S1 CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. BACKGROUND AND BASIS OF PRESENTATION
S1 Corporation (“S1”) is a global provider of software solutions for financial organizations including banks, credit unions and insurance companies. We operate and manage S1 in two business segments: Enterprise segment and Postilion segment. The Enterprise segment represents North America retail banking solutions business, global wholesale banking solutions business, and our State Farm business. The Postilion segment represents the community financial business, global ATM/payments business, and the retail banking business outside of North America. We sell our solutions to small, mid-sized and large financial organizations in four geographic regions: (i) the Americas region, (ii) Europe and Middle East (EME), (iii) Asia-Pacific (APAC), and (iv) Africa.
Our Enterprise segment software supports the primary channels a bank uses to interact with its customers, including self service channels like the internet for personal, business and corporate online banking and trade finance, as well as full service banking including the teller at the branch, sales and service activities including new account opening and the call center agent’s desktop applications. In the community bank and credit union market, our Postilion segment provides online personal and business banking applications as well as a telephone banking application in a robust single-channel platform that offers an excellent balance between cost and feature set and performance for this highly competitive market. In addition we offer our payments platform which provides software that operates ATM networks and Point of Sale debit card transaction processing networks.
During the third quarter of 2006, we sold our Risk and Compliance segment, which did business as FRS. Our Risk and Compliance business, previously an operating segment, provides a suite of regulatory reporting solutions with financial intelligence and analytic solutions to financial institutions worldwide. We were previously accounting for the planned divestiture as a business “held for sale.”
We license the right to use our software through a direct sales channel and with channel partners including information systems integrators and select core processors. We derive a significant portion of our revenues from licensing our solutions and providing professional services. We generate recurring data center revenues by charging our data center customers a monthly fixed fee or a fee based on the number of their end users who use the solutions we provide and the level of use of the solutions, subject to a minimum charge. Data Center revenues also include fees associated with the resale of bill payment services to our customers. We also generate recurring revenues by charging our customers a periodic fee for maintenance. We also generate recurring revenues by charging our customers a periodic fee for term licenses including the right-to-use software and receive maintenance and support for a specified period of time.
S1 is headquartered in Atlanta, Georgia, USA, with additional domestic offices in Norcross, Georgia; Littleton, Massachusetts; Charlotte, North Carolina; Austin, Texas; Deerfield Beach, Florida; Fairport, New York; Colorado Springs, Colorado; and West Hills, California; and international offices in Brussels, Cape Town, Dublin, Johannesburg, London, Melbourne, Munich, Pune, Chertsey and Singapore. S1 is incorporated in Delaware.
We have prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not contain all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements and should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K as amended for the year ended December 31, 2005. In our opinion, the accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting of only normal recurring adjustments) considered necessary for a fair presentation of our financial condition as of September 30, 2006 and our results of operations for the three and nine months ended September 30, 2005 and 2006 and cash flows for the nine months ended September 30, 2005 and 2006. The data in the condensed consolidated balance sheet as of December 31, 2005 was derived from our audited consolidated balance sheet as of December 31, 2005, as presented in our Annual Report on Form 10-K as amended for the year ended December 31, 2005, but does not include all disclosures required by
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accounting principles generally accepted in the United States of America. The condensed consolidated financial statements include the accounts of S1 and its wholly owned subsidiaries after the elimination of all significant intercompany accounts and transactions. We reclassified certain amounts in the prior years’ consolidated financial statements to conform to the current year presentation. Our operating results for the nine months ended September 30, 2006 are not necessarily indicative of the operating results that may be expected for the full year ending December 31, 2006.
2. RECENT ACCOUNTING PRONOUNCEMENTS AND SIGNIFICANT ACCOUNTING POLICIES
Recent accounting pronouncements
On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). SFAS No. 123R supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123. SFAS No. 123R requires all share-based payments to employees to be recognized in the income statement based on their grant date fair values over the corresponding service period and also requires an estimation of forfeitures when calculating compensation expense. We used the transition election under Financial Staff Position (“FSP”) FAS 123(R)-c to calculate the net excess tax benefits that would have qualified as such had the entity adopted SFAS No. 123 for recognition purposes. Under this methodology we have no excess tax benefits, because of our historical operating losses which have generated NOLs. We adopted SFAS No. 123R on January 1, 2006 using the “modified prospective” method. We expect to record stock based compensation expense of between $4 million and $6 million during the year ending December 31, 2006.
In May 2005, the FASB issued SFAS No. 154. “Accounting Changes and Error Correction – A Replacement of APB Opinion No. 20 and FASB Statement No. 3.” This statement requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. Statement 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a “restatement.” The new standard is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. We adopted SFAS No. 154 on January 1, 2006.
In June 2006, the FASB issued Financial Interpretation 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with Financial Accounting Statement No. 109, “Accounting for Income Taxes.” The interpretation is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of FIN 48 on our financial statements.
Except as disclosed below, our significant accounting policies are included in the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K as amended for the year ended December 31, 2005.
Stock-based compensation
Prior to January 1, 2006, we accounted for our stock option plans in accordance with the provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations and complied with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” As such, no expense was recognized for options to purchase our common stock that were granted with an exercise price equal to fair market value at the date of grant. We only recorded compensation expense on the date of grant if the current market price of the underlying stock exceeded the exercise price. Additionally, if a modification was made to an existing grant, any related compensation expense was calculated on the date both parties accepted the modification and recorded on the date the modification became effective.
On December 16, 2004, the FASB issued SFAS No. 123R, which is a revision of SFAS No. 123. Statement 123R supersedes APB Opinion No. 25, and amends SFAS No. 95. Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123. SFAS No. 123R requires all share-based payments to employees
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during the period to be based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Under SFAS No. 123R, the pro forma disclosures previously permitted under SFAS No. 123 are no longer an alternative to financial statement recognition. Effective January 1, 2006, we have adopted SFAS No. 123R using the “modified prospective” method. Under this method, the compensation expense recognized during the nine months ended September 30, 2006 included compensation expense for share based compensation granted prior to, but not yet vested as of January 1, 2006 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123 and compensation expense for share-based compensation granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. We did not change our method of attributing the value of stock-based compensation to expenses. Under both SFAS No. 123 and SFAS No. 123R the expense is amortized on a straight-line basis over the options’ vesting period. Pro forma results have not been restated. As stock-based compensation expense recognized in the Condensed Consolidated Statement of Operations for the three months and nine months ended September 30, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS No. 123R requires forfeitures to be estimated at the time of grant and adjusted over the requisite service period based on the extent to which actual forfeitures differ, or are expected to differ, from their estimates.
The fair value is estimated at the date of grant using a Black-Scholes option pricing model. In determining the fair value, management makes certain estimates related primarily to the expected term of the option, the volatility of our stock and the risk-free interest rate. These assumptions affect the estimated fair value of the option. As such, these estimates will affect the compensation expense we record in future periods. These assumptions are subjective and generally require significant analysis and judgment. Some of the assumptions will be based on external data, while some assumptions will be derived from our historical experience with share-based payments. We currently estimate expected term using our historical exercise and post-vesting cancellation activity. We currently estimate volatility by considering our historical stock volatility. The risk-free interest rate is the implied yield currently available on U.S. Treasury zero-coupon issues with the remaining term equal to the expected term used as the input to the Black-Scholes model. We estimated the forfeitures using a weighted average historical forfeiture rate. Our estimates of forfeitures will be adjusted over the requisite service period based on the extent to which actual forfeitures differ, or are expected to differ, from their estimates.
The fair values were determined using the Black-Scholes option-pricing model with the following weighted-average assumptions:
| | | | | | | | | |
| | | Nine Months Ended September, |
| | | 2005 | | 2006 |
| Expected dividend yield | | | 0 | % | | | 0 | % |
| Expected volatility | | | 83.8 | % | | | 59.8 | % |
| Risk-free interest rate | | | 3.9 | % | | | 4.8 | % |
| Expected life | | 4.0years | | 4.0years |
The following table shows the decrease in our income from continuing operations, discontinued operations and net income as a result of adopting SFAS No. 123R on January 1, 2006 compared to the results had we continued to account for stock-based employee compensation under APB No. 25 (in thousands, except for per share data):
| | | | | | | | | |
| | | Three Months Ended | | | Nine Months Ended | |
| | | September 30, | | | September 30, | |
| | | 2006 | | | 2006 | |
| Decrease in income from continuing operations | | $ | (1,076 | ) | | $ | (3,723 | ) |
| Decrease in income from discontinued operations | | | (20 | ) | | | (176 | ) |
| | | | | | | |
| Decrease in Net income | | $ | (1,096 | ) | | $ | (3,899 | ) |
| | | | | | | |
Basic and diluted net income per share for both the three and nine months ended September 30, 2006 would have been $0.48 had we not adopted SFAS No. 123R, compared to reported basic and diluted net income per share of $0.46 and $0.43. See Note 5 for additional information.
The following table shows the effect on net loss and net loss per share had we determined compensation cost based on the fair value at the grant date for our stock options and stock purchase rights under SFAS No. 123 for the three and nine months ended September 30, 2005, our net income would have decreased to the pro forma net loss amounts indicated below
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(in thousands, except per share data):
| | | | | | | | | |
| | | Three Months Ended | | | Nine Months Ended | |
| | | September 30, | | | September 30, | |
| | | 2005 | | | 2005 | |
| Net loss, as reported | | $ | (7,496 | ) | | $ | (4,460 | ) |
| Add: Stock-based employee compensation expense included in reported net loss, net of related tax effects | | | 570 | | | | 570 | |
| Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects | | | (4,823 | ) | | | (10,990 | ) |
| | | | | | | |
| Pro forma net loss | | $ | (11,749 | ) | | $ | (14,880 | ) |
| | | | | | | |
| | | | | | | | | |
| Basic and diluted net loss per share: | | | | | | | | |
| As reported — basic | | $ | (0.11 | ) | | $ | (0.06 | ) |
| As reported — diluted | | | (0.11 | ) | | | (0.06 | ) |
| Pro forma – basic and diluted | | | (0.17 | ) | | | (0.21 | ) |
The effect of applying SFAS No. 123 for providing these pro forma disclosures is not necessarily representative of the effects on reported net income (loss) in future periods.
The above pro forma disclosure was not presented for the three and nine month periods ended September 30, 2006 because stock-based compensation has been accounted for using the fair value recognition method under SFAS No. 123R for this period.
The following table shows the stock-based compensation expense included in the condensed consolidated statements of operations for the three and nine months ended September 30, 2006 (in thousands):
| | | | | | | | | |
| | | Three Months Ended | | | Nine Months Ended | |
| | | September 30, | | | September 30, | |
| | | 2006 | | | 2006 | |
| Costs and expenses: | | | | | | | | |
| Cost of professional services, support and maintenance | | $ | 119 | | | $ | 406 | |
| Cost of data center | | | 12 | | | | 60 | |
| Selling and marketing | | | 394 | | | | 1,150 | |
| Product development | | | 119 | | | | 690 | |
| General and administrative | | | 432 | | | | 1,417 | |
| Discontinued operations | | | 20 | | | | 176 | |
| | | | | | | |
| Total stock-based compensation expense | | $ | 1,096 | | | $ | 3,899 | |
| | | | | | | |
There was no capitalized stock-based compensation cost as of September 30, 2006. There were no recognized tax benefits during the nine months ended September 30, 2006.
