquires card transactions, it has certain contingent liabilities for the transactions processed. This contingent liability arises in the event of a billing dispute between the merchant and a cardholder that is not ultimately resolved in the merchant’s favor. In such a case, the transaction is “charged back” to the merchant and the disputed amount is credited or otherwise refunded to the cardholder. If the Company is unable to collect this amount from the merchant’s account, and if the merchant refuses or is unable to reimburse the Company for the charge back due to bankruptcy or other reasons, the Company will bear the loss for the amount of the refund paid to the cardholder. In most cases, this contingent liability situation is unlikely to arise because most products or services are delivered when purchased, and credits are issued on returned items. However, where the product or service is not provided until some later time following the purchase, the contingent liability could be more likely. Management believes the likelihood of any material loss under the chargeback rules is remote.
	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.
5.	NET INCOME PER COMMON SHARE
	The calculation of net income per common share follows (in thousands, except per share amounts):

		Three Months Ended				Nine Months Ended
		September 30				September 30
		2001		2000		2001		2000
BASIC
	Net income	$	15,034	$	12,984	$	34,491	$	33,008
	Average common shares outstanding		51,419		50,830		51,233		50,807
	Net income per common share — basic	$	0.29	$	0.26	$	0.67	$	0.65
DILUTED
	Net income	$	15,034	$	12,984	$	34,491	$	33,008
	Average common shares outstanding		51,419		50,830		51,233		50,807
	Dilutive effect of stock options		985		253		706		125
	Average common shares outstanding — diluted		52,404		51,083		51,939		50,932
	Net income per common share — diluted	$	0.29	$	0.25	$	0.66	$	0.65

6.

SEGMENT REPORTING

The Company operates two business segments – Merchant Card Services and Payment Services. Merchant Card Services authorizes, processes, and settles credit and debit card transactions. Payment Services provides non-card based financial settlement products. Payment Services was formerly a business unit within the Company’s Corporate Outsourcing Solutions segment. Upon the sale of the BPO business unit, this segment was renamed Payment Services. The below segment disclosures for the Payment Services segment include the divested BPO business unit through August 29, 2001, the date of sale.

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     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.

     General and administrative expense is allocated to the Company’s 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 Company’s segments. Corporate assets and liabilities are comprised primarily of cash, Eurodollar deposits, and income tax balances.

(Dollars in thousands)

	Merchant
	Card		Payment				Consolidated
	Services		Services		Corporate		Total
For the three months ended September 30, 2001
Revenue	$	105,551	$	16,825	$	—	$	122,376
Operating profit		20,964		2,457		—		23,421
Depreciation and amortization		4,405		719		—		5,124
Net interest income		1,324		153		—		1,477
Total assets		253,354		31,462		205,301		490,117
For the three months ended September 30, 2000
Revenue	$	79,687	$	28,945	$	—	$	108,632
Operating profit		13,690		5,238		—		18,928
Depreciation and amortization		3,429		1,947		—		5,376
Net interest income		1,612		619		—		2,231
Total assets		223,919		87,854		159,266		471,039

	Merchant
	Card		Payment				Consolidated
	Services		Services		Corporate		Total
For the nine months ended September 30, 2001
Revenue	$	286,255	$	63,042	$	—	$	349,297
Impairment, restructuring and related expense		—		6,250		—		6,250
Operating profit		53,213		1,393		—		54,606
Depreciation and amortization		11,424		4,064		—		15,488
Net interest income		4,805		785		—		5,590
Total assets		253,354		31,462		205,301		490,117
For the nine months ended September 30, 2000
Revenue	$	226,702	$	84,310	$	—	$	311,012
Impairment, restructuring and related expense		—		1,500		—		1,500
Operating profit		36,546		11,369		—		47,915
Depreciation and amortization		10,172		5,904		—		16,076
Net interest income		4,395		1,529		—		5,924
Total assets		223,919		87,854		159,266		471,039

7.

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 estimated 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 the effect these tests will have on the earnings and financial position of the Company.

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8.

RESTRICTED STOCK PLAN

On May 10, 2001, the shareholders of the Company approved the National Processing, Inc. 2001 Restricted Stock Plan. Under the terms of the plan, the Company may issue up to 500,000 shares of common stock to officers and key employees. In the third quarter of 2001, the Company issued 32,500 shares of restricted stock. The stock awards were provided in recognition of future contributions to the continuing success of the Company. In general, the restrictions on shares granted expire within a four-year period. The Company recognized approximately $40,000 of compensation expense in the third quarter related to these restricted stock awards.

