| · | The number of transactions we process and the mix of transactions among vertical markets are influenced by, among other things, bill-payers' preferences, the shift among federal, state, and local governments, educational institutions, and private entities to electronic payment options; the success of our sales and marketing effort; and the attractiveness of our products and services. |
Each of these factors is subject to change, and as a result, our gross margin from Continuing Operations and our gross margin percentage may change at different rates from each other.
We expect to see continued revenue growth in fiscal year 2012 compared with fiscal year 2011 as we continue to experience larger average payment size.
VSA Revenues: During the three months ended June 30, 2012, our VSA operations generated $0.3 million in revenues, a $0.1 million, or 27.2%, decrease from the three months ended June 30, 2011. During the nine months ended June 30, 2012, VSA generated $1.1 million in revenues, a $0.07 million, or 5.5%, decrease from the nine months ended June 30, 2011. We expect to continue to see decreases in VSA revenues as we continue to complete and wind down existing maintenance projects over the next 12 to 15 months.
Direct Costs (Continuing Operations)
Direct costs, which represent costs directly attributable to providing services to clients, consist predominantly of discount fees. Discount fees include payment card interchange fees and assessments payable to banks and payment card processing fees. Other, less significant costs include: payroll and payroll-related costs; travel-related expenditures; co-location and telephony costs; and the cost of hardware, software and equipment sold to clients. The following table provides a year-over-year comparison of direct costs incurred by our Continuing Operations during the three and nine months ended June 30, 2012 and 2011:
| | Three months ended | | | | |
| | June 30, | | | Variance | |
| (in thousands, except percentages) | | 2012 | | | 2011 | | | $ | | | % | |
| Direct costs | | | | | | | | | | | | |
| Payment Solutions: | | | | | | | | | | | | |
| Discount fees | | $ | 27,134 | | | $ | 29,170 | | | $ | (2,036 | ) | | | (7.0 | )% |
| Other costs | | | 1,642 | | | | 1,452 | | | | 190 | | | | 13.1 | % |
| Total Payment Solutions | | | 28,776 | | | | 30,622 | | | | (1,846 | ) | | | (6.0 | )% |
| VSA | | | 146 | | | | 74 | | | | 72 | | | | 97.3 | % |
| Total | | $ | 28,922 | | | $ | 30,696 | | | $ | (1,774 | ) | | | 5.8 | % |
| | Nine months ended | | | | |
| | June 30, | | | Variance | |
| (in thousands, except percentages) | | 2012 | | | 2011 | | | $ | | | % | |
| Direct costs | | | | | | | | | | | | |
| Payment Solutions: | | | | | | | | | | | | |
| Discount fees | | $ | 70,415 | | | $ | 74,462 | | | $ | 4,047 | | | | (5.4 | )% |
| Other costs | | | 4,684 | | | | 4,243 | | | | 441 | | | | 10.4 | % |
| Total Payment Solutions | | | 75,099 | | | | 78,705 | | | | (3,606 | ) | | | (4.6 | )% |
| VSA | | | 598 | | | | 193 | | | | 405 | | | | 209.8 | % |
| Total | | $ | 75,697 | | | $ | 78,898 | | | $ | (3,201 | ) | | | (4.1 | )% |
The following sections discuss the key factors that caused these changes in the direct costs for Continuing Operations.
Payment Solutions Direct Costs: We experienced a decrease in our Payment Solutions direct costs of $1.8 million, or 6.0%, during the three months ended June 30, 2012 compared to the same period last year. Discount fees decreased $2.0 million, or 7.0%, over the same period last year. The decrease in discount fees is a result of negotiating lower processing fees for some of our customers and the effects of
the Durbin provisions of the Financial Reform Act (effective on October 1, 2011). Durbin limits debit card interchange rates that card issuing banks may charge. Therefore, beginning in the first quarter of fiscal year 2012, we began to realize a decrease in Direct Costs in our Consolidated Statements of Operations, since we process a large number of debit card transactions, and we continued to see a reduction in our discount fees associated with debit card transactions in the third quarter of fiscal 2012. During the remainder of fiscal 2012, we expect to see a decrease in our Payment Solutions direct costs when compared to the same period in the prior year.
During the nine months ended June 30, 2012, Payment Solutions direct costs decreased $3.6 million, or 4.6%, when compared to the same period last year. Discount fees decreased $4.0 million, or 5.4%, over the same period last year. As stated above, our ability to negotiate lower interchange fees for some of our customers along with the impact of the Durbin amendment has contributed to the decrease in discount fees.
Other direct costs increased $0.4 million, or 10.4%, during the nine months ended June 30, 2012. This increase is attributed to increased co-location facility costs.
VSA Direct Costs: During the three and nine months ended June 30, 2012, direct costs from our VSA operations increased $0.1 million or 97.3%, and $0.4 million or 209.8%, respectively, from the same period last year. This increase is attributable to the cost associated with an equipment sale to a customer. As we wind down these operations, we expect that the direct costs of these operations will approximate $0.1 million or less for the final quarter of fiscal 2012.