On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123R-3 “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” We have elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS No. 123R. The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee stock-based compensation, and to determine the subsequent APIC pool and Consolidated Statement of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS No. 123R.
We use the “with-and-without” or “incremental” approach for ordering tax benefits derived from the share-based payment awards. Using the with-and-without approach actual income taxes payable for the period are compared to the amount
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of tax payable that would have been incurred absent the deduction for employee share-based payments in excess of the amount of compensation cost recognized for financial reporting. As a result of this approach tax net operating loss carryforwards not generated from share-based payments in excess of cost recognized for financial reporting are considered utilized before the current period’s share-based deduction. As a result of this accounting treatment as of September 30, 2006, of our approximate $238.1 million of domestic tax net operating loss carryforwards associated with the group of companies included in the S1 Corporation consolidated federal income tax return, the benefit of approximately $209.5 million of these tax net operating loss carryforwards will be accounted for directly to equity as additional paid-in-capital. Additionally, we have approximately $4.3 million and $110.3 million of domestic and foreign tax net operating loss carryforwards respectively unaffected by this accounting treatment.
3. DISCONTINUED OPERATIONS
On August 11, 2006, we completed the sale of our Risk and Compliance segment, which did business as FRS. Under the terms of the agreement, we received approximately $38.0 million in consideration, $34.5 million in cash with $3.5 million held in escrow. We recorded a gain of $32.3 million, net of tax in the third quarter of 2006. We recorded expenses of approximately $1.3 million in connection with the sale including legal fees and the cost of splitting shared offices. Our condensed consolidated balance sheet for September 30, 2006 included approximately $0.7 million of net current liabilities and $3.5 million of cash held in escrow in current assets relating to the sale of our Risk and Compliance business. Under the terms of this agreement, there is a provision for a working capital adjustment. During the third quarter we paid out $1.0 million as a preliminary working capital adjustment, which has been reflected in the gain on discontinued operations. The final working capital adjustment has not been resolved. We intend to record any additional consideration paid or received in connection with this transaction in the period in which the provision is resolved. In addition, FRS contracted with S1’s Pune, India location to continue to provide development and administrative services.
On December 30, 2005, we completed the sale of our Edify segment. Under the terms of the agreement, we received approximately $33.5 million in cash. We recorded a gain of $24.4 million, net of tax in 2005. We recorded expenses of approximately $4.4 million in connection with the sale including legal fees and employee severance payments. In 2006, we resolved the working capital adjustment provision of the agreement. We received $554,000 in the second quarter of 2006 bringing the total sale price to $34.1 million. In the third quarter of 2006, we incurred an additional $97,000 in expense related to the disposal of Edify. In addition, under the agreement, S1 has contracted to continue to be a reseller of Edify products following the closing of the transaction.
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Revenues and income (loss) from discontinued operations are as follows (in thousands):
| | | | | | | | | | | | | | | | | |
| | | Three Months Ended September 30, | | | Nine months Ended September 30, | |
| | | 2006 | | | 2005 | | | 2006 | | | 2005 | |
| Revenues: | | | | | | | | | | | | | | | | |
| Risk and Compliance | | $ | 2,176 | | | $ | 5,700 | | | $ | 12,434 | | | $ | 18,647 | |
| Edify | | | — | | | | 10,088 | | | | — | | | | 25,622 | |
| | | | | | | | | | | | | |
| Total | | $ | 2,176 | | | $ | 15,788 | | | $ | 12,434 | | | $ | 44,269 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Pretax (loss) income from discontinued operations: | | | | | | | | | | | | | | | | |
| Risk and Compliance | | $ | (712 | ) | | $ | (149 | ) | | $ | (1,969 | ) | | $ | 2,510 | |
| Davidge | | | — | | | | — | | | | — | | | | (31 | ) |
| Edify | | | — | | | | 1,305 | | | | — | | | | 1,936 | |
| (Loss) gain on disposal of Edify | | | (97 | ) | | | — | | | | 457 | | | | | |
| Gain on disposal of Risk and Compliance | | | 32,263 | | | | — | | | | 32,263 | | | | — | |
| Income tax (expense) benefit | | | (2 | ) | | | (47 | ) | | | 34 | | | | (298 | ) |
| | | | | | | | | | | | | |
| Income from discontinued operations | | $ | 31,452 | | | $ | 1,109 | | | $ | 30,785 | | | $ | 4,117 | |
| | | | | | | | | | | | | |
Assets and liabilities of the discontinued operations as of August 10, 2006 were as follows (in thousands):
| | | | | |
| Current assets | | $ | 8,373 | |
| Property and equipment, net | | | 1,075 | |
| Other non-current assets | | | 142 | |
| Intangible assets | | | 480 | |
| Goodwill | | | 1,558 | |
| Current liabilities | | | (7,557 | ) |
| Long term tax liabilities | | | (560 | ) |
| | | | |
| Net assets of discontinued operations | | $ | 3,511 | |
| | | | |
4. GOODWILL AND OTHER INTANGIBLE ASSETS
At September 30, 2006, our other intangible assets consisted of the following:
| | | | | | | | | |
| | | Gross | | | Accumulated | |
| | | Carrying Value | | | Amortization | |
| | | (In thousands) | |
| Purchased and acquired technology | | $ | 19,489 | | | $ | (12,647 | ) |
| Customer relationships | | | 12,000 | | | | (4,706 | ) |
| | | | | | | |
| Total | | $ | 31,489 | | | $ | (17,353 | ) |
| | | | | | | |
We recorded amortization expense of $3.7 million during the nine months ended September 30, 2006 and 2005. We estimate aggregate amortization expense for 2006 and the next four calendar years for each of our reporting segments to be as follows (in thousands):
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| | | | | | | | | | | | | | | | | | | | | |
| | | 2006 | | | 2007 | | | 2008 | | | 2009 | | | 2010 | |
| Enterprise | | $ | 2,199 | | | $ | 1,780 | | | $ | 1,057 | | | $ | 303 | | | $ | 210 | |
| Postilion | | | 2,733 | | | | 2,210 | | | | 2,108 | | | | 1,897 | | | | 880 | |
| | | | | | | | | | | | | | | | |
| Total | | $ | 4,932 | | | $ | 3,990 | | | $ | 3,165 | | | $ | 2,200 | | | $ | 1,090 | |
| | | | | | | | | | | | | | | | |
The changes in the carrying value of our goodwill by segment for the nine months ended September 30, 2006 are as follows:
| | | | | | | | | | | | | | | | | |
| | | Enterprise | | | Postilion | | | Risk and Compliance | | | Total | |
| | | (In thousands) | |
| Balance, January 1, 2006 | | $ | 66,064 | | | $ | 58,186 | | | $ | 1,558 | | | $ | 125,808 | |
| Additional consideration | | | — | | | | 1,100 | | | | — | | | | 1,100 | |
| Utilization of acquisition related income tax benefits | | | (50 | ) | | | — | | | | — | | | | (50 | ) |
| Sale of Risk and Compliance | | | — | | | | — | | | | (1,558 | ) | | | (1,558 | ) |
| | | | | | | | | | | | | |
| Balance, September 30, 2006 | | $ | 66,014 | | | $ | 59,286 | | | $ | — | | | $ | 125,300 | |
| | | | | | | | | | | | | |
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5. STOCK OPTION PLANS
We maintain certain stock option plans providing for the grant of stock options to officers, directors and employees. The plans provide for 12,807,503 shares of S1 common stock to be reserved for issuance under the plans. Substantially all stock options granted under the plans have ten-year contractual life terms and generally vest and become exercisable ratably over four years from the date of grant. At September 30, 2006, 1,552,062 shares were available for future grants under the plans.
A summary of our stock options as of September 30, 2006, and changes during the nine months ended September 30, 2006 is presented below:
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | Weighted- | | | | |
| | | | | | | Weighted- | | | average | | | Aggregate | |
| | | | | | | average | | | Remaining | | | Intrinsic | |
| | | Shares | | | Exercise | | | Contractual | | | Value | |
| | | (000) | | | Price | | | Life | | | ($000) | |
| Outstanding at December 31, 2005 | | | 14,932 | | | $ | 9.40 | | | | | | | | | |
| Granted | | | 525 | | | | 4.59 | | | | | | | | | |
| Exercised | | | (701 | ) | | | 3.63 | | | | | | | $ | 724 | |
| Forfeited/canceled | | | (3,501 | ) | | | 8.88 | | | | | | | | | |
| | | | | | | | | | | | | | | |
| Outstanding at September 30, 2006 | | | 11,255 | | | $ | 9.70 | | | | 5.40 | | | $ | 2,291 | |
| | | | | | | | | | | | | | | |
| Exercisable at September 30, 2006 | | | 7,805 | | | $ | 11.84 | | | | 3.87 | | | $ | 986 | |
| | | | | | | | | | | | | | | |
The aggregate intrinsic value for the stock options outstanding and exercisable in the preceding table represents the total pretax value, based on our closing stock price of $4.61 as of September 30, 2006.
Non-vested share activity of our stock options for the nine months ended September 30, 2006 is presented below:
| | | | | | | | | |
| | | Non-Vested | | | Weighted- | |
| | | Number of | | | average | |
| | | Shares | | | Grant-Date | |
| | | (000) | | | Fair Value | |
| Non-vested balance at December 31, 2005 | | | 4,339 | | | $ | 3.73 | |
| Granted | | | 525 | | | $ | 2.32 | |
| Canceled | | | (524 | ) | | $ | 3.80 | |
| Vested | | | (890 | ) | | $ | 5.75 | |
| | | | | | | |
| Non-vested balance at September 30, 2006 | | | 3,450 | | | $ | 2.98 | |
| | | | | | | |
As of September 30, 2006, $8.3 million of total unrecognized compensation expense related to non-vested awards is expected to be recognized over a weighted average period of 1.34 years. The total fair value of shares vested during the nine months ended September 30, 2006 was $5.1 million.
