Item 1. Business
National Processing, Inc. (the “Company” or “Registrant”), through its wholly-owned operating subsidiaries, which are collectively referred to as National Processing Company (“NPC”), operates two business segments, Merchant Card Services and Payment Services, which are focused on electronic payment settlement services. In 2001, the Company’s total dollar volume settled was over $230 billion.
Merchant Card Services authorizes, processes, and performs financial settlement and reporting of card transactions, including credit, debit, stored value, and electronic benefits transfer (“EBT”). Merchant Card Services provides services to virtually every industry that accepts cards for payment settlement and currently provides services to over 600,000 merchant locations primarily in the United States. Merchant Card Services represented 85% of the Company’s revenue in 2001.
Payment Services was formerly an operating unit within the Company’s Corporate Outsourcing Solutions segment. This segment was renamed Payment Services in 2001 after the sale of the Business Process Outsourcing (“BPO”) unit. Payment Services provides financial settlement and reporting solutions to large and mid-size corporate customers in the travel service and healthcare industries. Payment Services settles 100% of domestic airline tickets sold through travel agencies in the United States. Payment Services also settles commission payments for car rental companies, cruise line operators, and hotels. Payment Services represented 6% of the Company’s revenue in 2001.
During 2001, the Company divested its BPO business and exited its Denver collections business, which collectively represented 9% of the Company’s revenue in 2001.
The Company is an Ohio corporation that is 86% owned by National City Corporation, a financial holding company headquartered in Cleveland, Ohio (“National City”). The Company maintains operations, employees, and contracts substantially independent of National City’s other operating subsidiaries. The Company and National City are parties to agreements pursuant to which National City and its subsidiaries provide the Company, and the Company provides National City and its subsidiaries, certain administrative support, operations, and processing services. The Company is also a party to a tax-sharing agreement and a registration rights agreement with National City.
See Segment Reporting, Note N to the Consolidated Financial Statements, for additional financial disclosures of the Company’s operating segments and foreign operations.
Industry Overview
Merchant Card Services
The merchant card processing industry provides retailers and other merchants with card-based payment authorization, capture, settlement and reporting, exception processing, and other related services. The industry has enjoyed significant growth over the last ten years due to wider merchant acceptance of card-based payment products and increased consumer usage of card-based payment services.
NPC provides a diversified product mix to meet a wide range of customer needs, including:
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Processing of all credit card types 	
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Authorization and settlement accounting 	
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Merchant reporting 	
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Chargeback prevention and handling 	
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Point of Sale (POS) hardware and software 	
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On-line and off-line debit card acquiring 	
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Electronic Benefits Transfer (EBT) 	
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Customized reporting formats and data management 	
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Call-center services 	
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E-commerce solutions 	
NPC provides services to a wide array of customers in virtually every industry, including retailers, supermarkets, quick service and full service restaurants, petroleum and convenience stores, airlines, hospitality, and e-commerce. NPC is the second largest provider of merchant card processing services in the United States. In 2001, NPC processed 3.5 billion transactions, including approximately one out of every five Visa® and MasterCard ® transactions in the United States. NPC currently services over 600,000 merchant locations nationwide.
The merchant card processing market can generally be divided into two markets: 1) national merchants and 2) regional merchants, including smaller “mom and pop” merchants. Since 1997, NPC has deployed a dual strategy focused on growing both markets. On December 31, 1999, the Company increased its market share of regional merchants by acquiring a merchant contract portfolio from Heartland Payment Systems LLC. The Company further expanded its market share of regional merchants by acquiring the merchant services business units from several National City banking subsidiaries on January 8, 2001 and a 70% ownership interest in ABN AMRO Merchant Services, LLC (“AAMS”) on June 28, 2001. In 2001, 56% of merchant card processing revenue was from regional merchants.
Merchant Card Services revenue was $402.0 million, which represented 85% of the Company’s revenue in 2001. Total transaction volume increased by 24% to 3.5 billion in 2001. Total dollar settlement volume increased by 23% to $156 billion in 2001.
Merchant Card Services uses various sales and marketing channels for both its national and regional customers. The Company employs approximately 300 commission only sales representatives who focus on direct marketing channels. In addition, the Company sells its services through approximately 650 third-party relationships such as independent sales offices and community banks who, in most cases, represent NPC exclusively.
The merchant card processing market is extremely competitive, which results in pricing pressure and creates the need for continuous improvement in technology both to satisfy customer demands and to reduce operating costs. The increased costs to meet merchant requirements for improved service and satisfy the demand for additional technology-driven applications combined with the scale-driven nature of the industry have made it difficult for small-scale transaction processors to remain competitive and has led to consolidation in the industry. NPC competes in this industry by focusing on lowering the merchant’s “total cost of card acceptance”, which includes minimizing interchange and processing fees assessed by third parties.
According to published industry sources, the six largest card processors handle over 70% of the transaction and dollar volume in the United States. The remaining market is highly fragmented among smaller merchant service providers. As a result, the transaction processing industry will likely continue to undergo consolidation.
Payment Services
Payment Services was formerly an operating unit within the Company’s Corporate Outsourcing Solutions segment. This segment was renamed Payment Services in 2001 after the sale of the BPO unit. Payment Services provides financial settlement and reporting solutions to large and mid-size corporate customers in the travel service and healthcare industries. Payment Services revenue was $30.1 million, which represented 6% of the Company’s revenue in 2001. Payment Services settled $75 billion of payments in 2001.
In the travel service industry, Payment Services provides financial settlement and reporting to airlines, hotels, travel agents, cruise lines, and car rental companies. Through an exclusive long-term “cost-plus” contract with the Airlines Reporting Corporation (“ARC”), Payment Services provides payment settlement services for all airline tickets sold by travel agents in the United States. In addition, NPC provides an industry-wide global payment system for consolidating and processing business-to-business commission payments for
virtually all United States based car rental companies as well as for the hotel and cruise line industries. During 2001, these services were performed in both the Company’s Mexican and United States locations.
In the healthcare industry, Payment Services uses AcceleratedPaySM, a healthcare settlement solution, to provide financial settlement and reporting to healthcare organizations such as insurance companies, managed care organizations, and self-insured organizations. These services are performed in the Company’s United States locations.
Competition for the Payment Services segment varies based on the individual product lines. The Company currently has an exclusive long-term contract with ARC to provide payment settlement for all airline tickets sold by travel agents in the United States. The other Payment Services product lines experience competition in the marketplace. NPC competes in this industry by focusing on price, quality, and customer service.