General and Administrative (Continuing Operations)
General and administrative expenses consist primarily of payroll and payroll-related costs for technology, product management, strategic initiatives, information systems, general management, administrative, accounting, legal and fees paid for outside services, as well as reporting, compliance and other costs that we incur as a result of being a public company. Our information systems expenses include costs to enhance our processing platforms as well as the costs associated with ongoing maintenance of these platforms. The following table compares general and administrative costs incurred by our Continuing Operations during the three and nine months ended June 30, 2012 and 2011:
| | Three months ended | | | | |
| | June 30, | | | Variance | |
| (in thousands, except percentages) | | 2012 | | | 2011 | | | $ | | | % | |
| General and administrative | | | | | | | | | | | | |
| Payment Solutions | | $ | 6,584 | | | $ | 5,519 | | | $ | 1,065 | | | | 19.3 | % |
| VSA | | | 17 | | | | 11 | | | | 6 | | | | 54.5 | |
| Total | | $ | 6,601 | | | $ | 5,530 | | | $ | 1,071 | | | | 19.4 | % |
| | Nine months ended | | | | |
| | June 30, | | | Variance | |
| (in thousands, except percentages) | | 2012 | | | 2011 | | | $ | | | % | |
| General and administrative | | | | | | | | | | | | |
| Payment Solutions | | $ | 22,906 | | | $ | 16,328 | | | $ | 6,578 | | | | 40.3 | % |
| VSA | | | 190 | | | | 11 | | | | 179 | | | | 1,627.3 | % |
| Total | | $ | 23,096 | | | $ | 16,339 | | | $ | 6,757 | | | | 41.4 | % |
Payment Solutions General and Administrative: During the three months ended June 30, 2012, Payment Solutions incurred $6.6 million of general and administrative expenses, a $1.1 million, or 19.3%, increase over the same period last year. The third quarter financial operating results measured by our
management incentive plan caused us to accrue expenses in the three months ended June 30, 2012, whereas incentive accruals were reversed in the three months ended June 30, 2011 resulting in a total unfavorable variance of $1.5 million. Our management incentive plan is based primarily on our financial operating results. External legal and other consultants' expenses were lower by $0.4 million for the three months ended June 30, 2012 as compared with the same period last year.
During the nine months ended June 30, 2012, Payment Solutions incurred $22.9 million of general and administrative expenses, a $6.6 million or 40.3%, increase over the same period last year. During the nine months ended June 30, 2012, we recorded a restructuring charge of $1.6 million including relocation costs of $0.1 million related to the relocation of our principal executive offices from Reston, Virginia to Norcross, Georgia. In connection with vacating and subletting our Reston, Virginia facility we wrote off certain balances associated with our original lease agreement including leasehold improvements, net of accumulated amortization and deferred rent. The restructuring charge is included in General and administrative expense in the accompanying Consolidated Statements of Operations. We also incurred an increase in employee base compensation expense of $0.9 million and management incentive plan expense of $2.7 million in the first nine months of fiscal 2012 compared to the first nine months of fiscal 2011. The increase in base compensation expense is primarily attributable to increased headcount in our technology organization. Our share based compensation expense is $1.7 million greater in the nine months ended June 30, 2012 as compared to the prior year period primarily due to the reversal of $1.5 million of expense related to restricted stock units, or RSUs that had been granted to our former CEO. These RSUs would have vested only if certain conditions had been satisfied. These conditions were not satisfied and pursuant to US GAAP we reversed in the quarter ended March 31, 2011, $1.5 million of expense that had been recognized over the vesting period of the RSUs.
VSA General and Administrative: General and administrative costs for VSA operations for the three months ended June 30, 2012 were essentially unchanged from the same period last year. For the nine months ended June 30, 2012, general and administrative costs for VSA operations increased $0.2 million over the same period last year.
Selling and Marketing (Continuing Operations)
Selling and marketing expenses consist primarily of payroll and payroll-related costs, commissions, advertising and marketing expenditures and travel-related expenditures. We expect selling and marketing expenses to fluctuate from quarter to quarter due to a variety of factors, such as increased advertising and marketing expenses incurred in anticipation of the April federal tax season. The following table provides a year-over-year comparison of selling and marketing costs incurred by our Continuing Operations during the three and nine months ended June 30, 2012 and 2011:
| | Three months ended | | | | |
| | June 30, | | | Variance | |
| (in thousands, except percentages) | | 2012 | | | 2011 | | | $ | | | % | |
| Selling and marketing | | | | | | | | | | | | |
| Payment Solutions | | $ | 2,635 | | | $ | 1,690 | | | $ | 945 | | | | 55.9 | % |
| VSA | | | - | | | | - | | | | - | | | | - | |
| Total | | $ | 2,635 | | | $ | 1,690 | | | $ | 945 | | | | 55.9 | % |
| | Nine months ended | | | | |
| | June 30, | | | Variance | |
| (in thousands, except percentages) | | 2012 | | | 2011 | | | $ | | | % | |
| Selling and marketing | | | | | | | | | | | | |
| Payment Solutions | | $ | 6,296 | | | $ | 5,062 | | | $ | 1,234 | | | | 24.4 | % |
| VSA | | | - | | | | - | | | | - | | | | - | |
| Total | | $ | 6,296 | | | $ | 5,062 | | | $ | 1,234 | | | | 24.4 | % |
Payment Solutions Selling and Marketing: During the three months ended June 30, 2012, Payment Solutions incurred $2.6 million of selling and marketing expenses, a $0.9 million, or 55.9%, increase over the same period last year. The increase is primarily due to advertising expenses which were $0.5 million higher for the three months ended June 30, 2012 over the same period of the previous year, due to increased attention paid to income tax related verticals. Compensation related expenses including wages, commissions, and share based compensation were $0.2 million greater than the three months ended June 30, 2011. Travel related expenses were $0.1 million greater in the three months ended June 30, 2012 compared to the same period in the previous year as a result of an increase in the number of face to face customer meetings with our sales force.