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

Components of Revenue and Expenses

     Revenue.

     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.

     Payment Services revenue is generated from a variety of non-card based financial settlement products. The majority of Payment Services 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 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. The segment operating results as shown below exclude certain nonrecurring items. Certain prior year amounts have been reclassified to conform with the 2001 presentation.

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

			2001				2000				Change
					% of				% of
(Dollars in thousands)			Amount		Revenue		Amount		Revenue		Amount			%
Revenue:
	Merchant Card Services		$	105,551		86	$	79,687		73	$	25,864			32
	Payment Services			7,068		6		9,799		9		(2,731	)		(28	)
		Total Core Revenue		112,619		92		89,486		82		23,133			26
	Divested Business Lines			9,757		8		19,146		18		(9,389	)		(49	)
		Total Revenue		122,376		100		108,632		100		13,744			13
Expenses:
	Merchant Card Services			84,587		80		65,997		83		18,590			28
	Payment Services			5,790		82		7,397		75		(1,607	)		(22	)
		Total Core Operating Expenses		90,377		80		73,394		82		16,983			23
	Divested Business Lines			8,578		88		16,310		85		(7,732	)		(47	)
		Total Expenses		98,955		81		89,704		83		9,251			10
Operating Profit:
	Merchant Card Services			20,964		20		13,690		17		7,274			53
	Payment Services			1,278		18		2,402		25		(1,124	)		(47	)
		Total Core Operating Profit		22,242		20		16,092		18		6,150			38
	Divested Business Lines			1,179		12		2,836		15		(1,657	)		(58	)
		Total Operating Profit		23,421		19		18,928		17		4,493			24
Net Interest Income				1,477		1		2,231		2		(754	)		(34	)
Income Before Taxes and Minority Interest				24,898		20		21,159		19		3,739			18
Provision for Income Taxes				9,345		8		8,175		8		1,170			14
Income before Minority Interest				15,553		13		12,984		12		2,569			20
Minority Interest				519		1		—		—		519			100
Net Income			$	15,034		12	$	12,984		12	$	2,050			16

Merchant Card Services

     Revenue for the three months ended September 30, 2001 increased 32% to $105.6 million from $79.7 million in 2000. Revenue increased primarily due to increases of 27% in both transaction and dollar volume processed and the acquisitions of National City’s merchant business units on January 8, 2001 and ABN AMRO Merchant Services, LLC (AAMS) on June 28, 2001. The National City and AAMS acquisitions contributed $3.8 million and $8.5 million, respectively, of incremental revenue in the third 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.

     Expenses for the three months ended September 30, 2001 increased 28% to $84.6 million from $66.0 million in 2000 primarily due to increased processing volume. Operating margins as a percentage of revenue increased to 20% from 17% primarily due to economies of scale from increased volume and the National City and AAMS acquisitions. Operating profit for the quarter ended September 30, 2001 increased 53% to $21.0 million from $13.7 million in the 2000 third quarter due primarily to the factors outlined above.

Payment Services

     Revenue for the core Payment Services segment for the three months ended September 30, 2001 decreased 28% to $7.1 million from $9.8 million in 2000. Revenue decreased primarily due to decreased volume from the Company’s Airlines Reporting Corporation contract.

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     Expenses for the core Payment Services segment for the three months ended September 30, 2001 decreased 22% to $5.8 million from $7.4 million in 2000 due primarily to decreased volume and staff reductions. Operating profit for the quarter ended September 30, 2001 decreased 47% to $1.3 million from $2.4 million in the 2000 third quarter as a result of decreased volume.

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 unit. This business unit primarily processed 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 impairment associated with the divestiture. The charge totaled $6.2 million after-tax, or $0.12 per diluted share. On July 11, 2001, the Company signed a definitive agreement with Affiliated Computer Services (ACS) to sell the BPO business unit for $43.0 million in cash. The sale of the BPO business unit was completed on August 29, 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 unit. The charge totaled $1.0 million after-tax, or $0.02 per diluted 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 September 30, 2001 and 2000, the divested business units had revenue of $9.8 million and $19.1 million, respectively, and operating profit of $1.2 million and $2.8 million, respectively.

Net Interest Income

     Net interest income for the three months ending September 30, 2001, was $1.5 million, down 34% from the prior year third quarter due to lower average interest rates in 2001.