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The following table summarizes information about stock options outstanding at September 30, 2006:
| | | | | | | | | | | | | | | | | | | | | |
| | | | | | | Options Outstanding | | | | | | | | |
| | | | | | | Weighted- | | | | | | | Options Exercisable | |
| | | | | | | average | | | Weighted- | | | | | | | Weighted- | |
| | | Number | | | Remaining | | | average | | | Number | | | average | |
| | | Outstanding | | | Contractual | | | Exercise | | | Exercisable | | | Exercise | |
| Range of Exercise Price | | (000) | | | Life | | | Price | | | (000) | | | Price | |
| $ 0.95 – 4.00 | | | 1,049 | | | | 5.1 | | | $ | 3.56 | | | | 845 | | | $ | 3.54 | |
| 4.01 – 5.00 | | | 2,930 | | | | 8.2 | | | | 4.21 | | | | 472 | | | | 4.50 | |
| 5.01 – 7.00 | | | 1,085 | | | | 4.4 | | | | 5.96 | | | | 839 | | | | 6.17 | |
| 7.01 – 8.50 | | | 2,269 | | | | 4.7 | | | | 8.00 | | | | 1,864 | | | | 8.02 | |
| 8.51 – 11.00 | | | 641 | | | | 5.1 | | | | 9.34 | | | | 504 | | | | 9.40 | |
| 11.01 – 15.00 | | | 643 | | | | 4.6 | | | | 13.19 | | | | 643 | | | | 13.19 | |
| 15.01 – 20.00 | | | 2,295 | | | | 3.9 | | | | 16.79 | | | | 2,295 | | | | 16.79 | |
| 20.01 – 97.44 | | | 343 | | | | 2.2 | | | | 44.98 | | | | 343 | | | | 44.98 | |
| | | | | | | | | | | | | | | | |
| 0.95 – 97.44 | | | 11,255 | | | | 5.4 | | | $ | 9.70 | | | | 7,805 | | | $ | 11.84 | |
| | | | | | | | | | | | | | | | |
For stock options granted where the exercise price equaled the market price of the stock on the date of grant, the per share weighted-average exercise price was $5.13 and $4.59 and the per share weighted-average fair value was $3.19 and $2.32 for stock options granted during the nine months ended September 30, 2005 and 2006, respectively.
6. COMPREHENSIVE (LOSS) INCOME
The components of comprehensive (loss) income are as follows (in thousands):
| | | | | | | | | | | | | | | | | |
| | | Three Months Ended | | | Nine months Ended | |
| | | September 30, | | | September 30, | |
| | | 2006 | | | 2005 | | | 2006 | | | 2005 | |
| Net (loss) income | | $ | 33,345 | | | $ | (7,496 | ) | | $ | 30,790 | | | $ | (4,460 | ) |
| Foreign currency translation adjustment | | | (327 | ) | | | 426 | | | | (659 | ) | | | (617 | ) |
| Unrealized (loss) income on cash flow hedges | | | (40 | ) | | | 10 | | | | (263 | ) | | | 67 | |
| | | | | | | | | | | | | |
| Comprehensive (loss) income | | $ | 32,978 | | | $ | (7,060 | ) | | $ | 29,868 | | | $ | (5,010 | ) |
| | | | | | | | | | | | | |
7. DERIVATIVE FINANCIAL INSTRUMENTS
We use derivative financial instruments to manage the exposure to fluctuations in foreign currency under one long term hosting contract with a UK based customer to mitigate the risk that changes in exchange rates will adversely affect the eventual dollar cash flows resulting from the hedged transactions with a series of foreign currency options. Designation is performed on a specific exposure basis to support hedge accounting. The changes in fair value of these hedging instruments will be offset in part or in whole by corresponding changes in the cash flows of the underlying exposures being hedged. We do not hold or issue derivative financial instruments for trading purposes.
We entered into a long-term hosting agreement with a customer wherein S1 will provide the customer with hosting services for a period of approximately four years. Our costs associated with those services are denominated in United States Dollars (USD) and the customer will pay us in British Pounds Sterling (GBP). In this arrangement, ordinary fluctuations in currency exchange rates could adversely impact our profit margin on the hosting agreement. Consequently, during the quarter ended March 31, 2005, we purchased a series of options to exchange USD for GBP at dates throughout the term of the agreement for amounts proportional to the minimum fees to be earned under the contract.
The foreign currency options are designated as cash flow hedges and the options with expiration dates of December 31, 2006 to March 31, 2009 are deemed effective in the period ended September 30, 2006. Any mark-to-market gains or losses on these currency options are included in accumulated other comprehensive income (loss) and reclassified into sales in the period during which a specific hedged transaction affects earnings.
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The foreign currency option with the September 30, 2006 expiration date was designated as ineffective in the period ended September 30, 2006. The change in the value of the September 30, 2006 option was recognized in current earnings. The September 30, 2006 option was out of the money and expired. The premium paid for the September 30, 2006 option resulted in a loss of approximately $15,000.
For the three and nine months ended September 30, 2006, we recorded a decrease in Accumulated Other Comprehensive Income (AOCI) of approximately $25,000 and $238,000, respectively, related to losses on the effective portion of our foreign currency cash flow hedge. The following table summarizes activity in AOCI related to derivatives designated as cash flow hedges held by S1 during the applicable periods (in thousands):
| | | | | |
| | | Three Months | |
| | | Ended | |
| | | September 30, 2006 | |
| Accumulated derivative net gain as of July 1, 2006 | | $ | (109 | ) |
| Net change in fair value of derivatives | | | (40 | ) |
| Net losses reclassified from AOCI into earnings | | | 15 | |
| | | | |
| Accumulated derivative net loss as of September 30, 2006 | | $ | (134 | ) |
| | | | |
| | | | | |
| | | Nine months | |
| | | Ended | |
| | | September 30, 2006 | |
| Accumulated derivative net gain as of January 1, 2006 | | $ | 104 | |
| Net change in fair value of derivatives | | | (263 | ) |
| Net losses reclassified from AOCI into earnings | | | 25 | |
| | | | |
| Accumulated derivative net loss as of September 30, 2006 | | $ | (134 | ) |
| | | | |
Financial instruments held as part of the hedging transaction discussed above are recorded at fair value based upon comparable market transactions as quoted by the broker. The fair value and carrying amount of the options totaled $78,000 as of September 30, 2006. Deferred currency option premiums are included in other assets.
8. RESTRUCTURING CHARGES
For restructuring plans undertaken prior to December 31, 2004, the restructuring reserves as of December 31, 2005 and September 30, 2006 and their utilization for the nine months ended September 30, 2006 are summarized as follows (in thousands):
| | | | | |
| | | Lease Costs | |
| Balance at December 31, 2005 | | $ | 5,800 | |
| Amounts utilized through September 30, 2006 | | | (960 | ) |
| Change in estimate | | | (75 | ) |
| | | | |
| Balance at September 30, 2006 | | $ | 4,765 | |
| | | | |
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In 2005, we approved a restructuring plan. The restructuring charges from this plan and the restructuring reserves as of December 31, 2005 and September 30, 2006 and their utilization for the nine months ended September 30, 2006 are summarized as follows (in thousands):
| | | | | | | | | | | | | |
| | | Personnel Costs | | | Lease Costs | | | Total | |
| Balance at December 31, 2005 | | $ | 4,635 | | | $ | 5,050 | | | $ | 9,685 | |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| 2006 restructuring charge | | $ | 333 | | | $ | — | | | $ | 333 | |
| Amounts utilized | | | (4,003 | ) | | | (2,089 | ) | | | (6,092 | ) |
| Change in estimate | | | — | | | | 1,024 | | | | 1,024 | |
| | | | | | | | | | |
| Balance at September 30, 2006 | | $ | 965 | | | $ | 3,985 | | | $ | 4,950 | |
| | | | | | | | | | |
In the first quarter of 2006, we recorded restructuring charges of $0.3 million for employee termination benefits for employees who were placed on transition plans. In the second and third quarter of 2006, we adjusted our estimates based on sublease assumptions for certain vacant office space. As a result of this change in estimate of the leases related to previously vacated facilities, we recorded restructuring charges of $0.5 and $0.4 million in the second and third quarter of 2006, respectively.
The remaining restructuring reserves at September 30, 2006 relate to future rent expense for vacated facilities, net of sublease income, severance payments to terminated employees and other costs. We expect to make future cash expenditures, net of anticipated sublease income, related to these restructuring activities of approximately $9.7 million, of which we anticipate to pay approximately $4.4 million within the next twelve months. The leases expire on various terms through 2011.
9. CONTINGENCIES
Litigation
There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which S1, or any of its subsidiaries is a party or which their property is subject.
As previously reported, we were involved in litigation with Tradecard, Inc. relating to a claim of infringement of U.S. Patent 6,151,588 filed in the U.S. District Court for the Southern District of New York. The action was filed in March 2003 against S1 Corporation, Bank of America Corporation and Bank of America National Association. In March 2006, a jury decided in our favor that we were not infringing and that Tradecard’s patent is invalid. Tradecard has submitted a motion to the Federal District Court for reconsideration of the verdict. If that motion is denied, Tradecard may appeal the jury verdict to the Federal Court of Appeals.
Sale-Leaseback Transaction
In May 2006, we received $2.5 million for computer equipment and software (the “assets”) in a sale-leaseback transaction. In accordance with SFAS No.13, we accounted for this lease as a capital lease. The assets were purchased during first quarter of 2006 and we had recorded $0.2 million of depreciation expense related to the assets. The $0.2 million gain resulting from the transaction was deferred and is being amortized to depreciation expense over the life of the lease.
Guarantees
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We typically grant our customers a warranty that guarantees that our product will substantially conform to our current specifications for 90 days from the delivery date. We also indemnify our customers from third party claims of intellectual property infringement relating to the use of our products. Our standard software license agreements contain indemnification clauses that are limited in amount. Pursuant to these clauses, we indemnify and agree to pay any judgment or settlement relating to a claim. We account for these clauses under FASB Staff Position FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others — an Interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34.” Accordingly, there are no liabilities recorded for these agreements as of September 30, 2006.
10. EQUITY TRANSACTIONS
On September 29, 2006, we retired 4,053,886 shares of our common stock held in treasury at $25.0 million. The retirement of the treasury shares reduced our common stock and additional paid in capital for a total of $25.0 million.
11. SEGMENT REPORTING AND MAJOR CUSTOMERS
In the first quarter of 2006, we disaggregated our previously aggregated Financial Institution Segment into two segments, the Enterprise and Postilion segments. Management believes that disaggregating the Financial Institutions segment into the Enterprise and Postilion segments will provide stockholders with more information to help them to better understand our performance, better assess prospective future net cash flows and make more informed judgments about the company as a whole. In the second quarter of 2006, we reported our Risk and Compliance segment as “held for sale,” reporting the operating results in discontinued operations.
We operate and manage S1 in two business segments: Enterprise and Postilion. The Enterprise segment represents our North America retail banking business, global wholesale banking business, and State Farm business. The Postilion segment represents the community financial business, global ATM/payments business, and the retail banking business outside of North America.
We evaluate the performance of our operating segments based on their contribution before interest, other income and income taxes, as reflected in the tables presented below for the three and nine months ended September 30, 2006 and 2005. We do not use any asset-based metrics to measure the operating performance of our segments.