During the nine months ended June 30, 2012, Payment Solutions incurred $6.3 million of selling and marketing expenses, a $1.2 million or 24.4%, increase over the nine months ended June 30, 2011. The most significant factor in the year over year increase is the addition of $0.5 million in net advertising expense. Fees paid to marketing partners increased $0.3 million for the nine months ended June 30, 2012, as compared with the same period the previous year, driven by higher net revenues for related clients. Further contributing to the increase is $0.3 million in travel related expenses associated with increased headcount and a push towards face to face sales meetings.
VSA Selling and Marketing: As a result of our decision to not pursue new contracts within the VSA segment, we did not incur any selling and marketing expenses during the three and nine months ended June 30, 2012 and 2011.
Depreciation and Amortization (Continuing Operations)
Depreciation and amortization represents expenses associated with the depreciation and amortization of equipment, software and leasehold improvements, and intangible assets. The following table compares depreciation and amortization costs incurred by our Continuing Operations during the three and nine months ended June 30, 2012 and 2011:
| | Three months ended | | | | |
| | June 30, | | | Variance | |
| (in thousands, except percentages) | | 2012 | | | 2011 | | | $ | | | % | |
| Depreciation and amortization | | | | | | | | | | | | |
| Payment Solutions | | $ | 1,851 | | | $ | 1,856 | | | $ | 5 | | | | (0.3 | )% |
| VSA | | | - | | | | - | | | | - | | | | - | |
| Total | | $ | 1,851 | | | $ | 1,856 | | | $ | 5 | | | | (0.3 | )% |
| | Nine months ended | | | | |
| | June 30, | | | Variance | |
| (in thousands, except percentages) | | 2012 | | | 2011 | | | $ | | | % | |
| Depreciation and amortization | | | | | | | | | | | | |
| Payment Solutions | | $ | 5,620 | | | $ | 5,420 | | | $ | 200 | | | | 3.7 | % |
| VSA | | | - | | | | - | | | | - | | | | - | |
| Total | | $ | 5,620 | | | $ | 5,420 | | | $ | 200 | | | | 3.7 | % |
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Depreciation and amortization relating to Payment Solutions was essentially unchanged for the three months ended June 30, 2012 as compared with the same period of the previous year. For the nine months ended June 30, 2012, depreciation and amortization relating to Payment Solutions increased by $0.2 million, or 3.7%, primarily associated with internally developed software. We did not incur any amortization expense for our VSA operations for the three or nine months ended June 30, 2012 or June 30, 2011.
Other Income (Continuing Operations)
Interest income, net: Interest income during the three and nine months ended June 30, 2012 decreased $0.02 million and $0.1 million respectively, compared to the three and nine months ended June 30, 2011, attributable to both a decrease in the amount within our investment portfolio over the last twelve months, and decreases in interest rates. Our interest rates fluctuate with changes in the marketplace.
Income Tax Provision (Continuing Operations)
We reported an income tax provision of $5,000 during the three and nine months ended June 30, 2012. We reported an income tax provision of $46,000 and a benefit of $139,000, respectively, for the three and nine months ended June 30, 2011. Because of losses in Discontinued Operations during fiscal year 2012, there has been no intra-period tax allocation to it from Continuing Operations. Continuing Operations benefitted from a required intra-period tax allocation of $151,000 for the nine months ended June 30, 2011, as a result of a loss in Continuing Operations and income recorded in Discontinued Operations. The remaining provision for income taxes represents state tax obligations incurred by our Payment Solutions operations for both fiscal years. Our Consolidated Statements of Operations for the three and nine months ended June 30, 2012 and 2011 do not reflect a federal tax provision because of offsetting adjustments to our valuation allowance. Our effective tax rates differ from the federal statutory rate due to state income taxes, and the charge for establishing a valuation allowance on our net deferred tax assets. Our future tax rate may vary due to a variety of factors, including, but not limited to: the relative income contribution by tax jurisdiction; changes in statutory tax rates; changes in our valuation allowance; our ability to utilize net operating losses and any non-deductible items related to acquisitions or other nonrecurring charges.
Our acquired federal net operating loss carryforward is limited to $3.35 million per year pursuant to Internal Revenue Code Section 382, and approximately $14.5 million is still limited to this annual amount. The balance of our federal net operating loss carryforwards, approximately $2.0 million, is not eligible to use at June 30, 2012. Future ownership changes could further limit the use of our federal net operating loss carryforwards.
SECURITY
During the quarter ended March 31, 2012, one of our primary payment processors suffered a significant security breach. We do not believe this incident directly affected our Company, our systems or our clients or customers. Official Payments maintains security systems and data security precautions intended to protect our systems, networks, and the information provided by our clients and their customers from theft, and unauthorized access, use, or disclosure. Official Payments has been certified as Payment Card Industry (PCI) Data Security Standard (DSS) - Level 1 compliant. We also believe that our systems comply with National Institute of Standards and Technology (NIST) standards for security, and with information security requirements of the Internal Revenue Service (IRS). Despite our efforts to protect the integrity of our systems, it is possible that we may not be able to anticipate or to implement effective preventive measures against all security breaches, especially because the techniques used change frequently or are not recognized until launched, and because security attacks can originate from a wide variety of sources; we discuss the consequences of any such security breach in "Risk Factors" below.
LIQUIDITY AND CAPITAL RESOURCES
At June 30, 2012 we had $40.8 million in cash, cash equivalents and marketable securities compared with $39.7 million at September 30, 2011.