Divested Business Units and Related Charges
In 2001, the Company divested its BPO business and exited its Denver collections business which were components of the former Corporate Outsourcing Solutions segment. Revenue from these divested businesses was $41.2 million, which represented 9% of the Company’s revenue in 2001. The sale of the BPO business unit to Affiliated Computer Services (“ACS”) was completed on August 29, 2001, for $43.0 million in cash ($41.3 million after transaction related expenses). The Company recorded charges of $3.9 million ($4.6 million after-tax, or $0.09 per diluted share) related to the BPO divestiture. These charges consisted of a loss of $3.3 million ($4.2 million after-tax, or $0.08 per diluted share) on the sale of the business and a $0.6 million charge ($0.4 million after-tax, or $0.01 per diluted share) for severance costs related to fourth quarter organizational restructuring actions taken to reduce support costs associated with the BPO unit.
In 2000, the Company recorded charges of $8.6 million ($5.6 million after-tax, or $0.11 per diluted share) related to these business units. These charges consisted of $7.1 million ($4.6 million after-tax, or $0.09 per diluted share) to write-off goodwill and fixed assets for the Denver collections business and $1.5 million ($1.0 million after-tax, or $0.02 per diluted share) for site consolidation initiatives in the BPO unit.
In 1999, the Company recorded charges of $71.7 million ($71.7 million after-tax, or $1.42 per diluted share) related to divested business units. These charges consisted of $69.5 million ($69.9 million after-tax, or $1.38 per diluted share) for impairment and associated expenses related to the sale of the Freight, Payables, Remittance, and Check Acceptance business lines and a $2.2 million ($1.8 million after-tax, or $0.04 per diluted share) restructuring charge related to the closure of a BPO facility. The Freight, Payables, Remittance, and Check Acceptance business lines were sold in the first half of 1999 for $62.6 million in cash.
Regulation
As a result of National City’s ownership in the Company and as long as National City has a controlling interest, the Company is subject to banking laws, regulations, and orders (collectively, the “Banking Laws”). For example, the Company is subject to the supervision and examination by the Board of Governors of the Federal Reserve System (“FRB”), one of the principal regulatory bodies having jurisdiction over National City.
The FRB reviews acquisitions and new businesses to be engaged in by the Company, and the FRB’s written approval is required for the Company to consummate an acquisition. Pursuant to the Bank Holding Company Act, the Company shall not engage in any activity, or own, control, or have the power to vote more than 5% of any class of voting security of any company engaged in any activity (i) for which the Bank Holding Company Act requires a bank holding company to receive prior approval from the FRB without such approval having been obtained, or (ii) that would cause the Company or any affiliate of the Company to violate any regulation, administrative order, or court order made pursuant to the Bank Holding Company Act. If at any time it is determined that any activity conducted by the Company or any subsidiary does not comply with the requirements of the Bank Holding Company Act, the Company is required to take all reasonable steps to cease such activity, or to divest any ownership or control position. If National City is unable to obtain the
necessary consent or approval for any business activity substantially different from those business activities the Company currently conducts, then the Company may not engage in any of those new business activities or proceed with the contemplated acquisition of a business that would engage in such new activities. The Company does not believe, however, that either the Banking Laws or the Bank Holding Company Act will impede the manner in which the Company conducts its business or its product and service offerings, although there can be no assurance that the Banking Laws or Bank Holding Company Act will not have such an effect.
The Company is also subject to various other federal, state, local, and foreign laws, orders and regulations applicable to the Company’s operations in the jurisdictions where it conducts business. Where applicable, regulators and other persons are authorized to seek remedies against entities such as the Company for violations of such laws.
Through National City Bank of Kentucky, (“NCBK”), which serves as a member bank for the Company, the Company is registered with VISA® and MasterCard ® as a certified processor and member service provider. As a result, the Company must adhere to the standards of the VISA® and MasterCard ® credit card associations or risk suspension or termination of its designation and/or status. There can be no assurance that (i) VISA® and MasterCard ® will maintain the Company’s registrations; (ii) the current VISA® and MasterCard ® rules allowing the Company and other non-bank transaction processors to market and provide transaction processing services will remain in effect; or (iii) VISA® and MasterCard ® will continue to interpret their rules as they have done in the past, which may have an impact on the Company’s business operations. NCBK is a wholly-owned subsidiary of National City.
Sponsorship Agreement
The Company and NCBK are parties to a sponsorship agreement (the “Sponsorship Agreement”) whereby the Company acts as NCBK’s sole agent for the purposes of providing electronic data authorization and capture, reporting, settlement, and clearing services for merchants who participate in Visa® and MasterCard ® programs. The Company, along with other nonbank processors, must be sponsored by a financial institution that is a member of the Visa® and MasterCard ® associations. NCBK, being a member of such associations, acts as the Company’s sole sponsor under the terms of the Sponsorship agreement.
The Company retains full responsibility for performance of Merchant Card Services, except for certain obligations or responsibilities of NCBK pursuant to the Sponsorship Agreement. The Sponsorship Agreement provides that the Company will comply with (1) all Visa® and MasterCard ® bylaws, manuals and operating regulations and other written materials as they from time to time are amended which bind or apply to NCBK as a member of Visa® and MasterCard ® with respect to Merchant Card Services or to the Company as a third party processor, (2) all agreements between merchants and NCBK with respect to Merchant Card Services, and (3) all applicable federal or state laws and regulations. Under the Sponsorship Agreement, the Company will receive all fees, discounts and other amounts payable by merchants for Merchant Card Services and will bear the expenses of maintaining facilities necessary to provide such services. Certain indemnification provisions are also contained in the Sponsorship Agreement, under which the Company will indemnify NCBK against losses, claims or other amounts arising out of the Company’s failure to perform in accordance with the terms of the Sponsorship Agreement due to negligence of the Company.
The Company mitigates its contingent liability risk by instructing NCBK to withhold certain settlement funds due to merchants based on contractual terms. As of December 31, 2001, NCBK had $64.7 million of customer deposits and withheld settlement funds.
Employees
As of December 31, 2001, the Company and its subsidiaries had approximately 2,000 full-time and part-time employees.
Seasonality
The Company experiences seasonality in certain businesses and typically realizes higher revenue in the third and fourth calendar quarters and lower revenue in the first calendar quarter, reflecting increased transaction volume in the summer and holiday months. Accounts receivable is generally highest in the fourth quarter as December is typically the highest volume month due to holiday sales. As a result, cash balances are typically lower in the fourth quarter.