The following table shows revenues from continuing operations by revenue type for our reportable segments (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Software | | | Support and | | | Professional | | | Data | | | | | | | |
| | | Licenses | | | Maintenance | | | Services | | | Center | | | Other | | | Total | |
Three Months Ended September 30, 2006: | | | | | | | | | | | | | | | | | | | | | | | | |
| Enterprise | | $ | 5,369 | | | $ | 5,514 | | | $ | 14,366 | | | $ | 4,793 | | | $ | 140 | | | $ | 30,182 | |
| Postilion | | | 5,139 | | | | 5,606 | | | | 3,989 | | | | 6,823 | | | | 157 | | | | 21,714 | |
| | | | | | | | | | | | | | | | | | | |
| Total | | $ | 10,508 | | | $ | 11,120 | | | $ | 18,355 | | | $ | 11,616 | | | $ | 297 | | | $ | 51,896 | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Software | | | Support and | | | Professional | | | Data | | | | | | | |
| | | Licenses | | | Maintenance | | | Services | | | Center | | | Other | | | Total | |
Three Months Ended September 30, 2005: | | | | | | | | | | | | | | | | | | | | | | | | |
| Enterprise | | $ | 1,784 | | | $ | 5,815 | | | $ | 13,491 | | | $ | 4,132 | | | $ | 365 | | | $ | 25,587 | |
| Postilion | | | 2,656 | | | | 5,138 | | | | 2,756 | | | | 6,049 | | | | 262 | | | | 16,861 | |
| | | | | | | | | | | | | | | | | | | |
| Total | | $ | 4,440 | | | $ | 10,953 | | | $ | 16,247 | | | $ | 10,181 | | | $ | 627 | | | $ | 42,448 | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Software | | | Support and | | | Professional | | | Data | | | | | | | |
| | | Licenses | | | Maintenance | | | Services | | | Center | | | Other | | | Total | |
Nine months Ended September 30, 2006: | | | | | | | | | | | | | | | | | | | | | | | | |
| Enterprise | | $ | 10,830 | | | $ | 17,389 | | | $ | 40,696 | | | $ | 15,083 | | | $ | 405 | | | $ | 84,403 | |
| Postilion | | | 12,090 | | | | 15,585 | | | | 9,230 | | | | 20,030 | | | | 737 | | | | 57,672 | |
| | | | | | | | | | | | | | | | | | | |
| Total | | | 22,920 | | | | 32,974 | | | | 49,926 | | | | 35,113 | | | | 1,142 | | | | 142,075 | |
| | | | | | | | | | | | | | | | | | | |
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| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Software | | | Support and | | | Professional | | | Data | | | | | | | |
| | | Licenses | | | Maintenance | | | Services | | | Center | | | Other | | | Total | |
Nine months Ended September 30, 2005: | | | | | | | | | | | | | | | | | | | | | | | | |
| Enterprise | | $ | 8,956 | | | $ | 18,149 | | | $ | 44,721 | | | $ | 12,276 | | | $ | 702 | | | $ | 84,804 | |
| Postilion | | | 13,113 | | | | 15,787 | | | | 7,747 | | | | 17,452 | | | | 562 | | | | 54,661 | |
| | | | | | | | | | | | | | | | | | | |
| Total | | $ | 22,069 | | | $ | 33,936 | | | $ | 52,468 | | | $ | 29,728 | | | $ | 1,264 | | | $ | 139,465 | |
| | | | | | | | | | | | | | | | | | | |
The following table shows operating results for our reportable segments (in thousands):
| | | | | | | | | | | | | |
| | | Three Months Ended September 30, 2006 | |
| | | Enterprise | | | Postilion | | | Total | |
| Revenues | | $ | 30,182 | | | $ | 21,714 | | | $ | 51,896 | |
| Operating expenses: | | | | | | | | | | | | |
| Direct costs | | | 14,982 | | | | 9,488 | | | | 24,470 | |
| Selling and marketing | | | 3,158 | | | | 3,997 | | | | 7,155 | |
| Product development | | | 7,630 | | | | 1,886 | | | | 9,516 | |
| General and administrative | | | 3,743 | | | | 3,342 | | | | 7,085 | |
| Restructuring costs | | | 239 | | | | 161 | | | | 400 | |
| Depreciation | | | 1,368 | | | | 706 | | | | 2,074 | |
| Amortization of other intangible assets | | | 103 | | | | 224 | | | | 327 | |
| | | | | | | | | | |
| Total operating expenses | | | 31,223 | | | | 19,804 | | | | 51,027 | |
| | | | | | | | | | |
| Segment operating loss | | $ | (1,041 | ) | | $ | 1,910 | | | $ | 869 | |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| | | Three Months Ended September 30, 2005 | |
| | | Enterprise | | | Postilion | | | Total | |
| Revenues | | $ | 25,587 | | | $ | 16,861 | | | $ | 42,448 | |
| Operating expenses: | | | | | | | | | | | | |
| Direct costs | | | 13,868 | | | | 8,101 | | | | 21,969 | |
| Selling and marketing | | | 4,024 | | | | 3,347 | | | | 7,371 | |
| Product development | | | 8,344 | | | | 1,683 | | | | 10,027 | |
| General and administrative | | | 2,521 | | | | 3,107 | | | | 5,628 | |
| Restructuring costs | | | 2,384 | | | | 1,871 | | | | 4,255 | |
| Depreciation | | | 1,372 | | | | 732 | | | | 2,104 | |
| Amortization of other intangible assets | | | 108 | | | | 225 | | | | 333 | |
| | | | | | | | | | |
| Total operating expenses | | | 32,621 | | | | 19,066 | | | | 51,687 | |
| | | | | | | | | | |
| Segment operating (loss) income | | $ | (7,034 | ) | | $ | (2,205 | ) | | $ | (9,239 | ) |
| | | | | | | | | | |
| | | | | | | | | | | | | |
| | | Nine months Ended September 30, 2006 | |
| | | Enterprise | | | Postilion | | | Total | |
| Revenues | | $ | 84,403 | | | $ | 57,672 | | | $ | 142,075 | |
| Operating expenses: | | | | | | | | | | | | |
| Direct costs | | | 42,125 | | | | 26,512 | | | | 68,637 | |
| Selling and marketing | | | 8,807 | | | | 10,906 | | | | 19,713 | |
| Product development | | | 23,379 | | | | 5,620 | | | | 28,999 | |
| General and administrative | | | 10,030 | | | | 9,250 | | | | 19,280 | |
| Restructuring costs | | | 876 | | | | 406 | | | | 1,282 | |
| Depreciation | | | 3,733 | | | | 2,064 | | | | 5,797 | |
| Amortization of other intangible assets | | | 309 | | | | 672 | | | | 981 | |
| | | | | | | | | | |
| Total operating expenses | | | 89,259 | | | | 55,430 | | | | 144,689 | |
| | | | | | | | | | |
| Segment operating (loss) income | | $ | (4,856 | ) | | $ | 2,242 | | | $ | (2,614 | ) |
| | | | | | | | | | |
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| | | | | | | | | | | | | |
| | | Nine months Ended September 30, 2005 | |
| | | Enterprise | | | Postilion | | | Total | |
| Revenues | | $ | 84,804 | | | $ | 54,661 | | | $ | 139,465 | |
| Operating expenses: | | | | | | | | | | | | |
| Direct costs | | | 41,420 | | | | 23,767 | | | | 65,187 | |
| Selling and marketing | | | 12,201 | | | | 10,234 | | | | 22,435 | |
| Product development | | | 26,186 | | | | 5,233 | | | | 31,419 | |
| General and administrative | | | 8,404 | | | | 9,875 | | | | 18,279 | |
| Restructuring costs | | | 2,384 | | | | 1,871 | | | | 4,255 | |
| Depreciation | | | 4,408 | | | | 2,389 | | | | 6,797 | |
| Amortization of other intangible assets | | | 316 | | | | 674 | | | | 990 | |
| | | | | | | | | | |
| Total operating expenses | | | 95,319 | | | | 54,043 | | | | 149,362 | |
| | | | | | | | | | |
| Segment operating (loss) income | | $ | (10,515 | ) | | $ | 618 | | | $ | (9,897 | ) |
| | | | | | | | | | |
Currently, we have one major customer in the Enterprise segment (defined as any customer who individually contributes more than 10% of total revenues). We derived 26% and 24% of our total revenues from State Farm Mutual Automobile Insurance Company during the three months ended September 30, 2005 and 2006. We derived 25% of our total revenues from State Farm Mutual Automobile Insurance Company during the nine months ended September 30, 2005 and 2006, respectively. We derived 43% and 40% of our Enterprise segment revenues from State Farm Mutual Automobile Insurance Company during the three months ended September 30, 2005 and 2006, respectively. We derived 42% of our Enterprise segment revenues from State Farm Mutual Automobile Insurance Company during both the nine months ended September 30, 2005 and 2006.
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11. NET (LOSS) INCOME PER COMMON SHARE
We calculate earnings per share using the two-class method during periods which we recorded income from continuing operations. For periods which we record a loss from continuing operations, we calculate net loss per share as the net loss during the period divided by the weighted average number of common shares outstanding during the period as the effect of applying the two-class method would be anti-dilutive.
Net income has been allocated to the common and preferred stock based on their respective rights to share in dividends. Net losses have not been allocated to preferred stock, as there is no contractual obligation for the holders of the participating preferred stock to share in our losses. We excluded the preferred convertible stock from diluted earnings per share under the if-converted method because the effect is anti-dilutive.
Diluted earnings per share is calculated to reflect the potential dilution that would occur if stock options or other contracts to issue common stock were exercised and resulted in additional common stock that would share in the earnings of the Company. Because of our loss from continuing operations in the three and nine months ended September 30, 2005, the issuance of additional shares of common stock through the exercise of stock options and the conversion of preferred stock were excluded as they would have an anti-dilutive effect on our loss per share for that period.
| | | | | | | | | | | | | | | | | |
| | | Three Months Ended | | | Nine months Ended | |
| | | September 30, | | | September 30, | |
| | | 2006 | | | 2005 | | | 2006 | | | 2005 | |
| | | (in thousands, except per share data) | |
Basic earnings per share: | | | | | | | | | | | | | | | | |
| (Loss) income from continuing operations | | $ | 1,893 | | | $ | (8,605 | ) | | $ | 5 | | | $ | (8,577 | ) |
| Amount allocated to participating preferred stockholders | | | (28 | ) | | | — | | | | — | | | | — | |
| | | | | | | | | | | | | |
| (Loss) income from continuing operations available to common stockholders — basic | | $ | 1,865 | | | $ | (8,605 | ) | | $ | 5 | | | $ | (8,577 | ) |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Weighted average common shares outstanding | | | 71,008 | | | | 70,303 | | | | 70,799 | | | | 70,362 | |
| Basic (loss) income from continuing operations per share | | $ | 0.03 | | | $ | (0.12 | ) | | $ | 0.00 | | | $ | (0.12 | ) |
| | | | | | | | | | | | | | | | | |
Diluted earnings per share: | | | | | | | | | | | | | | | | |
| (Loss) income from continuing operations | | $ | 1,893 | | | $ | (8,605 | ) | | $ | 5 | | | $ | (8,577 | ) |
| Amount allocated to participating preferred stockholders | | | (28 | ) | | | — | | | | — | | | | — | |
| | | | | | | | | | | | | |
| (Loss) income from continuing operations available to common stockholders — diluted | | $ | 1,865 | | | $ | (8,605 | ) | | $ | 5 | | | $ | (8,577 | ) |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Weighted average common shares outstanding | | | 71,008 | | | | 70,303 | | | | 70,799 | | | | 70,362 | |
| Weighted average effect of common stock equivalent | | | | | | | | | | | | | | | | |
| Stock options | | | 154 | | | | 435 | | | | 189 | | | | 992 | |
| Convertible preferred stock | | | — | | | | 1,070 | | | | — | | | | 1,070 | |
| | | | | | | | | | | | | |
| Weighted average diluted shares outstanding | | | 71,162 | | | | 71,808 | | | | 70,988 | | | | 72,424 | |
| Diluted (loss) income from continuing operations per share | | $ | 0.03 | | | $ | (0.12 | ) | | $ | 0.00 | | | $ | (0.12 | ) |
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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
This quarterly report contains forward-looking statements and information relating to our subsidiaries and us. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends” or similar terminology identify forward-looking statements. These statements are based on the beliefs of management as well as assumptions made using information currently available to management. Because these statements reflect the current views of management concerning future events, they involve risks, uncertainties and assumptions. Therefore, actual results may differ significantly from the results discussed in the forward-looking statements. You are urged to read the risk factors described in our Annual Report on Form 10-K, as amended for the year ended December 31, 2005, as filed with the Securities and Exchange Commission, as well as the risk factors discussed under Item 1A of Part II of this form 10-Q. Except as required by law, we undertake no obligation to update publicly any forward-looking statement for any reason, even if new information becomes available.