As discussed in Note 8-Contingencies and Commitments and Note 5-Customer Concentration and Risk our Consolidated Balance Sheets include settlements payable and receivable. Our $40.8 million in cash and cash equivalents includes $6.9 million of accrued discount fees and funds of $1.1 million we have not yet paid to clients due to the timing of bank transactions. These items reduce the cash available for our use. Therefore, the cash and cash equivalents available to us at June 30, 2012 is $32.7 million (cash and cash equivalents less settlements payable and accrued discount fees plus settlements receivable). Using the same calculation, we had $32.7 million available to us at September 30, 2011. Due to the seasonality of our business at the end of the third quarter there was an increase in settlement processing assets and liabilities as compared to the fourth quarter of the previous fiscal year. Contributing to this increase is the fact that our third fiscal quarter end fell on a Saturday; we are unable to transmit funds to our clients on days when the Federal Reserve is closed. We also received a larger amount of IRS payments at the end of our third quarter than we had received at the end of the fourth quarter of the previous fiscal year or the end of the previous year's third fiscal quarter.
Our current investment strategy is to ensure our cash, cash equivalents and marketable securities remain highly liquid. We believe we have sufficient liquidity to meet currently anticipated needs, including capital expenditures, working capital investments, and acquisitions for the next twelve months. We expect to generate cash flows from operating activities over the long term; however, we may experience significant fluctuations from quarter to quarter resulting from the timing of billing and collections. To the extent that our existing capital resources are insufficient to meet our capital requirements, we will have to raise additional funds. There can be no assurance that additional funding, if necessary, will be available on favorable terms, if at all. Currently, we do not have any short-term or long-term debt.
Net Cash from Continuing Operations-Operating Activities. During the nine months ended June 30, 2012, our operating activities from Continuing Operations provided $4.6 million of cash. This reflects a net loss of $3.9 million from Continuing Operations and $7.5 million of non-cash items. During the nine months ended June 30, 2012, $1.5 million in cash was provided by an increase in accounts payable and accrued liabilities. An increase in settlement processing assets and obligations, net used $1.0 million. The timing of bank transactions causes fluctuations in these amounts from month to month. An increase in prepaid expenses and other assets used $0.5 million of cash, primarily attributable to the purchase of additional maintenance contracts on infrastructure. A decrease in deferred income used $0.2 million of cash, while an increase in other long term liabilities generated $0.2 million in cash.
Net Cash from Continuing Operations-Investing Activities. Net cash used by our investing activities from Continuing Operations for the nine months ended June 30, 2012 was $3.6 million for the purchase of equipment and software to support our Payment Solutions operations and additional goodwill related to the ChoicePay earn-out.
Net Cash from Continuing Operations-Financing Activities. During the nine months ended June 30, 2012, $26,000 of cash was used for capital lease obligations.
CONTRACTUAL OBLIGATIONS
During the three and nine months ended June 30, 2012, there was no material change in the contractual obligations disclosed in our most recent annual report.
CRITICAL ACCOUNTING POLICIES
The preparation of our financial results of operations and financial position requires us to make judgments and estimates that may have a significant impact upon our financial results. We believe that of our accounting policies, the following estimates and assumptions, which require complex subjective judgments by management, could have a material impact on reported results: collectability of receivables; share-based compensation; valuation of goodwill, intangibles and investments; contingent
liabilities; and effective tax rates, deferred taxes and associated valuation allowances. Although we believe the estimates and assumptions used in preparing our Consolidated Financial Statements and related notes are reasonable in light of known facts and circumstances, actual results could differ materially.
Our policy is to evaluate goodwill for possible impairment at least annually and whenever events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. All of our goodwill and intangible assets are included in our Payment Solutions reporting unit. Goodwill is evaluated for possible impairment by comparing the fair value of a reporting unit with its carrying value, including the goodwill assigned to that reporting unit. Fair value of the reporting unit is estimated using a combination of income-based and market-based valuation methodologies. Under the income approach, forecasted cash flows of a reporting unit are discounted to a present value using a discount rate commensurate with the risks of those cash flows. Under the market approach, the fair value of a reporting unit is estimated based on trading multiples of a group of comparable public companies and from values implied by recent merger and acquisition transactions involving comparable companies. An impairment charge is recorded if the carrying value of the Payment Solutions reporting unit exceeds its implied fair value. We complete our annual impairment testing for goodwill in the fourth quarter of our fiscal year. Based on our assessment as of September 30, 2011, we concluded that the fair value of the Payment Solutions reporting unit exceeded its carrying value by at least 50%. Significant assumptions inherent in the valuation methodologies employed include, but are not limited to, projected business results, growth rates and discount rates. These assumptions are based primarily on our historical results and expectations for future operations. Our assumptions do not include the potential impacts of alternative payment methods payors might begin to use, significant changes in the overall economy or loss of significant customers, each of which would likely decrease our estimated fair value and potentially cause us to record an impairment of our recorded goodwill.
For a full discussion of our critical accounting policies and estimates, see the Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended September 30, 2011.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We maintain a portfolio of cash equivalents in a variety of securities including on demand deposits, and money market funds. These securities are not generally subject to interest rate risk.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of June 30, 2012. The term "disclosure controls and procedures" means controls and other procedures that are designed to ensure that information required to be disclosed by a company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to the company's management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of June 30, 2012, our Chief Executive Officer and our Chief Financial Officer concluded that as of that date, our disclosure controls and procedures were effective at the reasonable assurance level.
30
There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended June 30, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Investing in our common stock involves a degree of risk. You should carefully consider the risks and uncertainties described below in addition to the other information included or incorporated by reference in this quarterly report. If any of the following risks actually occur, our business, financial condition or results of operations would likely suffer. In that case, the trading price of our common stock could fall.