Item 2.
Item 2. Properties
The Company leases its main processing facility in Louisville, Kentucky, consisting of approximately 224,000 square feet, from National City Bank of Kentucky. (See Transactions with Affiliates, Note F to Consolidated Financial Statements). The Company’s lease for the Louisville processing facility expires on February 28, 2019. The Company’s other U.S. facilities have varying lease expiration terms and range in size from 2,000 square feet to 16,000 square feet. The Company also has 32 marketing and sales offices, which have varying lease expiration terms and range in size from 200 square feet to 2,600 square feet and are located throughout the United States. The Company owns one processing facility in Juarez, Mexico, consisting of 50,000 square feet. All properties leased and owned by the Company are in good repair and suitable condition for the purposes for which they are used. The Company periodically reviews its overall facility needs in order to add or delete capacity.
Item 3.
Item 3. Legal Proceedings
Various legal actions arising in the ordinary course of business are pending against the Company. None of the litigation pending against the Company, individually or collectively, in the opinion of management, is expected to have a material adverse effect on the Company’s financial condition, results of operations, or liquidity.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5. Market for the Registrant’s Common Equity and Related Shareholder Matters
The Company’s common stock is traded on the New York Stock Exchange under the symbol NAP. The quarterly high and low trade price and the final day’s closing price of the Company’s common stock for each of the quarterly periods in 2001 and 2000 were as follows:
The number of holders of record of the Company’s common stock as of January 31, 2002 was 118. The Company believes it has significantly more than 118 beneficial holders of its common stock.
The Company has never declared or paid cash dividends on its common stock and has no plans to pay cash dividends in the foreseeable future. The declaration and payment of cash dividends on the Company’s common stock is at the discretion of the Company’s Board of Directors, and any decision to declare a dividend will be based on a number of factors, including, but not limited to, earnings, financial condition, borrowing covenants, and other factors deemed relevant.
The name and address of the Company’s common stock transfer agent and registrar is National City Bank, Corporate Trust Operations, P.O. Box 92301, Locator 5352, Cleveland, Ohio, 44139-0900, (800.622.6757).
Investors or analysts requiring further information should contact:
David E. Fountain 	
Chief Financial Officer 	
1231 Durrett Lane 	
Louisville, KY 40213-2008 	
(502.315.3311) 	
Item 6.
Item 6. Selected Financial Data
The following data should be read in conjunction with the Consolidated Financial Statements and related notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in Item 7.
Item 7.
(1)
This financial data includes the impact of the 	following acquisitions during the periods presented: on 	February 4, 1997, the Company acquired NTA, Inc., a freight 	payment processing company; on June 18, 1997, the Company 	acquired the operating assets and liabilities of InTraCon, Inc., 	a freight payment processing company; on June 20, 1997, the 	Company acquired the operating assets and liabilities of MRS 	Jamaica, Inc., a healthcare claim form processing company; on 	September 30, 1997, the Company acquired Caribbean Data 	Services, Ltd., a data processing company; on October 24, 	1997, the Company acquired 79.6% of the outstanding shares of FA 	Holdings, Inc., a debit and credit card processor; (the Company 	acquired the remaining outstanding shares of FA Holdings, Inc. 	on January 2, 1998); on January 15, 1998, the Company 	acquired JBH Travel Audit Inc., a commission audit and 	collections company; on December 31, 1999, the Company 	acquired a regional merchant processing portfolio from Heartland 	Payment Systems LLC; on June 28, 2001, the Company acquired 	a 70% ownership interest in ABN AMRO Merchant Services, LLC. 	Each of these transactions were accounted for as purchases; 	accordingly, the results of operations are included in the 	consolidated statements of operations from the respective 	acquisition dates. On January 8, 2001, the Company 	purchased the merchant services business units from several of 	National City’s banking subsidiaries. This acquisition was 	accounted for as a transaction among entities under common 	control and was recorded at the historical cost bases of 	National City. The results of operations of the National City 	Merchant Services business units have been included in the 	consolidated financial statements since the date of acquisition. 	
Effective April 1, 1999, the Company sold 	its Freight and Payables business lines. Effective June 1, 	1999, the Company sold its Check Acceptance and Remittance 	business lines. Effective August 29, 2000, the Company sold 	its Springfield remittance operation. Effective March 31, 	2001, the Company discontinued its Denver collections business. 	Effective August 29, 2001, the Company sold its Business 	Process Outsourcing business. 	
(2)
Included in net income (loss) are certain 	unusual items summarized as follows: for 2001, $3.9 million 	($4.6 million after-tax) of restructuring and divestiture 	expenses; for 2000, $8.6 million ($5.6 million 	after-tax) of impairment and site consolidation expenses; for 	1999, $71.7 million (also $71.7 million after-tax) of 	impairment, restructuring, and related expenses; for 1998, 	$1.4 million ($0.8 million after-tax) of net gains 	related to contract terminations; for 1997, $13.3 million 	($8.1 million after-tax) of impairment, restructuring, and 	related expenses. 	
Item 7.
Management’s Discussion and Analysis of 	Financial Condition and Results of Operations
Components of Revenue and Expenses
Revenue. The Company’s Merchant Card Services revenue is primarily derived from fees paid by merchants for the authorization, processing, and settlement of credit and debit card transactions. Fees are generated either on a per transaction basis or on a “discount” basis, which is a percent of dollar volume processed. Revenue is recorded net of interchange fees charged by the credit card associations as such costs are not controlled by the Company. Revenue is also derived from the sale of equipment used to process card transactions.
Payment Services revenue is generated from a variety of electronic payment settlement and reporting products. The majority of Payment Services revenue is earned from an exclusive long-term contract with the Airlines Reporting Corporation under which the Company is compensated on a “cost-plus” basis.
A portion of total revenue is derived from earnings on customer cash balances, which are maintained by NCBK pursuant to contract terms. For the years ended December 31, 2001, 2000, and 1999, this represented less than 2% of consolidated revenue.
Expenses. Expenses include costs of providing services to customers including wages and personnel costs, assessment fees, authorization fees, data processing costs, and general and administrative expenses.