The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and notes appearing elsewhere herein and our Annual Report on Form 10-K as amended for the year ended December 31, 2005.
Overview
We operate and manage S1 in two business segments: Enterprise and Postilion. The Enterprise segment represents North America retail banking solutions and global wholesale banking solutions, including our business with State Farm. The Postilion segment represents the community financial business, global ATM/payments business, and the retail banking business outside of North America.
Our Enterprise segment software supports the primary channels a bank uses to interact with its customers, including self service channels like the internet for personal, business and corporate online banking and trade finance, as well as full service banking including the teller at the branch, sales and service activities including new account opening and the call center agent’s desktop applications. In the community bank and credit union market, our Postilion segment provides online personal and business banking applications as well as a telephone banking application in a robust single-channel platform that offers an excellent balance between cost and feature set and performance for this highly competitive market. In addition we offer our payments platform which provides software that operates ATM networks and Point of Sale debit card transaction processing networks.
We sell our solutions primarily to traditional financial services providers, such as banks and insurance companies, as well as non-traditional financial providers, such as retailers. Our solutions address the needs of small, mid-sized and large financial organizations. We derive a significant portion of our revenues from licensing our solutions and providing professional services. We generate recurring revenue from support and maintenance as well as from hosting revenue related to hosting applications and electronic bill payment services sold to customers in our data center. We also generate recurring revenues by charging our customers a periodic fee for term licenses including the right-to-use software and receive maintenance and support for a specified period of time. In discussions with our customers and investors, we use the term “subscription” as being synonymous with a term license. We intend to primarily license our suite of Community and Regional products and future versions as well as certain other applications primarily on a subscription basis wherein revenue will be recognized evenly over the term of the contract. We intend to license the Enterprise Suite of Products on both a perpetual and subscription basis.
We sell our solutions to small, mid-sized and large financial organizations in four geographic regions: (i) the Americas region, (ii) the Europe and Middle East (EME) region, (iii) the Asia-Pacific (APAC) region and (iv) the Africa region. Our S1 Enterprise solutions target larger banks, credit unions and insurance companies, while our Postilion solutions target community and regional banks with self service banking applications and the full range of banks and retailers with the suite of payment applications. We have over 3,000 financial institution customers, the majority of which are located in the United States.
Throughout 2006, we continued to invest in the development of the integrated S1 Enterprise Platform as the technology foundation for the S1 Enterprise family of products. The S1 Enterprise Platform includes the following applications: Internet based operations including retail/personal banking, small business banking, cash management and trade finance. In addition, the following full service branch applications are offered: teller, sales and service platform, call center, voice banking and analytics. These can be sold as stand-alone applications or as an integrated suite of products. In 2006, we
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have been focusing on delivering quality solutions on the S1 Enterprise Platform. We released our Enterprise 3.5 products from development in a Managed Introduction Program (“MIP”) in February 2006. The MIP is designed to enable the entire organization to work with a limited number of customers in pre-production and live production environments. The MIP is expected to continue throughout 2006 and into 2007 and will include all of the released Enterprise applications. Additionally, we are investing in our next-generation community banking solution sold by our Postilion segment which will include our personal Internet and voice banking, cash management and ATM/payments solutions, integrated on our Postilion payments solution platform.
During the third quarter of 2006, we sold our Risk and Compliance business. Our Risk and Compliance business, previously an operating segment, provides a suite of regulatory reporting solutions with financial intelligence and analytic solutions to financial institutions worldwide. We were previously accounting for the planned divestiture as a business “held for sale.”
Recent Accounting Pronouncements
On December 16, 2004, the FASB issued SFAS No. 123R, “Share-Based Payment,” (“SFAS 123R”) which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). SFAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS 123R is similar to the approach described in SFAS 123. SFAS 123R requires all share-based payments to employees during the period to be based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Under SFAS No. 123R, the pro forma disclosures previously permitted under SFAS No. 123 is no longer an alternative to financial statement recognition. Effective January 1, 2006, we have adopted SFAS No. 123R using the “modified prospective” method. Under this method, the compensation expense recognized during the three months ended March 31, 2006 included compensation expense for share based compensation granted prior to, but not yet vested as of January 1, 2006 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123 and compensation expense for share-based compensation granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. We did not change our method of attributing the value of stock-based compensation to expenses. Under both SFAS No. 123 and SFAS No. 123R the expense is amortized on a straight-line basis over the options vesting period. Prior period and pro forma results have not been restated. As stock-based compensation expense recognized in the Condensed Consolidated Statement of Operations for the three months ended March 31, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures.
In May 2005, the FASB issued SFAS No. 154. “Accounting Changes and Error Correction – A Replacement of APB Opinion No. 20 and FASB Statement No. 3.” This statement requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. Statement 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a “restatement.” The new standard is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. We adopted SFAS No. 154 on January 1, 2006.
In June 2006, the FASB issued Financial Interpretation 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with Financial Accounting Statement No. 109, “Accounting for Income Taxes.” The interpretation is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of FIN 48 on our financial statements.
Stock based compensation recognized in the financial statements under SFAS No. 123R for the nine months ended September 30, 2006 was $3.9 million which consisted of stock-based compensation expense related to employee stock options. Under the previous standards this expense was only disclosed in the pro forma information in the notes to the financial statements.
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Critical Accounting Policies and Estimates
For a complete list of our critical accounting policies and estimates, please refer to the Notes to the Consolidated Financial Statements in our Annual Report on Form 10-K as amended for the year ended December 31, 2005. Additional items are described below.
Determination of the fair value of employee stock options.We are required to determine the fair value of stock options when they are granted to our employees. Historically, the pro-forma expense was presented in a footnote. However, beginning January 1, 2006, this expense was recorded in our statement of operations due to the adoption of SFAS No. 123R, “Share-Based Payment”. The fair value is estimated at the date of grant using a Black-Scholes option pricing model. In determining the fair value, management makes certain estimates related primarily to the expected life of the option, the volatility of our stock, the risk-free interest rate and the estimated forfeiture rate. These assumptions affect the estimated fair value of the option. As such, these estimates will affect the compensation expense we record in future periods. These assumptions are subjective and generally require significant analysis and judgment. Some of the assumptions will be based on external data, while some assumptions will be derived from our historical experience with share-based payments. We currently estimate expected life using our historical exercise and post-vested termination activity. We currently estimate volatility by considering our historical stock volatility. The risk-free interest rate is the implied yield currently available on U.S. Treasury zero-coupon issues with the remaining term approximately the same as the expected life used as the input to the Black-Scholes model. We estimated the forfeitures using a weighted average historical forfeiture rate. Our estimates of forfeitures will be adjusted over the requisite service period based on the extent to which actual forfeitures differ, or are expected to differ, from their estimates.
Comparison of the Three Months Ended September 30, 2006 and 2005
Revenues.The following table sets forth our revenue data for the three months ended September 30, 2006 and 2005 (in thousands).
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Software | | | Support and | | | Professional | | | Data | | | | | | | |
| | | Licenses | | | Maintenance | | | Services | | | Center | | | Other | | | Total | |
Three Months Ended September 30, 2006: | | | | | | | | | | | | | | | | | | | | | | | | |
| Enterprise | | $ | 5,369 | | | $ | 5,514 | | | $ | 14,366 | | | $ | 4,793 | | | $ | 140 | | | $ | 30,182 | |
| Postilion | | | 5,139 | | | | 5,606 | | | | 3,989 | | | | 6,823 | | | | 157 | | | | 21,714 | |
| | | | | | | | | | | | | | | | | | | |
| Total | | $ | 10,508 | | | $ | 11,120 | | | $ | 18,355 | | | $ | 11,616 | | | $ | 297 | | | $ | 51,896 | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Software | | | Support and | | | Professional | | | Data | | | | | | | |
| | | Licenses | | | Maintenance | | | Services | | | Center | | | Other | | | Total | |
Three Months Ended September 30, 2005: | | | | | | | | | | | | | | | | | | | | | | | | |
| Enterprise | | $ | 1,784 | | | $ | 5,815 | | | $ | 13,491 | | | $ | 4,132 | | | $ | 365 | | | $ | 25,587 | |
| Postilion | | | 2,656 | | | | 5,138 | | | | 2,756 | | | | 6,049 | | | | 262 | | | | 16,861 | |
| | | | | | | | | | | | | | | | | | | |
| Total | | $ | 4,440 | | | $ | 10,953 | | | $ | 16,247 | | | $ | 10,181 | | | $ | 627 | | | $ | 42,448 | |
| | | | | | | | | | | | | | | | | | | |
Total revenues increased by $9.5 million or 22%, to $51.9 million for the three months ended September 30, 2006 compared to $42.4 million for the same period in 2005.
Since 2005, we have been licensing our Enterprise suite of products, Lending and our suite of Community and Regional products and future versions as well as certain other applications primarily on a subscription basis. Subscription license revenue is recognized evenly over the term of the contract which is typically between 12 and 60 months whereas perpetual license revenue is generally recognized upon execution of the contract and delivery or on a percentage of completion basis over the installation period. Subscription, or term, licenses combine the right to use the licensed software and the right to receive support and maintenance and unspecified enhancements into one periodic fee and typically do not transfer the right to use at the end of its initial term. Beginning in the fourth quarter of 2006, all Enterprise products will primarily be offered on a perpetual license basis. In addition, we expect to continue to recognize perpetual license revenue through sales of our legacy products, including add-on sales to customers with existing perpetual licenses, as well as through our reseller channels.