The following factors and other risk factors could cause our actual results to differ materially from those contained in forward-looking statements in this Form 10-Q.
We have incurred losses in the past and may not be profitable in the future. We have reported net losses of $7.2 million in fiscal 2011, $6.2 million in fiscal 2010, $11.5 million in fiscal 2009, $27.4 million in fiscal 2008, and $3.0 million in fiscal 2007. We are undertaking steps and implementing strategies to reduce costs and increase revenues. As part of our cost reduction efforts, we are seeking to negotiate more favorable terms and fees that we pay including with processors, partners, vendors, suppliers and other providers of our services. We are in the process of consolidating certain vendors and suppliers of our business to achieve greater efficiency and reduce indirect and direct costs and expenses including cost of services, interchange related costs, processor fees, and other transaction expenses. We recently relocated our principal executive offices from Reston, Virginia to Norcross, Georgia as part of our strategic plan to eliminate duplicative operations and functions, improve efficiency, and save costs. If we are unable to reduce costs and our cost reduction steps and strategies are not successful, our costs may increase, may remain the same, or may not be reduced significantly enough to enable us to be profitable, or our losses may increase.
Our sales and marketing objectives include developing favorable client and customer relationships, driving repeat business, increasing transactions, and developing cross-sale opportunities in order to grow our business and our revenue. We recently made changes to our sales strategy to focus on acquiring new clients, and we created a new sales structure, hired new managers and sales representatives, implemented a new sales commission plan, and have taken other steps to grow sales and revenue and expand our reseller partner relationships. To further enhance sales, we are in the process of developing new products and solutions for partners and biller direct clients in order to increase transactions and utilization of our services. If any of these strategies or efforts do not succeed, or do not increase sales, transactions and revenue, or if our products are not competitive, our operating results, revenues and cash flows could decline, or may not increase sufficiently to enable us to be profitable, or our losses may increase.
Our revenues and operating margins may decline and may be difficult to forecast, which could result in a decline in our stock price. Our revenues, operating margins and cash flows are subject to significant variation from quarter to quarter due to a number of factors, many of which are outside our control. These factors include:
| · | general economic conditions; |
| · | loss of significant clients; |
| · | demand for our services; |
| · | seasonality of business, resulting from timing of property tax payments and federal and state income tax payments; |
| · | timing of service and product implementations; |
| · | unplanned increases in costs; |
| · | delays in completion of projects; |
| · | costs of compliance with laws and government regulations; |
| · | costs of acquisitions, consolidation and integration of new business and technology; and |
| · | costs of operating in the payment processing industry, including interchange fees and other processing-related dues, assessments and fees. |
The occurrence of any of these factors may cause the market price of our stock to decline or fluctuate significantly, which may result in substantial losses to investors. We believe that period-to-period comparisons of our operating results are not necessarily meaningful and/or indicative of future performance. From time to time, our operating results may fail to meet analysts' and investors' expectations, which could cause a significant decline in the market price of our stock. Fluctuations in the price and trading volume of our stock may be rapid and severe and may leave investors little time to react. Fluctuations in the price of our stock could cause investors to lose all or part of their investment.
We could suffer material losses and liability if our operations, systems or platforms are disrupted or fail to perform properly or effectively. The continued efficiency and proper functioning of our technical systems, platforms, and operational infrastructure is integral to our performance. We operate on multiple platforms. If any or all of the platforms or portions of the platforms, systems, or resources are disrupted or fail to perform properly or effectively, we could incur significant remediation costs and we might not be able to process transactions or provide services during the disruption or failure, which would result in a decrease in revenue. Our operations, systems and platforms might be disrupted or fail to perform properly for many reasons including operational or technical failures of our systems and platforms, human error, failure of third-party support and services, system failure due to age and lack of integrity of hardware and software infrastructure, existence of single points of failure which has resulted in system interruption and outages, diminished availability and reliability of our services causing us to fail to meet contractual service level requirements, and loss of key individuals or failure of key individuals to perform who have unique knowledge of system architecture and platform customizations. Our operations, systems and platforms may also be disrupted or fail due to catastrophic events such as natural disasters, telecommunications failures, power outages, cyber-attacks, war, terrorist attacks, or other catastrophic events. We are currently undertaking a multi-million dollar project to upgrade and replace significant portions of our infrastructure including the majority of our servers, system equipment, and software. Loss or degradation of services, failure of transactions or loss of functionality could result in the event of disruption or failure of equipment or software during this upgrade project.
We process a high volume of time-sensitive payment transactions. The majority of our tax-related transactions are processed in short periods of time, including between April 1 and April 17 of the current tax year for federal tax payments. If there is a defect or malfunction in our platforms or system software or hardware, an interruption or failure due to damage or destruction, a loss of system or platform functionality, a delay in our system processing speed, a lack of system capacity, or a loss of personnel on short notice, even for a short period of time, our ability to process transactions and provide services may be significantly limited, delayed or eliminated, resulting in lost business and revenue and harm to our reputation. We might be required to incur significant costs to remediate or address any such defect, malfunction, interruption, failure, loss of functionality, delay, lack of capacity, or loss of personnel. Our insurance may not provide coverage or be adequate to compensate us for losses that may occur as a result of any such event, or any system, platform, security or operational failure or disruption.