Provision for Income Taxes

     The overall effective tax rate for the third quarter of 2001 was 37.5% compared to 38.6% for the same quarter a year ago. The decrease in the effective tax rate is principally due to differences in state income tax rates between legal entities within the Company due to recent acquisition and divestiture activity.

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Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30, 2000

					2001						2000					Change
								% of						% of
(Dollars in thousands)					Amount			Revenue			Amount			Revenue		Amount			%
Revenue:
	Merchant Card Services				$	286,255			82		$	226,702			73	$	59,553			26
	Payment Services					21,877			6			27,897			9		(6,020	)		(22	)
		Total Core Revenue				308,132			88			254,599			82		53,533			21
	Divested Business Lines					41,165			12			56,413			18		(15,248	)		(27	)
		Total Revenue				349,297			100			311,012			100		38,285			12
Expenses:
	Merchant Card Services					233,042			81			190,156			84		42,886			23
	Payment Services					17,817			81			21,659			78		(3,842	)		(18	)
			Total Core Operating Expenses			250,859			81			211,815			83		39,044			18
	Divested Business Lines					37,582			91			49,782			88		(12,200	)		(25	)
			Total Operating Expenses			288,441			83			261,597			84		26,844			10
Operating Profit:
	Merchant Card Services					53,213			19			36,546			16		16,667			46
	Payment Services					4,060			19			6,238			22		(2,178	)		(35	)
				Total Core Operating Profit		57,273			19			42,784			17		14,489			34
	Divested Business Lines					3,583			9			6,631			12		(3,048	)		(46	)
				Total Operating Profit		60,856			17			49,415			16		11,441			23
Net Interest Income						5,590			2			5,924			2		(334	)		(6	)
Income Before Taxes, Minority Interest and Nonrecurring Items						66,446			19			55,339			18		11,107			20
Nonrecurring Items						(6,250	)		(2	)		(1,500	)		—		(4,750	)	NM
Income Before Taxes and Minority Interest						60,196			17			53,839			17		6,357			12
Provision for Income Taxes						25,186			7			20,831			7		4,355			21
Income before Minority Interest						35,010			10			33,008			11		2,002			6
Minority Interest						519		NM				—			—		519		NM
Net Income					$	34,491			10		$	33,008			11	$	1,483			4

NM — Not Meaningful

Merchant Card Services

     Revenue for the nine months ended September 30, 2001 increased 26% to $286.3 million from $226.7 million in 2000. Revenue increased primarily due to increases of 26% in both transaction and dollar volume processed over the prior year and the acquisitions of National City’s merchant business units on January 8, 2001 and ABN AMRO Merchant Services, LLC (AAMS) on June 28, 2001. The National City and AAMS acquisitions contributed $11.9 million and $8.5 million, respectively, of incremental revenue for the first nine 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 23% to $233.0 million from $190.2 million primarily due to increased processing volume. Operating margins as a percentage of revenue increased to 19% from 16% primarily due to economies of scale from increased volume and the National City and AAMS acquisitions. Operating profit for the nine months ended September 30, 2001 increased 46% to $53.2 million from $36.5 million for 2000 due primarily to the factors outlined above.

Payment Services

     Revenue for the core Payment Services segment for the nine months ended September 30, 2001 decreased 22% to $21.9 million from $27.9 million in 2000. Revenue decreased primarily due to decreased volume from the Company’s Airlines Reporting Corporation contract.

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     Expenses for the core Payment Services segment decreased 18% to $17.8 million from $21.7 million due primarily to decreased volume and staff reductions. Operating profit for the nine months ended September 30, 2001 decreased 35% to $4.1 million from $6.2 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 unit. This business unit primarily processed 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 impairment associated with the divestiture. The charge totaled $6.2 million after-tax, or $0.12 per diluted share. On July 11, 2001 the Company signed a definitive agreement with Affiliated Computer Services (ACS) to sell the BPO business unit for $43.0 million in cash. The sale of the BPO business unit was completed on August 29, 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 unit. 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 nine months ended September 30, 2001 and 2000, the divested business units had revenue of $41.2 million and $56.4 million, respectively, and operating profit (loss) of ($2.7) million and $5.1 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 nine months ending September 30, 2001 was $5.6 million, down 6% from prior year due to lower average interest rates in 2001.

Provision For Income Taxes

     The overall effective tax rate for the nine months ended September 30, 2001 was 41.8% 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 unit for nondeductible losses, repatriation of previously untaxed earnings in foreign countries, and dividends from foreign subsidiaries. The increase in the effective tax rate was partially offset by differences in state income tax rates between legal entities within the Company due to recent acquisition and divestiture activity.