Results of Operations
The Company’s operating results are presented below in the manner in which they are viewed by management. The Company divested certain business units during 2001 and 2000 in order to focus on its core competency of electronic payment settlement. Accordingly, the segment results presented below segregate the operating performance for the core business lines from those that were divested. Certain prior year amounts have been reclassified to conform with the 2001 presentation.
Year Ended December 31, 2001 Compared to Year Ended December 31, 2000
NM - Not Meaningful
Merchant Card Services
Revenue for 2001 increased 26% to $402.0 million from $317.9 million in 2000. The Company acquired National City’s merchant business units on January 8, 2001 and a 70% interest in ABN AMRO Merchant Services, LLC on June 28, 2001, which contributed $15.5 million and $17.7 million, respectively, of incremental revenue in 2001. Organic revenue growth, which excludes the impact of current year acquisitions, was 16% in 2001.
Transaction volume processed increased by 24% to 3.5 billion in 2001 from 2.8 billion in 2000. Dollar volume processed increased 23% to $156 billion in 2001 from $127 billion in 2000. Organic transaction and dollar volume growth increased 23% and 20%, respectively, in 2001. Organic transaction and dollar volume increased primarily due to the addition of new national customers, strong execution in regional sales channels and continued expansion in new vertical markets.
Expenses increased 23% to $325.0 million in 2001 from $263.5 million in 2000 primarily due to increased processing volumes. Operating margins as a percentage of revenue increased to 19% in 2001 from 17% in 2000, primarily due to economies of scale from increased volume and the National City and AAMS acquisitions. Due primarily to the factors listed above, operating profits increased 41% to $76.9 million in 2001 from $54.4 million in 2000.
Payment Services
Payment Services was formerly an operating unit within the Company’s Corporate Outsourcing Solutions segment. This segment was renamed Payment Services in 2001 after the sale of the BPO unit.
Revenue for 2001 decreased 18% to $30.1 million in 2001 from $36.5 million in 2000. Revenue decreased primarily due to decreased volume from the Company’s Airlines Reporting Corporation contract, which is the result of continuing conversion from paper to electronic reporting in the airline industry.
Expenses were $24.4 million in 2001, down 12% from $27.7 million in 2000 due primarily to decreased volume and staff reductions. Operating margins as a percentage of revenue decreased to 19% in 2001 from 24% in 2000. Operating profits decreased 35% to $5.8 million in 2001 from $8.8 million in 2000.
Divested Business Lines and Related Charges
In 2001, the Company divested its BPO business and exited its Denver collections business which were components of the former Corporate Outsourcing Solutions segment. Revenue from these divested businesses was $41.2 million, which represented 9% of the Company’s revenue in 2001. The sale of the BPO business unit to Affiliated Computer Services was completed on August 29, 2001, for $43.0 million in cash ($41.3 million after transaction related expenses). The Company recorded charges of $3.9 million ($4.6 million after-tax, or $0.09 per diluted share) related to the BPO divestiture. These charges consisted of a loss of $3.3 million ($4.2 million after-tax, or $0.08 per diluted share) on the sale of the business and a $0.6 million charge ($0.4 million after-tax, or $0.01 per diluted share) for severance costs related to fourth quarter organizational restructuring actions taken to reduce support costs associated with the BPO unit.
In 2000, the Company recorded charges of $8.6 million ($5.6 million after-tax, or $0.11 per diluted share) related to these business units. These charges consisted of $7.1 million ($4.6 million after-tax, or $0.09 per diluted share) to write-off goodwill and fixed assets for the Denver collections business and $1.5 million ($1.0 million after-tax, or $0.02 per diluted share) for site consolidation initiatives in the BPO unit.
Net Interest Income
Net interest income decreased 17% to $6.9 million in 2001 from $8.3 million in 2000 due primarily to lower average interest rates in 2001.
Provision for Income Taxes
The overall effective tax rate was 40.1% in 2001 compared to 38.4% in 2000. The increase in the effective tax rate was due to additional provisions related to the sale of the BPO unit due to repatriation of previously untaxed earnings for U.S. tax purposes. The increase in the effective tax rate was partially offset by differences in state income tax rates between legal entities within the Company due to recent acquisition and divestiture activity and a $0.3 million reduction in the valuation allowance for state net operating loss carry forwards.
Year Ended December 31, 2000 Compared to Year Ended December 31, 1999
NM - Not Meaningful
Merchant Card Services
Revenue for 2000 increased 20% to $317.9 million from $264.5 million in 1999. The Company acquired Heartland Payment Systems LLC on December 31, 1999, which contributed $15.1 million of incremental revenue in 2000. Organic revenue growth, which excludes the impact of current year acquisitions, was 14% in 2000.
Transaction volume processed increased by 26% to 2.8 billion in 2000 from 2.2 billion in 1999. Dollar volume processed increased 22% to $127 billion in 2000 from $104 billion in 1999. Organic transaction and dollar volume growth increased 24% and 20%, respectively, in 2000. The addition of new national customers, strong execution in regional sales channels, and continued expansion in new vertical markets led to the increase in organic transaction and dollar volume.
Expenses increased 13% to $263.5 million in 2000 from $232.2 million in 1999 primarily due to the customer base expansion and increased volumes. Operating margins as a percentage of revenue increased to 17% in 2000 from 12% in 1999, primarily due to increased revenue from higher margin regional merchants, economies of scale from increased volumes and cost savings initiatives. Operating expenses for 1999 also included $0.5 million ($0.3 million after-tax, or $0.01 per diluted share) for severance and other costs related to the closure of a processing facility. Operating profit increased 68% to $54.4 million in 2000 from $32.3 million in 1999.
Payment Services
Payment Services was formerly an operating unit within the Company’s Corporate Outsourcing Solutions segment. This segment was renamed Payment Services in 2001 after the sale of the BPO unit.
Revenue for 2000 of $36.5 million was down slightly from $36.8 million in 1999. Revenue declined primarily due to decreased volume from the Company’s Airlines Reporting Corporation contract, which was the result of the continuing conversion from paper to electronic reporting in the airline industry.
Expenses were $27.7 million, down 7% from $29.8 million due to cost savings initiatives and decreased volume. Operating margins as a percentage of revenue increased to 24% from 19% as a result of improved productivity and other cost saving initiatives. As a result, operating profit increased 27% to $8.8 million in 2000 from $7.0 million in 1999.
Divested Business Lines and Related Charges
Divested business lines are comprised of the Remittance, Payables, Freight, and Check Acceptance business lines that were sold by the Company in the first half of 1999, the Denver collections operation discontinued in March 2001, and the Business Process Outsourcing business unit sold in August 2001.