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With the move to perpetual licenses for all of our Enterprise products going forward, license revenues may fluctuate depending on the amount, timing and nature of customer licensing activity in the future. We anticipate consolidated license revenue in the fourth quarter of 2006 will be between $6.5 and $7.5 million.
Our Enterprise segment generated revenues of $30.2 million for the quarter ended September 30, 2006 compared with $25.6 million for the same period in 2005. The increase in revenues from our Enterprise business during the third quarter of 2006 is primarily due to an increase in license revenue and an increase in our professional services and data center revenues. Software license revenues for our Enterprise segment were $5.4 million for the three months ended September 30, 2006, an increase of $3.6 million from the same period in 2005. The license revenue increase includes a $2.8 million add on sale to an Enterprise customer on a perpetual license basis for our Corporate Banking application and additional capacity purchased by existing customers of our other Enterprise products. Support and maintenance revenues for our Enterprise segment were $5.5 million for the three months ended September 30, 2006 as compared to $5.8 million for the same period in 2005. Professional services revenues for our Enterprise segment were $14.4 million for the three months ended September 30, 2006, an increase of $0.9 million from the same period in 2005. Services revenue in any one quarter can be impacted by large customer projects and therefore can increase or decrease based on the projects. Data center revenues for our Enterprise segment were $4.8 million for the third quarter of 2006, an increase of $0.7 million from $4.1 million for the third quarter of 2005. The increase resulted from an increase in user counts by existing customers. In addition a large international customer went live in the first quarter of 2006 in our global data center.
Revenues for our Postilion segment were $21.7 million for the three months ended September 30, 2006 compared with $16.9 million for the same period in 2005. Software license revenues for our Postilion segment were $5.1 million for the three months ended September 30, 2006, an increase of $2.4 million from the same period in 2005. The increase is primarily due to the addition of several new large international customers as well as an increase in subscription revenue and the demand for the Multi-factor Authentification product. Support and maintenance revenues for the Postilion segment were $5.6 million for the three months ended September 30, 2006, an increase of $0.5 million from the same period in 2005. The Postilion segment recorded $4.0 million for professional services revenues during the third quarter of 2006, an increase of $1.2 million from $2.8 million for the third quarter of 2005. The increase is primarily driven by the demand for the Multi-factor Authentification product. Data center revenues for our Postilion segment were $6.8 million for the third quarter of 2006, an increase of $0.8 million from $6.0 million for the third quarter of 2005. The increase resulted from increases in the number of hosted customers, including a large international customer that went live in the first quarter. As we add hosted customers on our Postilion products and our existing customer base grows, we expect data center revenues to increase on a sequential quarterly basis.
Other revenues are primarily related to the sale of third party hardware and software that is used in connection with our products. Other revenue fluctuates based on the mix of products and services sold and is not typical in our sales arrangements. The related cost of the hardware sold is included in “cost of other revenue” as the hardware is delivered. There is only minimal gross margin associated with other revenue.
Direct Costs.Direct costs increased by $2.5 million to $24.5 million for the three months ended September 30, 2006 from the same period in 2005. As a percentage of revenues, direct costs were 47% and 52% for the three months ended September 30, 2006 and 2005, respectively.
Direct costs exclude charges for depreciation of property and equipment.
Cost of software licenses for our products sold includes the cost of software components that we license from third parties as well as the amortization of purchased technology. In general, the cost of third party software licenses for our products is minimal because we internally develop most of the software components, the cost of which is reflected in product development expense as it is incurred. The cost of software licenses could increase in future periods based on the mix and release of products sold. However, cost of software licenses will continue to vary with the mix of products sold. Overall, software license costs were 11% and 23% of software license revenues for the third quarter of 2006 and 2005, respectively, including $0.9 million for amortization of intangibles in both years.
Costs of professional services, support and maintenance consist primarily of personnel and related infrastructure costs. Direct costs associated with professional services, support and maintenance was $17.4 million for the three months ended September 30, 2006, an increase of $1.9 million from $15.5 million for the same period in 2005. As a percentage of revenue, costs of professional services, support and maintenance were 59% and 57% of related revenues for the third quarter
24
of 2006 and 2005, respectively. This increase is attributable to an increase in outside contractors, stock based compensation expense and the accrual of $0.5 million in our Enterprise segment for the estimated future costs to complete service projects where our expected costs will exceed the contractual.
Costs of data center consist of personnel costs, facility costs and related infrastructure costs to support our data center business as well as third party bill payment fees. A portion of the data center direct costs are fixed. As such, the incremental costs to add customers and/or users is minimal. However, direct data center costs increased $1.0 million to $5.7 million for the three months ended September 30, 2006 from $4.7 million for same period in 2005. As a percentage of data center revenues, data center costs excluding depreciation were 49% and 47% for the three months ended September 30, 2006 and 2005, respectively. This increase is attributable to an increase in the cost to support new hardware purchased when bringing disaster recovery in house as well as an increase in the third party bill payment fees.
Selling and Marketing Expenses.Total selling and marketing expenses decreased by $0.2 million to $7.2 million for the three months ended September 30, 2006 from $7.4 million for the same period in 2005. This decrease is primarily attributable to a reduction in personnel related expenses as a result of lower headcount from the reduction in force during the second half of 2005. This was partially offset by an increase in the cost of our annual trade show and stock based compensation expense of $0.4 million.
Product Development Expenses.Total product development expenses decreased by $0.5 million to $9.5 million for the three months ended September 30, 2006 from $10.0 million for the same period in 2005. This decrease is primarily attributable to a reduction in personnel related expenses as a result of lower headcount from the reduction in force during the second half of 2005. This was partially offset by stock based compensation expense of $0.1 million. As a percentage of revenues, product development expenses were 18% and 24% in the third quarter of 2006 and 2005.
Historically we have not capitalized software development costs because of the insignificant amount of costs incurred between technological feasibility and general customer release. However, if the amount of time between the completion of beta testing and general customer release lengthens, we may be required to capitalize certain software development costs in the future.
General and Administrative Expenses.General and administrative expenses increased by $1.5 million to $7.1 million for the three months ended September 30, 2006 from $5.6 million for the same period in 2005. As a percentage of revenues, general and administrative expenses were 14% and 13% for the three months ended September 30, 2006 and 2005, respectively. This increase is primarily attributable to $0.4 million of costs related to the pursuit of strategic alternatives and stock based compensation expense of $0.4 million.
Restructuring costs.Restructuring costs of $0.4 million were recorded during the third quarter of 2006. We adjusted our estimates based on sublease assumptions and actual subleases entered into for certain vacant office. Restructuring costs of $4.3 million were recorded during the third quarter of 2005. These costs consist of termination benefits paid to employees who have exited the business. Included in these charges is non-cash stock compensation expense of $0.6 million.
Depreciation.Depreciation was $2.1 million for each of the three months ended September 30, 2006 and 2005.
Amortization of Other Intangible Assets.Amortization of other intangible assets remained at $0.3 million for each of the three months ended September 30, 2006 and 2005. Amortization expense is expected to be approximately $0.3 million in fourth quarter of 2006.
Interest and Other Income, Net.Interest and other income net was $1.3 million and $0.8 million for the three months ended September 30, 2006 and 2005, respectively. Interest income increased due to higher average balances for cash and short-term investments as well as higher interest rates.
Income Tax (Expense) Benefit.We recorded income tax expense of $0.3 million and $0.1 million for the three months ended September 30, 2006 and 2005, respectively.
Although we have fully reserved net deferred tax assets of approximately $175.8 million as of December 31, 2005
25
primarily related to our net operating loss carryforwards (NOLs) and tax credit carryforwards, from time-to-time we are required to record an income tax provision in periods:
| | • | | for tax expense in certain subsidiaries or jurisdictions for which do not have NOLs to utilize; |
| |
| | • | | in the United States due to limitations on the use of our federal NOLs for alternative minimum tax purposes which will be paid in cash; or |
| |
| | • | | if there are NOLs that were acquired as part of a business combination, upon which we placed a valuation allowance at acquisition date. This results in non-cash income tax expense as goodwill is reduced and the valuation allowance is released. |
We incurred foreign income tax expense in certain European countries in the third quarter of 2006 and 2005. In 2006 and 2005, we recorded alternative minimum tax expense for components of our domestic operations as a result of limitations on the use of our federal NOLs. In 2006, some components of our domestic operations incurred income tax expense at regular statutory rates because they are not included in our consolidated federal income tax return and therefore do not benefit from our federal NOLs. There was minimal income tax expense related to pre-acquisition NOLs for the three months ended September 30, 2006.
APB Opinion 28 requires that companies report income taxes on interim periods’ financial statements using an estimated annual effective tax rate. Using this method income taxes are computed at the end of each interim period based on the best estimate of the effective rate expected to be applicable for the full fiscal year. Income forecasts prepared by the Company do not reflect the distinct taxable jurisdictions required to utilize this approach. Due to the break-even nature of our quarterly operational results and various domestic and foreign jurisdictions that have and do not have NOLs available, it is difficult to produce jurisdictionally accurate income forecast. Therefore, a reliable estimate of the annual effective rate cannot be made and the Company uses the actual effective tax rate for the year-to-date as the best estimate for the annual effective rate.
Income from discontinued operations. We recorded income from discontinued operations of $31.5 million, including $20,000 in stock based compensation expense during the three months ended September 30, 2006 as compared to income of $1.1 million for the three months ended September 30, 2005. Income from discontinued operations consisted of (in thousands):
| | | | | | | | | |
| | | Three Months Ended September 30, | |
| | | 2006 | | | 2005 | |
| Loss from Risk and Compliance | | $ | (712 | ) | | $ | (149 | ) |
| Gain on disposal of Risk and Compliance | | | 32,263 | | | | — | |
| Income from Edify | | | — | | | | 1,305 | |
| Loss on disposal of Edify | | | (97 | ) | | | — | |
| Income tax expense | | | (2 | ) | | | (47 | ) |
| | | | | | | |
| | | | | | | | | |
| Total | | $ | 31,452 | | | $ | 1,109 | |
| | | | | | | |
Comparison of the Nine Months Ended September 30, 2006 and 2005
Revenues.The following table sets forth our revenue data for the nine months ended September 30, 2006 and 2005 (in thousands).