We could suffer material losses and liabilities if the services of any of our third party suppliers, vendors or other providers are disrupted, eliminated or fail to perform properly or effectively. Our payment solution services, systems, security, infrastructure and technology platforms are highly dependent on continuous, timely and accurate provision of third party services, software, and hardware, including data transmission and telecom service providers, subcontractors, co-location facilities, network access providers, card companies, processors, banks, merchants and other suppliers and providers. We also provide services on complex multi-party projects where we depend on integration and implementation of third-party products and services. Our systems are periodically impacted by partner
and vendor system outages that can result in periods when our systems and services are partially available, are not available, or operate with diminished functionality. The failure or loss of any of these third party systems, services, software or products, our inability to obtain replacement services, or damage to or destruction of such services could cause degraded functionality, loss of product and service offerings, restricted transaction capacity, loss of transactions, limited processing speed and/or capacity, system failure, and contractual claims which could result in significant cost, liability, diminished profitability and damage to our reputation and competitive position. Our insurance may not provide coverage or be adequate to compensate us for losses that may occur as a result of any such event, or any system, security or operational failure or disruption.
In the event we proceed with consolidation of our technology platforms, the consolidation involves significant risk and may not be successful or may be delayed. We are in the process of evaluating the consolidation of our technology platforms. We currently maintain three payment processing platforms: one in San Jose, California; one in Norcross, Georgia; and a third in Tulsa, Oklahoma. Consolidation of our technology platforms could result in significant risks, including restricted and limited transaction volume, operational inefficiencies, inability to achieve our goals for fiscal years 2012 and 2013, inability to expand existing products and services, higher development and labor costs, significant client migration costs, increased hardware and software costs, inability to provide certain functionality, or system and service disruption or failure. Additionally, migration of clients to a new platform, or consolidation into one or two platforms could result in client service outages, loss of functionality and loss of customers. Our business is highly dependent upon having safe and secure information technology platforms with sufficient capacity to meet both the high volume of transactions and the future growth of our business. If our ability to develop and/or acquire upgrades or replacements for our existing platforms does not keep pace with the growth of our business, we may not be able to increase business. Furthermore, if we are not able to acquire or develop these platforms and systems on a timely and economical basis, our profitability may be adversely affected. Since we maintain three separate platforms, the cost to develop products is significantly greater than if we maintained one platform, and such costs may continue to increase as we enhance existing products and develop new products.
We could suffer material losses or disruption of our business if we are not successful in integration and consolidation of operations and corporate functions. In September 2011 we opened an office in Norcross, Georgia, and vacated our Reston, Virginia office, effective December 31, 2011. As part of this transition we consolidated and continue to consolidate, certain resources, key positions, corporate departments and company functions including our financial operations (financial planning and analysis, cash settlement/reconciliation, general ledger accounting, and tax functions) and certain product development, human resources, technology services, and facilities management functions. As a result of such consolidation, certain key employees are no longer employed by the Company and certain internal processes have changed, and continue to change, which resulted in the loss of certain historical knowledge from departing employees and changes in our systems, protocols and processes. If this restructuring and consolidation is not successful, we could suffer disruption of our operations, systems or services, which could result in remediation efforts, increased costs, and material adverse impact on our business, reputation and stock price.
Security breaches or unauthorized access to confidential data and personally identifiable information in our facilities, computer networks, or databases, or those of our suppliers, may cause harm to our business and result in liability and systems interruptions. Our business requires us to obtain, process, use, and destroy confidential and personally identifiable data and information of clients and consumers. We have programs, procedures and policies in place to protect against security breaches, unauthorized access and fraud. Despite security measures we have taken, our systems may be vulnerable to physical break-ins, fraud, computer viruses, attacks by hackers and similar acts and events, causing interruption in service and loss or theft of confidential data and personally identifiable information that we process and/or store. It is possible that our security controls over confidential
information and personal data, our training on data security, and other practices we follow may not prevent the improper disclosure or unauthorized access to confidential data and personally identifiable information. In addition, our service could be subject to employee fraud or other internal security breaches, and we may be required to reimburse customers for any funds stolen as a result of such actions or breaches. Our third-party vendors or suppliers also may experience security breaches, fraud, computer viruses, attacks by hackers or other similar incidents involving the unauthorized access and theft of confidential data and personally identifiable information. One of our primary payment processor vendors recently suffered a significant security breach incident, and additional incidents could occur in the future. While we do not believe this incident directly impacted our Company or our clients, if client or consumer data and/or information was lost or stolen as a result of a security breach or unauthorized access, such an incident could potentially result in compliance costs, loss of clients and revenues, liability and fines. Any security breach within our systems, software or hardware or our vendors' or suppliers' systems, software or hardware could result in unauthorized access, theft, loss, disclosure, deletion or modification of such data and information, and could cause harm to our business and reputation, liability for fines and damages, costs of notification, and a loss of clients and revenue.
Financial loss could result from fraudulent payments, lack of integrity of systems, or fraudulent use of our systems or the systems of third parties. We receive funds and facilitate payment and settlement of funds on behalf of clients, consumers and businesses for a variety of transaction types including debit/credit cards, ACH payments and other electronic bill payments. Our facilitation of these payments depends on the integrity of our systems and our technology infrastructure as well as the integrity of the systems and technology infrastructure of third parties in the payment transaction process such as financial institutions, processors, networks, and other businesses, and vendors and suppliers. In addition, our service could be subject to employee fraud or other internal security breaches, and we may be required to reimburse customers for any funds stolen as a result of such actions or breaches. If the integrity of this payment process is impaired or the ability to detect fraud or fraudulent payments compromised, including in connection with verification, authentication, settlement, and other payment processes, it could result in financial loss.