In 2000, the Company recorded charges of $8.6 million ($5.6 million after-tax, or $0.11 per diluted share) related to these business units. These charges consisted of $7.1 million ($4.6 million after-tax, or $0.09 per diluted share) to write-off goodwill and fixed assets for the Denver collections business and $1.5 million ($1.0 million after-tax, or $0.02 per diluted share) for site consolidation initiatives in the BPO unit.
In 1999, the Company recorded charges of $71.7 million ($71.7 million after-tax, or $1.42 per diluted share) related to these business units. These charges consisted of $69.5 million ($69.9 million after-tax, or $1.38 per diluted share) for impairment and associated expenses related to the sale of the Freight, Payables, Remittance, and Check Acceptance business lines and a $2.2 million ($1.8 million after-tax, or $0.04 per diluted share) restructuring charge related to the closure of a BPO facility. The Freight, Payables, Remittance, and Check Acceptance business lines were sold in the first half of 1999 for $62.6 million in cash.
Net Interest Income
Net interest income increased to $8.3 million in 2000 from $4.5 million in 1999 due to higher interest rates in 2000 compared to 1999 and increased levels of cash and investments due to the receipt of sale proceeds from the business lines that were divested in the first half of 1999, as well as cash flow from operations.
Provision for Income Taxes
The overall effective tax rate was 38.4% in 2000. The 2000 provision for income taxes was lowered by $1.1 million due to a reduction in the valuation allowance for state net operating loss carry forwards. The 1999 provision for income taxes included the effect of the write-off of $65.7 million of nondeductible goodwill related to the divested business lines.
Liquidity and Capital Resources
The Company’s primary uses of capital resources include capital expenditures, working capital and acquisitions. Future business acquisitions may be funded through current liquidity, borrowed funds, and/or issuances of common stock.
The Company’s capital expenditures include amounts for computers, external and internally developed software, as well as improvements to operating facilities. During 2001, the Company’s capital expenditures totaled $20.1 million. Such expenditures were financed from operating cash flow, which for 2001 totaled $49.9 million. Capital expenditures and operating cash flow for 2000 were $14.4 million and $45.1 million, respectively. Operating cash flow increased 11% in 2001 compared to 2000 due to improved profits and the timing of tax payments between the Company and National City, offset by higher accounts receivable
balances at year end. The Company expects capital expenditures for 2002 to be comparable to 2001 which will be principally used to enhance merchant card processing capabilities.
On January 8, 2001, the Company acquired the merchant services business units from several National City banking subsidiaries for $44.0 million in cash.
On June 28, 2001, the Company acquired a 70% ownership interest in AAMS for $48.5 million in cash.
On August 29, 2001, the Company completed the sale of the BPO unit to Affiliated Computer Services, Inc. for $43.0 million cash ($41.3 million after transaction related expenses).
As the Company does not carry significant amounts of inventory and historically has experienced short collection periods for its accounts receivable, it does not require substantial working capital to support revenue growth. Working capital requirements will vary depending upon future acquisition activity. Increases in working capital needs are expected to be financed through operating cash flow and current cash balances.
Effects of September 11 Terrorist Attacks
The terrorist attacks in New York and Washington on September 11, 2001, led to reduced levels of air travel. The Company currently processes credit card transactions for six of the top ten United States airlines, and the majority of its Payment Services business is also tied to the travel industry. Travel-related customers, principally airlines, represented approximately 13% of revenue from continuing businesses for the year ended December 31, 2001, 6% from Merchant Card Services and 7% from Payment Services. To the extent future air travel continues at levels below historical trends, that portion of Merchant Card Services and Payment Services revenue will be impacted. There is less revenue exposure in the Payment Services business due to the cost-plus contract with the Airlines Reporting Corporation and contractual minimums with other travel-related customers.
The unprecedented slowdown in air travel, combined with the costs of additional security measures, has raised questions about the ongoing financial viability of the airline industry. In the event of bankruptcy liquidation of one or more of the Company’s airline customers, the Company could become financially responsible for refunding tickets purchased through VISA® or MasterCard ® under the chargeback rules of those associations. See Commitments and Contingencies, Note L to Consolidated Financial Statements.
In the near term, management believes that airline bankruptcy liquidations are highly unlikely given the recent Federal financial support for the airline industry. In November 2001, Congress passed the Aviation and Transportation Security Act which requires airlines to honor tickets for other airlines that may suspend, interrupt or discontinue service due to insolvency or bankruptcy. Considering the foregoing and in light of other actions taken to mitigate the situation, management believes the likelihood of any material loss under the chargeback rules is remote.
Recent Accounting Pronouncements
Goodwill and Other Intangible Assets
In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards (SFAS) 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets. SFAS 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting and broadens the criteria for recording intangible assets separate from goodwill. Under the provisions of SFAS 142, goodwill and certain other intangible assets, which do not possess finite useful lives, will no longer be amortized over the estimated life but rather will be tested at least annually for impairment based on specific guidance provided in the new standard. Intangible assets determined to have finite lives will continue to be amortized over their estimated useful lives and also continue to be subject to impairment testing.
The provisions of SFAS 142 were adopted by the Company as required effective January 1, 2002. Application of the nonamortization provisions of the statement is expected to reduce amortization expense by approximately $3.2 million pre-tax, resulting in an increase in net income of approximately $2.6 million, or
$0.05 per diluted share, in 2002 as compared to 2001. SFAS 142, as part of its adoption provisions, requires a transitional impairment test to be applied to all goodwill and other indefinite-lived intangible assets prior to June 30, 2002 and any resulting impairment loss be reported as a change in accounting principle. Management does not expect an impairment loss to be recorded in 2002 as a result of adoption. The Company currently does not have any other indefinite-lived intangible assets on its balance sheet. It is also anticipated there will not be any material categorical reclassifications or adjustments to the useful lives of finite-lived intangible assets as a result of adopting the new guidance.
In general, application of the new provisions may result in more income statement volatility due to the potential periodic recognition of impairment losses, which are likely to vary in amount and regularity, for goodwill and other indefinite-lived intangible assets, versus reducing those assets through the recognition of recurring, consistent amortization amounts.