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Software | | | Support and | | | Professional | | | Data | | | | | | | |
| | | Licenses | | | Maintenance | | | Services | | | Center | | | Other | | | Total | |
Nine Months Ended September 30, 2006: | | | | | | | | | | | | | | | | | | | | | | | | |
| Enterprise | | $ | 10,830 | | | $ | 17,389 | | | $ | 40,696 | | | $ | 15,083 | | | $ | 405 | | | $ | 84,403 | |
| Postilion | | | 12,090 | | | | 15,585 | | | | 9,230 | | | | 20,030 | | | | 737 | | | | 57,672 | |
| | | | | | | | | | | | | | | | | | | |
| Total | | | 22,920 | | | | 32,974 | | | | 49,926 | | | | 35,113 | | | | 1,142 | | | | 142,075 | |
| | | | | | | | | | | | | | | | | | | |
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| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Software | | | Support and | | | Professional | | | Data | | | | | | | |
| | | Licenses | | | Maintenance | | | Services | | | Center | | | Other | | | Total | |
Nine Months Ended September 30, 2005: | | | | | | | | | | | | | | | | | | | | | | | | |
| Enterprise | | $ | 8,956 | | | $ | 18,149 | | | $ | 44,721 | | | $ | 12,276 | | | $ | 702 | | | $ | 84,804 | |
| Postilion | | | 13,113 | | | | 15,787 | | | | 7,747 | | | | 17,452 | | | | 562 | | | | 54,661 | |
| | | | | | | | | | | | | | | | | | | |
| Total | | $ | 22,069 | | | $ | 33,936 | | | $ | 52,468 | | | $ | 29,728 | | | $ | 1,264 | | | $ | 139,465 | |
| | | | | | | | | | | | | | | | | | | |
Total revenues increased by $2.6 million or 2%, to $142.1 million for the nine months ended September 30, 2006 compared to $139.5 million for the same period in 2005.
Our Enterprise segment generated revenues of $84.4 million for the nine months ended September 30, 2006 compared with $84.8 million for the same period in 2005. The decrease in revenues from our Enterprise business during the first nine months of 2006 is primarily due to a decrease in support and maintenance and professional services revenue partially offset by an increase in license revenue. Software license revenues for our Enterprise segment were $10.8 million for the nine months ended September 30, 2006, an increase of $1.9 million from the same period in 2005. This increase includes a one time $2.8 million perpetual license for our Corporate Banking application. Support and maintenance revenues for our Enterprise segment were $17.4 million for the nine months ended September 30, 2006 as compared to $18.1 million for the same period in 2005. Professional services revenues for our Enterprise segment were $40.7 million for the nine months ended September 30, 2006, a decrease of $4.0 million from the same period in 2005. This decrease is principally attributable to the decrease in professional services revenues from our largest customer and the completion of several projects which have not been replaced with new projects. Services revenue in any one quarter can be impacted by one or two large customer projects and therefore can increase or decrease based on the projects. Data center revenues for our Enterprise segment were $15.1 million for the first nine months of 2006, an increase of $2.8 million from $12.3 million for the first nine months of 2005. The increase resulted from increases in the number of hosted customers and an increase in usage. In addition a large international customer went live in the first quarter of 2006 in our global data center.
Revenues for our Postilion segment were $57.7 million for the nine months ended September 30, 2006 compared with $54.7 million for the same period in 2005. Software license revenue for our Postilion segment were $12.1 million for the nine months ended September 30, 2006, a decrease of $1.0 million from the same period in 2005 due to the transition to subscription licenses in our community and regional business. This decrease is partly a result of a slow down in the sales process after we announced that the company was exploring strategic alternatives, which in turn discouraged some customers from entering into long term commitments with us. Support and maintenance revenues for the Postilion segment were $15.6 million for the nine months ended September 30, 2006, a decrease of $0.2 million from the same period in 2005. This decrease is primarily due to the transition to subscription licenses in our community and regional business. The Postilion segment recorded $9.2 million for professional services revenues during the first nine months of 2006, an increase of $1.5 million from $7.7 million for the first nine months of 2005. Postilion professional service revenue increased primarily due to a large retail customer in the UK that went live in the second quarter of 2006. Data center revenues for our Postilion segment were $20.0 million for the first nine months of 2006, an increase of $2.5 million from $17.5 million for the first nine months of 2005. The increase resulted from increases in the number of hosted customers, including a large international customer that went live in the second quarter as well as an increase in the third party bill payment costs. As we add hosted customers on our Postilion products and our existing customer base grows, we expect data center revenues to increase on a sequential quarterly basis.
Other revenues are primarily related to the sale of third party hardware and software that is used in connection with our products. Other revenue fluctuates based on the mix of products and services sold and is not typical in our sales arrangements. The related cost of the hardware sold is included in “cost of other revenue” as the hardware is delivered. There is only minimal gross margin associated with other revenue.
Direct Costs.Direct costs increased by $3.4 million to $68.6 million for the nine months ended September 30, 2006 from the same period in 2005. As a percentage of revenues, direct costs were 48% and 47% for the nine months ended September 30, 2006 and 2005, respectively.
Direct costs exclude charges for depreciation of property and equipment.
Cost of software licenses for our products sold includes the cost of software components that we license from third
27
parties as well as the amortization of purchased technology. In general, the cost of third party software licenses for our products is minimal because we internally develop most of the software components, the cost of which is reflected in product development expense as it is incurred. The cost of software licenses could increase in future periods as we license and install more of our new S1 Enterprise products. These products include software components that we license from third parties. However, cost of software licenses will continue to vary with the mix of products sold. Overall, software license costs were 14% and 17% of software license revenues for the first nine months of 2006 and 2005, respectively, including $2.7 million for amortization of intangibles in both years.
Costs of professional services, support and maintenance consist primarily of personnel and related infrastructure costs. Direct costs associated with professional services, support and maintenance was $47.8 million for the nine months ended September 30, 2006, an increase of $1.2 million from $46.6 million for the same period in 2005. This increase is attributable to an increase in outside contractors and the accrual of $0.5 million for the estimated future costs to complete service projects where our expected costs will exceed the contractual revenues and by stock based compensation expense of $0.4 million. As a percentage of revenue, costs of professional services, support and maintenance were 58% and 54% of related revenues for the first nine months of 2006 and 2005, respectively.
Costs of data center consist of personnel costs, facility costs and related infrastructure costs to support our data center business as well as third party bill payment fees. A portion of the data center direct costs are fixed. As such, the incremental costs to add customers and/or users is minimal. However, direct data center costs increased $2.9 million to $16.9 million for the nine months ended September 30, 2006 from $14.0 million for same period in 2005. This increase is attributable to an increase in contractors to support the migration of new platforms and security initiatives and an increase in the cost to support new hardware purchased when bringing disaster recovery in house and an increase in third party bill payment fees. As a percentage of data center revenues, data center costs excluding depreciation were 48% and 47% for the nine months ended September 30, 2006 and 2005.
Selling and Marketing Expenses.Total selling and marketing expenses decreased by $2.7 million to $19.7 million for the nine months ended September 30, 2006 from $22.4 million for the same period in 2005. This decrease is primarily attributable to a reduction in personnel related expenses as a result of lower headcount from the reduction in force during the second half of 2005. This was partially offset by an increase in the cost of our annual trade show and stock based compensation expense of $1.2 million.
Product Development Expenses.Total product development expenses decreased by $2.4 million to $29.0 million for the nine months ended September 30, 2006 from $31.4 million for the same period in 2005. This decrease is primarily attributable to a reduction in personnel related expenses as a result of lower headcount from the reduction in force during the second half of 2005. This was partially offset by stock based compensation expense of $0.7 million. As a percentage of revenues, product development expenses were 20% and 23% during the first nine months of 2006 and 2005.
Historically we have not capitalized software development costs because of the insignificant amount of costs incurred between technological feasibility and general customer release. However, if the amount of time between the completion of beta testing and general customer release lengthens, we may be required to capitalize certain software development costs in the future.
General and Administrative Expenses.General and administrative expenses increased by $1.0 million to $19.3 million for the nine months ended September 30, 2006 from $18.3 million for the same period in 2005. As a percentage of revenues, general and administrative expenses were 14% and 13% for the nine months ended September 30, 2006 and 2005, respectively. This increase is primarily attributable to $1.2 million of costs related to the proxy contest and ultimate settlement agreement with the shareholder group led by Ramius Capital Group, L.L.C., the pursuit of strategic alternatives and stock based compensation expense of $1.4 million. This was partially offset by a reduction in personnel related expenses as a result of lower headcount from the reduction in force during the second half of 2005.
Restructuring costs.Restructuring costs of $1.3 million were recorded during the nine months ended September 30, 2006 of which $1.0 million relates to adjustment of our estimates based on sublease assumptions and actual subleases entered into for certain vacant office space and $0.3 million of employee termination benefits for employees who were placed on transition plans. Restructuring costs of $4.3 million were recorded during the nine months ended September 30, 2005. These
28
costs consist of termination benefits paid to employees who have exited the business, included in these charges is non-cash stock compensation expense of $0.6 million.
Depreciation.Depreciation was $5.8 million and $6.8 million for the nine months ended September 30, 2006 and 2005, respectively.
Amortization of Other Intangible Assets.Amortization of other intangible assets was $1.0 million for the nine months ended September 30, 2006 and 2005. Amortization expense is expected to be approximately $0.3 million in the fourth quarter of 2006.
Interest and Other Income, Net.Interest and other income net was $3.5 million and $1.8 million for the nine months ended September 30, 2006 and 2005, respectively. Interest income increased due to higher average balances for cash and short-term investments as well as higher interest rates.
Income Tax Expense.We recorded income tax expense of $0.9 million and $0.5 million for the nine months ended September 30, 2006 and 2005, respectively.
We incurred foreign income tax expense in certain European countries in the first nine months of 2006 and 2005. In 2006 and 2005, we recorded alternative minimum tax expense for components of our domestic operations as a result of limitations on the use of our federal NOLs. In 2006, some components of our domestic operations incurred income tax expense at regular statutory rates because they are not included in our consolidated federal income tax return and therefore do not benefit from our federal NOLs. Approximately $50,000 of our income tax expense in 2006 resulted from the release of the valuation allowance against pre-acquisition NOLs and does not represent anticipated cash taxes to be paid.
�� Income from discontinued operations.We recorded income from discontinued operations of $30.8 million during the first nine months of 2006 as compared to income from discontinued operations of $4.1 million for the nine months ended September 30, 2005. Income from discontinued operations consisted of (in thousands):
| | | | | | | | | |
| | | Nine months Ended September 30, | |
| | | 2006 | | | 2005 | |
| (Loss) income from Risk and Compliance | | $ | (1,969 | ) | | $ | 2,510 | |
| Loss from Davidge | | | — | | | | (31 | ) |
| Income from Edify | | | — | | | | 1,936 | |
| Gain on disposal of Edify | | | 457 | | | | — | |
| Gain on disposal of Risk and Compliance | | | 32,263 | | | | — | |
| Income tax benefit (expense) | | | 34 | | | | (298 | ) |
| | | | | | | | | |
| | | | | | | |
| Total | | $ | 30,785 | | | $ | 4,117 | |
| | | | | | | |
Liquidity and Capital Resources
The following tables show information about our cash flows during the nine months ended September 30, 2006 and 2005 and selected balance sheet data as of September 30, 2006 and December 31, 2005:
| | | | | | | | | |
| | | Nine months Ended September 30, | |
| | | 2006 | | | 2005 | |
| | | (In thousands) | |
| Net cash provided by operating activities before changes in operating assets and liabilities | | $ | 12,324 | | | $ | 10,484 | |
| Change in operating assets and liabilities | | | (15,792 | ) | | | (6,614 | ) |
| | | | | | | |
| Net cash (used in) provided by operating activities | | | (3,468 | ) | | | 3,870 | |
| Net cash provided by investing activities | | | 28,131 | | | | 12,937 | |
| Net cash provided by (used in) financing activities | | | 3,573 | | | | (3,585 | ) |
| Effect of exchange rates on cash and cash equivalents | | | (116 | ) | | | (538 | ) |
| | | | | | | |
| Net increase in cash and cash equivalents | | $ | 28,120 | | | $ | 12,684 | |
| | | | | | | |
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| | | | | | | | | |
| | | As of |
| | | September 30, 2006 | | December 31, 2005 |
| | | (In thousands) |
| Cash and cash equivalents. | | $ | 113,228 | | | $ | 85,108 | |
| Short term investments | | | 26,009 | | | | 44,170 | |
| Working capital | | | 141,438 | | | | 106,250 | |
| Total assets | | | 362,824 | | | | 344,523 | |
| Total stockholders’ equity | | | 288,721 | | | | 252,386 | |
Operating Activities.During the nine months ended September 30, 2006, cash used in operations was $3.5 million compared to cash provided by operations of $3.9 million for same period in 2005. The decrease in net cash flows from operating activities generally reflects the effects of changes in operating assets and liabilities. Changes in operating assets and liabilities, especially trade accounts receivable, trade accounts payable and accrued expenses, are generally the result of timing differences between the collection of fees billed and payment of operating expenses.