Our revenues and cash flows could decline significantly if we were unable to retain our largest client, or a number of significant clients. The majority of our client contracts, including our contract with the U.S. Internal Revenue Service, allow clients to terminate all or part of their contracts on short notice, or provide notice of non-renewal with little prior notification. Our contract with the IRS has generated 17.8%, 17.1%, and 19.8%, of our annual revenues from Payment Solutions for fiscal years 2011, 2010, and 2009 respectively. In April 2009 we were one of three companies awarded a multi-year contract by the IRS to provide electronic payment options for personal and business taxes. The contract contains a base period commencing April 2, 2009 and ending December 31, 2009 and four one-year option periods running until December 31, 2013. To obtain this contract, we reduced our historical pricing. We compete with the other contract award recipients to provide services to the IRS. If the other recipients reduce their prices, or if additional companies are awarded contracts, we may have to reduce our prices further to remain competitive. If we were unable to retain this client, or replace it in the event it is terminated, or if we were unable to renew this contract, or are unsuccessful in future re-bids of this contract, or if we are forced to reduce our prices in response to competitive pressures, our operating results and cash flows could decline significantly. Termination or non-renewal of a number of client contracts, or certain significant client contracts, including the IRS contract, or a number of large state, local, utility or education-related contracts, could result in significant loss of revenues and reduction in profitability.
Recent economic conditions may continue to negatively impact our business. As a result of the current global and U.S. economic conditions, including high unemployment and real estate foreclosures, we have suffered a downturn in revenue in our property tax and federal vertical markets, due to decreased payments of federal income tax and property tax. If current conditions do not improve, additional declines in revenue may occur, especially in the property tax and federal vertical markets, negatively impacting use of our services and our overall revenues.
Additionally, the ongoing worldwide and U.S. economic downturn has made it difficult to borrow money or obtain credit. We currently have no credit line or credit facility and rely solely on cash on hand, investments and cash from operations to fund our business. If current levels of economic and market disruption and volatility continue or worsen, there can be no assurance that credit, bank loans, contractual lending agreements or other funding sources will be available on reasonable terms, or at all. If we were not able to fund operations our level of services, staffing, resources or equipment may need to be reduced or eliminated which could negatively impact our revenue and stock price.
We are subject to numerous laws and regulations. Violation of any existing or future laws or regulations, including laws governing money transmitters and anti-money laundering laws, could expose us to substantial liability and fines, force us to cease providing our services, or force us to change our business practices. Our business is subject to numerous federal, state and local laws, government regulations, corporate governance standards, compliance controls, accounting standards, licensing and bonding requirements, industry/association rules, and public disclosure requirements including under the Sarbanes Oxley Act of 2002, SEC regulations, the Financial Reform Act and Nasdaq Stock Market rules. Compliance with and changes in these laws, regulations, standards and requirements may result in increased general and administrative expenses for outside services, increased risks associated with compliance, and a diversion of management time and attention from revenue-generating activities, which could curtail the growth of our business. Non-compliance with these laws or regulations could result in significant costs of remediation, fines, penalties or regulatory restrictions.
We are registered as a money services business with the Financial Crimes Enforcement Network (FinCEN), and we are licensed as a money transmitter in numerous states. We are subject to compliance with federal and state laws and licensing regulations as a money services business and as a money transmitter including anti-money laundering laws and the USA Patriot Act. We are also subject to the applicable rules of the credit/debit card associations, the National Automated Clearing House Association (NACHA), and other industry standards, privacy, data security, and other laws and regulations associated with payment transaction services which are critical to our business. New laws and regulations in these areas may be enacted, or existing ones changed, which could negatively impact our services, restrict or eliminate our ability to provide services, make our services unprofitable, or create significant liability for us. Our anti-money laundering program requires us to monitor transactions, report suspicious activity, and prohibit certain transactions. We currently hold money transmitter licenses in 43 states and have pending applications for licensure as a money transmitter in two states. We entered into consent orders with six states which included payment of a fine for unlicensed activity prior to our submission of the money transmitter application, and three other states have imposed an assessment or fine. In the future we may be subject to additional states' money transmitter regulations, money laundering regulations, regulation of Internet transactions, consent orders, and related payment of fees and fines. If we are found to be in violation of any laws, rules, regulations or standards, we could be exposed to significant financial liability, substantial fines and penalties, cease and desist orders, and other sanctions that could restrict or eliminate our ability to provide our services in one or more states or accept certain types of transactions in one or more states, or could force us to make costly changes to our business practices. Even if we are not forced to change our business practices, the costs of compliance and obtaining necessary licenses and regulatory approvals could be substantial.
We could suffer material revenue losses and liability in the event the divested business projects and contracts are not successfully concluded. We have completed divestment of certain operations and portions of the business including our former Financial Institutions Data Match services, State Systems Integration, Financial Management Systems and Unemployment Insurance operations. We remain liable for certain obligations under some of the divested projects and their related contracts. In February 2009, we completed the sale of our Unemployment Insurance, or UI, business to RKV Technologies, Inc, or RKV. The sale was completed pursuant to an Asset Purchase Agreement dated February 6, 2009. As a part of the agreement, Official Payments is required to leave in place a $2.4 million performance bond on the continuing contract for the State of Indiana, or the State.
Subsequent to the sale of the UI business to RKV, the prime contractor, Haverstick Corporation, or Haverstick, the State, and RKV determined that the contract completion would be delayed and additional funding would be needed to complete the contract. In November 2009 Haverstick cancelled its contract with RKV and directly rehired various RKV resources and contractors. Official Payments retains certain liabilities for completion of the project, and continues as the indemnitor under the performance bond. The State and Haverstick have each alleged that we did not obtain consent to assign the contract to RKV prior to our divestment of the Unemployment Insurance business. It is anticipated that the project will be completed by December 2012. Mediation is expected to take place promptly after the project is finished to discuss the allocation of the costs of project completion. If a claim is made in connection with services or products provided by either us or the acquiring company, or if the claim of breach of contract is successful, we could be subject to liability and damages, unanticipated expenses costs of defense, liquidated damages, and bond forfeiture.