Accounting for Long-Lived Assets
SFAS 144, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, was issued in October 2001 and addresses how and when to measure impairment on long-lived assets and how to account for long-lived assets that an entity plans to dispose of either through sale, abandonment, exchange, or distribution to owners. The new provisions supersede SFAS 121, which addressed asset impairment, and certain provisions of APB Opinion 30 related to reporting the effects of the disposal of a business segment and requires expected future operating losses from discontinued operations to be recorded in the period in which the losses are incurred rather than the measurement date. Under SFAS 144, more dispositions may qualify for discontinued operations treatment in the income statement. The provisions of SFAS 144 became effective for the Company January 1, 2002 and are not expected to have a material impact on the Company’s results of operations, financial position, or liquidity.
Forward Looking Statements and Risk Factors
Item 1 (the sections entitled Industry Overview, Merchant Card Services, Payment Services, and Regulation), Item 2 (entitled Properties), Item 3 (entitled Legal Proceedings), Item 5 (entitled Market for the Registrant’s Common Equity and Related Shareholder Matters), Item 7 (entitled Liquidity and Capital Resources, Effect of September 11 Terrorist Attacks, and Recent Accounting Pronouncements), and Item 7A
Item 7A. Quantitative and Qualitative Disclosure About Market Risk
Derivative Instruments
The Company does not use derivative instruments.
Market Risk of Financial Instruments
The Company’s primary market risk exposure with regard to financial instruments is to changes in interest rates. As of December 31, 2001, the Company had $101 million in unrestricted cash and cash equivalents. For the year ended December 31, 2001, NCBK also held an average of approximately $150 million of customer funds, on which the Company earns interest.
Because of the short-term nature of these instruments, a sudden change in market interest rates would not impact the fair value of these instruments. The Company’s earnings, however, are impacted by changes in interest rates, affecting both interest earnings on the Company’s cash equivalents and interest earnings on customer funds maintained by NCBK. At December 31, 2001, a hypothetical 100 basis point increase in short-term interest rates would result in an increase of approximately $3 million in annual pre-tax earnings. A hypothetical 100 basis point decrease in short-term interest rates would result in a decrease of approximately $3 million in annual pre-tax earnings.
Item 8.
Item 8. Financial Statements and Supplementary Data
See Index to Consolidated Financial Statements at Item 14.
Item 9.
Item 9.
Changes in and Disagreements with Accountants 	on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The Executive Officers of the Company as of January 31, 2002 were as follows:
An executive officer will serve until his successor is chosen and qualified. There is no family relationship between any of the executive officers.
Mr. Wimsett was appointed President and Chief Executive Officer in September 1999. Mr. Wimsett previously served as Executive Vice President of NPC’s Merchant Card Services Division from 1997 to 1999 and as President of NPC Check Services from 1995 to 1997. Mr. Wimsett has held various management positions at NPC from 1983 to 1995.
Mr. Pyke was appointed Chief Operating Officer in October 2001. Mr. Pyke previously served as Executive Vice President - Merchant Card Services from October 1999 to October 2001 and was a Senior Vice President of the Merchant Card Services Division from 1998 to 1999. Mr. Pyke held a variety of management positions in NPC’s Merchant Card Services Division from 1996 to 1998. Prior to joining NPC,
Mr. Pyke spent four years with NaBANCO, a merchant credit card processing subsidiary of First Data Corporation.
Mr. Martin was appointed as Executive Vice President - Merchant Card Services Product Management in January 2000. Mr. Martin previously served as President of Client Merchant Services for First Data Corporation from 1997 to 1998 and was an Executive Vice President for First Data Corporation from 1995 to 1997. Before working with First Data Corporation, Mr. Martin served in various positions at NPC for over 25 years.
Mr. Robins was appointed Executive Vice President - Business Development in November 2000. Mr. Robins was employed by Visa U.S.A. from 1989 to 2000 and served as Executive Vice President of Market Development and Acceptance from 1996 to 2000.
Mr. Fountain was appointed Chief Financial Officer in October 1999. Mr. Fountain was appointed interim Chief Financial Officer in July 1999 and served as Senior Vice President - Chief Accounting Officer from 1998 to 1999. Mr. Fountain held a variety of financial management positions with NPC from 1996 to 1998. Before working with NPC, from 1983 to 1995, Mr. Fountain held various financial management positions in the credit card industry with Total System Services, Inc., MBNA Corporation and Associates First Capital.
Mr. Lanham was appointed Chief Accounting Officer in May 2000. Mr. Lanham joined NPC in November 1999 as Vice President - Corporate Controller. From 1991 to 1999, Mr. Lanham was employed by Arthur Andersen, serving as a manager in the firm’s Audit and Business Advisory division from 1996 to 1999.
The other information required by Item 10 is incorporated by reference from the Company’s Definitive Proxy Statement to be dated approximately March 6, 2002.
Item 11.
Item 11. Executive Compensation
Incorporated by reference from the Company’s Definitive Proxy Statement to be dated approximately March 6, 2002.
Item 12.
Item 12.
Security Ownership of Certain Beneficial 	Owners and Management
Incorporated by reference from the Company’s Definitive Proxy Statement to be dated approximately March 6, 2002.
Item 13.
Item 13.
Certain Relationships and Related 	Transactions
Incorporated by reference from the Company’s Definitive Proxy Statement to be dated approximately March 6, 2002.
PART IV
Item 14.
Item 14.
Exhibits, Financial Statement Schedules and 	Reports on Form 8-K
(a) 1. Financial Statements
2. Financial Statement Schedules
Omitted due to inapplicability or because required information is shown in the Company’s consolidated financial statements or notes thereto.
3. Exhibits
The index of exhibits has been filed as separate pages of the 2001 Form 10-K and is available to shareholders on request from the Secretary of the Company at the principal executive offices. Copies of the exhibits may be obtained at a cost of 30 cents per page.
(b) Reports on Form 8-K
October 17, 2001: The Registrant issued a news release reporting earnings for the quarter and nine months ended September 30, 2001.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on February 20, 2002.
NATIONAL PROCESSING, INC. 	
By:
/s/ DAVID E. FOUNTAIN
Senior Vice President and Chief 	
Financial Officer 	
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated.
*
The undersigned by signing his name hereto, does 	sign and execute the Annual Report on Form 10-K for fiscal 	year 2001 pursuant to the Power of Attorney executed by the 	above named Directors of the Company and which have been filed 	with the Securities Exchange Commission on behalf of such 	directors. 	
By:
/s/ CARLTON E. LANGER
Carlton E. Langer 	
As Attorney-in-Fact 	
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
Shareholders and Board of Directors
National Processing, Inc.