Cash used in operations for the nine months ended September 30, 2006 included the effects of:
| | • | | our net income of $30.8 million; |
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| | • | | depreciation and amortization expense of $9.6 million; |
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| | • | | gain on the disposal of Edify of $0.6 million and gain on disposal of the Risk and Compliance business of $32.2 million; |
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| | • | | provision of doubtful accounts receivable and billing adjustments of $0.9 million; |
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| | • | | stock based compensation expense of $3.9 million; |
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| | • | | a decrease in accrued expenses and other liabilities of $10.7 million; |
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| | • | | an increase of $12.7 million in accounts receivable due to the timing of revenue recognized and billing terms on fixed price implementation projects during the quarter; |
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| | • | | a $7.0 million increase in deferred revenues resulting from annual billing of maintenance and subscription fees; and |
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| | • | | changes in other operating assets and liabilities of $0.5 million. |
Cash provided by operations for the nine months ended September 30, 2005 included the effects of:
| | • | | our net loss of $4.5 million; |
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| | • | | depreciation and amortization expense of $11.2 million; |
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| | • | | provision of doubtful accounts receivable and billing adjustments of $3.2 million; |
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| | • | | a decrease in accrued expenses and other liabilities of $9.6 million, approximately $4.7 million related to the payment of annual expenses, including annual employee bonuses and incentive pay; |
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| | • | | an increase of $4.8 million in accounts receivable due to the timing of revenue recognized and billing terms on fixed price implementation projects during the quarter; |
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| | • | | a $5.7 million increase in deferred revenues resulting from annual billing of maintenance and subscription fees; and |
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| | • | | changes in other operating assets and liabilities of $2.1 million. |
Investing Activities.Cash provided by investing activities was $28.1 million for the nine months ended September 30, 2006 compared to cash provided by investing activities of $12.9 million in the same period in 2005.
In the first nine months of 2006, we:
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| | • | | paid $14.0 million to the sellers of Mosaic in settlement of the earn-out; |
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| | • | | converted $18.2 million, net, from short-term investments to cash and cash equivalents; |
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| | • | | received net proceeds from the sale of the Risk and Compliance segment of $32.6 million; |
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| | • | | cash held in escrow of $3.5 million related to the sale of the Risk and Compliance segment; |
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| | • | | received $0.6 million working capital adjustment from the sale of Edify; and |
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| | • | | purchased $5.2 million of property and equipment. |
In the first nine months of 2005, we:
| | • | | converted $19.5 million, net, from cash and cash equivalents to short-term investments; |
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| | • | | purchased $5.7 million of property and equipment; and |
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| | • | | paid approximately $0.9 million in connection with the acquisition of the Providus business. |
Financing Activities.Cash provided by financing activities was $3.6 million for the nine months ended September 30, 2006 compared to cash used in financing activities of $3.6 million in same period in 2005.
In the first nine months of 2006, we:
| | • | | received $2.5 million from the sale of common stock under our employee stock option plans; and |
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| | • | | received $2.5 million from a sale lease back transaction ; and |
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| | • | | paid $1.5 million for capital lease obligations. |
In the first nine months of 2005, we:
| | • | | received $1.1 million from the sale of common stock under our employee stock option plans; and |
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| | • | | repurchased $3.4 million of our common stock; and |
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| | • | | paid $1.3 million for capital lease obligations. |
We believe that our expected cash flows from operations together with our existing cash and short term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. If cash generated from operations is insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or issue debt securities or establish a credit facility. The sale of additional equity or convertible debt securities could result in additional dilution to our stockholders. The addition of indebtedness would result in increased fixed obligations and could result in operating covenants that would restrict our operations. We cannot assure that financing will be available in amounts or on terms acceptable to us, if at all.
Item 3.Quantitative and Qualitative Disclosures about Market Risk
Quantitative and qualitative disclosures about market risk were included in Item 7A of the Company’s 2005 Annual Report on Form 10-K as amended. With the exception of the long term contract described below, there have been no significant changes in our market risk from December 31, 2005.
In general we do not use financial instruments to hedge our foreign exchange exposure because the effect of the foreign exchange rate fluctuations are not material. We entered into a long-term hosting agreement with a customer wherein S1 will provide the customer with hosting services for a period of approximately four years. Our costs associated with those services are denominated in United States Dollars (USD) and the customer will pay us in British Pounds Sterling (GBP). In this arrangement, ordinary fluctuations in currency exchange rates could adversely impact our profit margin on the hosting agreement. Consequently, during the quarter ended March 31, 2005, we purchased a series of options to exchange USD for GBP at dates throughout the term of the agreement for amounts proportional to the minimum fees under the contract. As of September 30, 2006, the fair value of these options was $0.1 million.
Item 4.Controls and Procedures
Evaluation of Disclosure Controls. Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, the Chief Executive Officer and Chief Financial Officer have concluded that the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is
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recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. Additionally, our disclosure controls and procedures were effective in ensuring that information required to be disclosed in our Exchange Act reports is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.
Changes in Internal Control over Financial Reporting. There have not been any changes in the Company’s internal control over financial reporting during the quarter ended September 30, 2006, which have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II — OTHER INFORMATION
Item 1.Legal Proceedings.
There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which S1 or any of its subsidiaries is a party or to which their property is subject.
As previously reported, we were involved in litigation with Tradecard, Inc. relating to a claim of infringement of U.S. Patent 6,151,588 filed in the U.S. District Court for the Southern District of New York. The action was filed March 2003 against S1 Corporation, Bank of America Corporation and Bank of America National Association. In March 2006, a jury decided in our favor that we were not infringing and that Tradecard’s patent is invalid. Tradecard has submitted a motion to the Federal District Court for reconsideration of the verdict. If that motion is denied, Tradecard may appeal the jury verdict to the Federal Court of Appeals.
Item 1A.Risk Factors
The following discussion supplements the Risk Factors in Item 1A. Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2005.
We face a number of significant risks and uncertainties in our business, which are detailed under “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005, and amended or supplemented in our Quarterly Reports on Form 10-Q. These risk factors may affect our current position and future prospects, and should be considered carefully in evaluating us and an investment in our common stock. There have been no material changes from the previously disclosed risk factors, except as described below.
The risk factor entitled “Our exploration of strategic alternatives may create uncertainties that could affect our business” is no longer relevant as the Company announced on October 23, 2006 that it had completed the review of strategic alternatives announced in May 2006.
In addition, the following risks replace the same-titled risks included in our Annual Report on Form 10-K for the year ended December 31, 2005:
Our quarterly operating results may fluctuate and any fluctuations could adversely affect the price of our common stock
Our quarterly operating results have fluctuated significantly to date. If we fail to meet the expectations of securities analysts or investors as a result of any future fluctuations in our quarterly operating results, the market price of our common stock would likely decline. We may experience fluctuations in future quarters because:
| • | | we cannot accurately predict the number and timing of contracts we will sign in a period, in part because the budget constraints and internal review processes of existing and potential customers are not within our control; |
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| • | | as we will be selling our financial institutions products on both a perpetual license and a term or subscription license, we cannot accurately predict the mix of perpetual licenses to term licenses sold in any one quarter. Term licenses significantly reduce the amount of revenue recognized in the first year of the contract, but is intended to increase the overall revenue earned from the customer during the typical customer life cycle; perpetual license revenue can vary significantly on a quarterly basis; |
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| • | | the length of our sales cycle to large financial organizations generally lasts from six to eighteen months, which adds an element of uncertainty to our ability to forecast revenues; |
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| • | | if we fail to or are delayed in the introduction of new or enhanced products, or if our competitors introduce new or enhanced products, sales of our products and services may not achieve expected levels and/or may decline; |
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| • | | our ability to expand the mix of distribution channels through which our products are sold may be limited; |
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| • | | our products may not achieve widespread consumer acceptance, which could cause our revenues to be lower than expected; |
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| • | | we have had significant contracts with legacy customers that have decreased or terminated their services and we may not be able to replace this revenue and / or the gross margins associated with this revenue; |
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| • | | our sales may be constrained by the timing of releases of third-party software that works with our products; |
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| • | | a significant percentage of our expenses is relatively fixed, and we may be unable to reduce expenses in the short term if revenues decrease; and |
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| • | | the migration of our license sales model to be more focused on recurring revenue contracts may result in less predictable revenue due to an inability to predict the rate at which it is adopted by our customers, or the rate at which it may be deferred. |
We have experienced substantial losses in the past and may not achieve or maintain profitable operations in the future
We incurred losses from continuing operations in fiscal years 2003 and 2005, and from time-to-time make changes in our organizational structure to improve operating efficiencies. These changes can create additional costs during periods of transition, and we could experience losses in the future, which could negatively impact the value of our common stock.
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Item 6.Exhibits
| | | |
| Exhibit | | |
| No. | | Exhibit Description |
| | | |
| 31.1 | | Certification of Chief Executive Officer |
| | | |
| 31.2 | | Certification of Chief Financial Officer |
| | | |
| 32.1 | | Certificate of Chief Executive Officer pursuant to §906 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 32.2 | | Certificate of Chief Financial Officer pursuant to §906 of the Sarbanes-Oxley Act of 2002 |
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SIGNATURE
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, as of November 9, 2006.
| | | | | |
| | S1 CORPORATION
| |
| | By: | /s/ JOHN A. STONE | |
| | | John A. Stone | |
| | | Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) | |
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Exhibit Index
| | | |
| Exhibit | | |
| No. | | Exhibit Description |
| | | |
| 31.1 | | Certification of Chief Executive Officer |
| | | |
| 31.2 | | Certification of Chief Financial Officer |
| | | |
| 32.1 | | Certificate of Chief Executive Officer pursuant to §906 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 32.2 | | Certificate of Chief Financial Officer pursuant to §906 of the Sarbanes-Oxley Act of 2002 |
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