If we undertake acquisitions, they could be expensive, increase our costs or liabilities or disrupt our business. One of our strategies may be to pursue growth through acquisitions. Negotiations of potential acquisitions and the integration of acquired business operations could disrupt our business by diverting management attention away from day-to-day operations. Acquisitions of businesses or other material operations may require debt or equity financing, resulting in leverage or dilution of ownership. We also may not realize cost efficiencies or synergies that we anticipated when selecting our acquisition candidates. In addition, we may need to record write-downs from future impairments of identified intangible assets and goodwill, which could reduce our future reported earnings. Acquisition candidates may have liabilities or adverse operating issues that we fail to discover through due diligence prior to the acquisition. Any costs, liabilities or disruptions associated with any future acquisitions we may pursue could harm our operating results.
We operate in a highly competitive market. If we do not compete effectively, we could face price reductions, reduced profitability and loss of market share. Our business is focused on electronic payment transaction solutions, which is a highly competitive market and is served by numerous international, national and local firms. Many of our competitors have significantly greater financial, technical and marketing resources and name recognition than we do. Parts of our business are subject to increasing pricing pressures from competitors, and some competitors are able to operate at significant losses for extended periods of time, which increases pricing pressure on our products and services. Additionally, the use of credit and debit cards and electronic checks (ACH) to make payments is subject to rapid technological change and competitive product offerings. Our future success depends in part on our ability to innovate, develop, acquire and introduce successful new products and services for our target markets and to respond quickly to changes in the market. If our products or services do not achieve market acceptance, or if we are unable to deliver competitive products or services, or if competitors develop more successful products and services, we may lose market share, and our revenues could decline.
The success of our business is based largely on our ability to attract and retain talented and qualified employees and contractors. The market for skilled workers in our industry is extremely competitive. In particular, qualified managers and senior technical and professional staff are in great demand. If we are not successful in our recruiting efforts or are unable to retain key employees, our ability to staff projects and deliver products and services may be adversely affected. We believe our success also depends upon the continued services of senior management and a number of key employees whose employment may terminate at any time. If one or more key employees resign to join a competitor or to form a competing company, the loss of such personnel and any resulting loss of existing or potential clients could harm our competitive position. Additionally, as part of the transition to our Norcross, Georgia office we terminated some existing employees, hired new employees, consolidated certain resources, and continue to transition some corporate departments, positions, and company functions, which may result in loss of historical knowledge and skills, disruption in our business and loss of revenues.
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If we are not able to protect our intellectual property, our business could suffer serious harm. Our systems and operating platforms, scripts, software code and other intellectual property are generally proprietary, confidential, and may be trade secrets. We protect our intellectual property rights through a variety of methods, such as use of nondisclosure and license agreements and use of trade secret, copyright and trademark laws. Despite our efforts to safeguard and protect our intellectual property and proprietary rights, there is no assurance that these steps will be adequate to avoid the loss or misappropriation of our rights or that we will be able to detect unauthorized use of our intellectual property rights. If we are unable to protect our intellectual property, competitors could market services or products similar to ours, and demand for our offerings could decline, resulting in an adverse impact on revenues.
We may be subject to infringement claims by third parties, resulting in increased costs and loss of business. Our business is dependent on intellectual property rights including software license rights and restrictions, and trademark rights. From time to time we receive notices from others claiming we are infringing on their intellectual property rights. Defending a claim of infringement against us could prevent or delay our providing products and services, cause us to pay substantial costs and damages or force us to redesign products or enter into royalty or licensing agreements on less favorable terms. If we are required to enter into such agreements or take such actions, our operating margins could decline.
| Exhibit Number | Description |
| 31.1 | Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended. † |
| 31.2 | Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended. † |
| 32.1 | Certification of 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 Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. † |
| 101.INS | XBRL Instance Document † |
| 101.INS | XBRL Taxonomy Extension Schema Document †* |
| 101.CAL | XBRL Taxonomy Calculation Linkbase Document †* |
| 101.LAB | XBRL Taxonomy Label Linkbase Document †* |
| 101.PRE | XBRL Taxonomy Presentation Linkbase Document †* |
| |
† | Filed herewith |
* | *XBRL (Extensible Business Reporting Language) information is furnished and not filed herewith, is not a part of a registration statement or Prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections. |
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized.
| OFFICIAL PAYMENTS HOLDINGS, INC. |
| Dated: August 9, 2012 | | |
| | |
| By: | /s/ Jeff Hodges |
| | Jeff Hodges |
| | Chief Financial Officer |
| | (Principal Financial and Accounting Officer) |
| Exhibit Number | Description |
| 31.1 | Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended. † |
| 31.2 | Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended. † |
| 32.1 | Certification of 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 Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. † |
| 101.INS | XBRL Instance Document † |
| 101.INS | XBRL Taxonomy Extension Schema Document †* |
| 101.CAL | XBRL Taxonomy Calculation Linkbase Document †* |
| 101.LAB | XBRL Taxonomy Label Linkbase Document †* |
| 101.PRE | XBRL Taxonomy Presentation Linkbase Document †* |
| |
† | Filed herewith |
* | *XBRL (Extensible Business Reporting Language) information is furnished and not filed herewith, is not a part of a registration statement or Prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections. |