We have audited the accompanying consolidated balance sheets of National Processing, Inc. and subsidiaries (a majority owned subsidiary of National City Corporation) as of December 31, 2001 and 2000, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of National Processing, Inc.’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Processing, Inc. and subsidiaries at December 31, 2001 and 2000, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States.
/s/ Ernst & Young LLP 	
Cleveland, Ohio
January 23, 2002
NATIONAL PROCESSING, INC.
Consolidated Balance Sheets
See notes to consolidated financial statements.
NATIONAL PROCESSING, INC.
Consolidated Statements of Operations
See notes to consolidated financial statements.
NATIONAL PROCESSING, INC.
Consolidated Statements of Changes in Shareholders’ Equity
See notes to consolidated financial statements.
NATIONAL PROCESSING, INC.
Consolidated Statements of Cash Flows
See notes to consolidated financial statements.
NATIONAL PROCESSING, INC.
Notes to Consolidated Financial Statements
A. Organization and Business
Organization
National Processing, Inc. and subsidiaries (the “Company”) is a provider of electronic payment processing and is headquartered in Louisville, Kentucky. The Company is 86% owned by National City Corporation (“National City”), a financial holding company headquartered in Cleveland, Ohio.
The Company and National City are parties to a registration rights agreement whereby National City has the right to require the Company to use its best efforts to register under the Securities Act of 1933, as amended, all or a portion of the issued and outstanding common stock held by National City. National City also has the right to participate, or “piggy-back”, in equity offerings initiated by the Company, subject to a reduction of the size of the offering on the advice of the managing underwriter.
Business
The Company operates two business segments, Merchant Card Services and Payment Services. Merchant Card Services authorizes, processes, and performs financial settlement and reporting of card transactions including credit, debit, stored value, and electronic benefits transfer (“EBT”). Merchant Card Services represented 85% of the Company’s revenue in 2001 and provides services to over 600,000 merchant locations primarily in the United States.
Payment Services was formerly an operating unit within the Company’s Corporate Outsourcing Solutions segment. This segment was renamed Payment Services in 2001 after the sale of the Business Process Outsourcing (“BPO”) unit. Payment Services provides financial settlement and reporting solutions to large and mid-size corporate customers in the travel service and healthcare industries. Payment Services settles 100% of domestic airline tickets sold through travel agencies in the United States. Payment Services also settles commission payments for car rental companies, cruise line operators, and hotels.
Sponsorship Agreement
The Company and National City are parties to a sponsorship agreement (the “Sponsorship Agreement”) whereby the Company acts as National City’s sole agent for the purposes of providing electronic data authorization and capture, reporting, settlement, and clearing services for merchants who participate in Visa® and MasterCard ® programs. The Company, along with other nonbank processors, must be sponsored by a financial institution that is a member of the Visa® and MasterCard ® associations. National City, being a member of such associations, acts as the Company’s sole sponsor under the terms of the Sponsorship Agreement.
The Company retains full responsibility for performance of Merchant Card Services, except for certain obligations or responsibilities of National City pursuant to the Sponsorship Agreement. The Sponsorship Agreement provides that the Company will comply with (1) all Visa® and MasterCard ® bylaws, manuals and operating regulations and other written materials as they from time to time are amended which bind or apply to National City as a member of Visa® and MasterCard ® with respect to Merchant Card Services or to the Company as a third party processor, (2) all agreements between merchants and National City with respect to Merchant Card Services, and (3) all applicable federal or state laws and regulations. Under the Sponsorship Agreement, the Company will receive all fees, discounts and other amounts payable by merchants for Merchant Card Services and will bear the expenses of maintaining facilities necessary to provide such services. Certain indemnification provisions are also contained in the Sponsorship Agreement, under which the Company will indemnify National City against losses, claims or other amounts arising out of the Company’s failure to perform in accordance with the terms of the Sponsorship Agreement due to negligence of the Company.
NATIONAL PROCESSING, INC.
Notes to Consolidated Financial Statements - (Continued)
B. Summary of Significant Accounting Policies
Principles of Consolidation and Basis of Presentation
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. Beginning June 29, 2001, the consolidated financial statements also include the Company’s 70% ownership interest in ABN AMRO Merchant Services, LLC (“AAMS”) (see Note D). All significant intercompany transactions and balances have been eliminated in consolidation. The accounting and reporting policies of the Company conform with accounting principles generally accepted in the United States.
Financial statements prepared in accordance with accounting principles generally accepted in the United States require the use of estimates and assumptions by management that affect the reported amounts of revenue and expenses, assets and liabilities, and the disclosure requirements for contingent assets and liabilities during and at the date of the financial statements. Consequently, actual results could differ from those estimates.
Revenue Recognition
The Company recognizes as revenue the amounts charged to its customers for processing activities at the time services are rendered. Revenue is recorded net of interchange fees charged by the credit card associations as such costs are not controlled by the Company.
A portion of total revenue is derived from earnings on customer cash balances, which are maintained by NCBK pursuant to contract terms. For the years ended December 31, 2001, 2000, and 1999, this represented less than 2% of consolidated revenue.
Cash, Cash Equivalents, and Eurodollar Deposits
Cash equivalents consist of highly liquid bank overnight repurchase agreements, which are readily convertible to cash. Eurodollar deposits are short-term deposits with maturities of less than one year. These securities are stated at cost, which approximates fair value.
Property and Equipment
Property and equipment is stated at cost and depreciated on a straight-line basis over the estimated useful life or term of the lease, whichever is shorter. Maintenance and repairs are expensed as incurred, while improvements that extend the useful life of the related asset are capitalized and depreciated over the remaining life of the related asset.
The Company capitalizes certain costs incurred to develop or obtain internal-use software. For purposes of amortization and impairment, capitalized costs are treated in the same manner as other long-lived assets. To be considered as internal-use software, the software is either acquired, internally developed, or modified solely to meet the Company’s internal needs with no plans to market the software externally. Project costs that are considered research and development costs are expensed as incurred. Capitalized software development and purchased software costs are recorded at cost. Commencing the month following project completion, these costs are amortized on a straight-line basis over the estimated useful life of the software.
NATIONAL PROCESSING, INC.