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Effects of September 11 Terrorist Attacks

     The terrorist attacks in New York and Washington on September 11, 2001, have led to reduced levels of air travel. The Company currently processes credit card transactions for six of the top 10 U. S. airlines, and the majority of its Payment Services business is also tied to the travel industry. Travel-related customers, principally airlines, represented about 12% of consolidated third quarter revenue, 7% from Merchant Card Services and 5% from Payment Services. To the extent future air travel continues at levels below historical trends, that portion of Merchant Card Services and Payment Services revenue will be impacted. There is less revenue exposure in the Payment Services business due to the cost-plus contract with the Airlines Reporting Corporation and contractual minimums with other travel-related customers.

     The unprecedented slowdown in air travel, combined with the costs of additional security measures, has raised questions about the ongoing financial viability of the airline industry. In the event of bankruptcy liquidation of one or more of the Company’s airline customers, and to the extent that other carriers would refuse to honor outstanding tickets, the Company could become financially responsible for refunding tickets purchased through MasterCard_® or VISA^® under the chargeback rules of those associations. See Commitments and Contingencies, Note 4 to Consolidated Financial Statements. In the near term, management believes that airline bankruptcy liquidations are highly unlikely given the recent Federal financial support for the airline industry. Based on information available to the company, and actions management is taking to mitigate the situation, management further believes the likelihood of any material loss under the chargeback rules is remote.

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 estimated 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 the effect these tests will have on the earnings and financial position of the Company.

Seasonality

     The Company experiences seasonality resulting in fluctuations in quarterly operating results. The Company typically realizes higher revenue in the third and fourth calendar quarters and lower revenue in the first calendar quarter, reflecting increased transaction volumes during the summer and holiday months. Accounts receivable is generally highest in the fourth quarter as December is typically the highest volume month due to holiday sales.

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Liquidity and Capital Resources

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

     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 nine months ended September 30, 2001, the Company’s capital expenditures totaled $14.8 million. Such expenditures were financed from operating cash flow, which totaled $90.8 million for the nine month period of 2001. Operating cash flow and capital expenditures during the nine months ended September 30, 2000 totaled $61.7 million and $8.8 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 in cash.

     On June 28, 2001, the Company acquired a 70% ownership interest in AAMS for $48.5 million in cash.

     On August 29, 2001, the Company completed the sale of the Business Process Outsourcing unit to Affiliated Computer Services, Inc. for $43.0 million cash.

     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 $25.3 million and $31.5 million as of September 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 and subsequent filings with the Securities and Exchange Commission for risks and uncertainties that could cause actual results to differ materially.

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Item 3. Quantitative and Qualitative Disclosure of Market Risk

Derivative Instruments

     The Company does not use derivative instruments.

Market Risk of Financial Instruments

     The Company’s primary market risk exposure with regard to financial instruments is to changes in interest rates. As of September 30, 2001, the Company had $157 million in cash equivalents. For the third quarter of 2001, the Company also held an average of $154 million of customer funds.

     Because of the short-term nature of these instruments, a sudden change in market interest rates would not impact the fair value of these instruments. The Company’s earnings, however, are impacted by changes in interest rates, which affects both interest earnings on the Company’s cash equivalents and interest earnings on customer funds. At September 30, 2001, a hypothetical 100 basis point increase in short-term interest rates would result in an increase of approximately $3 million in annual pre-tax earnings. A hypothetical 100 basis point decrease in short-term interest rates would result in a decrease of approximately $3 million in annual pre-tax earnings.

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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 (None)

Item 5. Other Information (None)

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

a.     Exhibits (None)

b.     Reports on Form 8-K

     July 13, 2001: On July 13, 2001, the Registrant issued a press release announcing that National Processing Company acquired a 70% ownership interest in ABN AMRO Merchant Services, LLC.

     July 18, 2001: On July 18, 2001, the Registrant issued a press release reporting earnings for the three and six months ended June 30, 2001.

     July 26, 2001: On July 12, 2001, the Registrant issued a press release announcing that National Processing Company signed a definitive agreement to sell its Business Process Outsourcing Services unit to Affiliated Computer Services, Inc.

     September 4, 2001: On August 29, 2001, the Registrant issued a press release announcing that National Processing Company completed the sale of its Business Process Outsourcing Services unit to Affiliated Computer Services, Inc. for $43 million cash.

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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:     November 14, 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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