Notes to Consolidated Financial Statements - (Continued)
The ranges of estimated useful lives are as follows:
Upon the sale or disposal of property or equipment, the cost and accumulated depreciation accounts are adjusted accordingly and any gain or loss is recognized in income. Depreciation expense, including depreciation expense on property leased from affiliates, was $12.0 million, $14.2 million, and $15.8 million in 2001, 2000, and 1999, respectively.
Other Intangible Assets
Other intangible assets are composed primarily of acquired merchant portfolios which represent costs allocated to customer contracts acquired through acquisitions. These costs are amortized on a straight-line basis over periods ranging from 7 to 10 years.
Goodwill
Operating results of companies acquired in purchase transactions are included in the consolidated statements of operations from their respective acquisition dates. The excess of the purchase price over the net assets acquired (goodwill) is amortized on a straight-line basis over 40 years.
Effective January 1, 2002, the Company adopted SFAS 142, Goodwill and Other Intangible Assets, which changes the way goodwill is amortized. See Note C for further discussion of the impact of this new accounting pronouncement on the Company’s financial statements.
Asset Impairment
Long-lived assets to be held and those to be disposed of and certain intangibles are evaluated for impairment using the guidance provided by Statement of Financial Accounting Standards (“SFAS”) No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of. The provisions of this statement establish when an impairment loss is recognized and how it is measured.
Effective January 1, 2002, the Company adopted SFAS 144, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, which changes the way asset impairment is measured. See Note C for further discussion of the impact of this new accounting pronouncement on the Company’s financial statements.
Accrued Bankcard Assessments
Liabilities to Visa® and MasterCard ® originating from the Company’s agreements with these agencies, as an authorized processor, are accrued and settled on a monthly and quarterly basis, respectively. The Company recovers these assessment charges through various contractual arrangements with its customers.
Income Taxes
The Company is included in the consolidated federal income tax return of National City. National City allocates income taxes to its subsidiaries on a separate return basis. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying
NATIONAL PROCESSING, INC.
Notes to Consolidated Financial Statements - (Continued)
amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.
Reclassifications
Certain prior year amounts have been reclassified to conform with the 2001 presentation.
C. Recent Accounting Pronouncements
Goodwill and Other Intangible Assets
In June 2001, the Financial Accounting Standards Board issued SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets. SFAS 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting and broadens the criteria for recording intangible assets separate from goodwill. Under the provisions of SFAS 142, goodwill and certain other intangible assets, which do not possess finite useful lives, will no longer be amortized into net income over an estimated life but rather will be tested at least annually for impairment based on specific guidance provided in the new standard. Intangible assets determined to have finite lives will continue to be amortized over their estimated useful lives and also continue to be subject to impairment testing.
The provisions of SFAS 142 were adopted by the Company as required effective January 1, 2002. Application of the nonamortization provisions of the statement is expected to reduce amortization expense by approximately $3.2 million pre-tax, resulting in an increase in net income of approximately $2.6 million, or $0.05 per diluted share, in 2002 as compared to 2001. SFAS 142, as part of its adoption provisions, requires a transitional impairment test be applied to all goodwill and other indefinite-lived intangible assets prior to June 30, 2002 and any resulting impairment loss be reported as a change in accounting principle. Management does not expect an impairment loss to be recorded in 2002 as a result of adoption. The Company currently does not have any other indefinite-lived intangible assets on its balance sheet. It is also anticipated there will not be any material categorical reclassifications or adjustments to the useful lives of finite-lived intangible assets as a result of adopting the new guidance.
In general, application of the new provisions may result in more income statement volatility due to potential periodic recognition of impairment losses, which are likely to vary in amount and regularity, for goodwill and other indefinite-lived intangible assets, versus reducing those assets through the recognition of recurring, consistent amortization amounts.
Accounting for Long-Lived Assets
SFAS 144, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, was issued in October 2001 and addresses how and when to measure impairment on long-lived assets and how to account for long-lived assets that an entity plans to dispose of either through sale, abandonment, exchange, or distribution to owners. The new provisions supersede SFAS 121, which addressed asset impairment, and certain provisions of APB Opinion 30 related to reporting the effects of the disposal of a business segment and requires expected future operating losses from discontinued operations to be recorded in the period in which the losses are incurred rather than the measurement date. Under SFAS 144, more dispositions may qualify for discontinued operations treatment in the income statement. The provisions of SFAS 144 became effective for the Company January 1, 2002 and are not expected to have a material impact on the Company’s results of operations, financial position, or liquidity.
NATIONAL PROCESSING, INC.
Notes to Consolidated Financial Statements - (Continued)
D. Acquisitions
On June 28, 2001, the Company acquired a 70% ownership interest in ABN AMRO Merchant Services, LLC for $48.5 million in cash. Under the terms of the agreement, the Company provides AAMS with all merchant processing services including both authorization and settlement of all card-based transactions. The acquisition, accounted for as a purchase, increased the Company’s goodwill by approximately $27 million. The remainder of the purchase price was allocated to other indentifiable intangibles, primarily acquired merchant contracts, which are being amortized on a straight-line basis over 10 years. The results of operations of AAMS have been included in the consolidated financial statements since the date of its acquisition. Incremental revenue as a result of this acquisition was $17.7 million for 2001.
On January 8, 2001, the Company purchased the merchant services business units from several of National City’s banking subsidiaries for $44.0 million in cash. This acquisition included merchant contracts and additional sales personnel. The Company also assumed responsibility for all merchant processing sales efforts throughout National City’s 1,200 branch network via an exclusive multi-year marketing agreement. The Company had previously provided the authorization and settlement processing for these merchants via a third party processing contract with National City. For the year 2001, the Company recorded $15.5 million of incremental revenue as a result of this acquisition. The acquisition was accounted for as a transaction among entities under common control and was recorded at the historical cost basis of National City. The excess of the cash paid over the historical cost bases was recorded as a reduction in shareholder’s equity, net of income taxes of $15.4 million. The results of operations of the National City merchant services business units have been included in the consolidated financial statements since the date of acquisition.
On December 31, 1999, the Company acquired a merchant processing portfolio from Heartland Payment Systems LLC for $23 million. Amounts paid were recorded as acquired merchant portfolios, which is included in other intangible assets in the accompanying balance sheet and are being amortized over 10 years.
E. Divested Business Units and Related Charges
In 2001, the Company divested its BPO business and exited its Denver collections business which were components of the former Corporate Outsourcing Solutions segment. Revenue from these divested businesses was $41.2 million, which represented 9% of the Company’s revenue in 2001. The sale of the BPO unit to Affiliated Computer Services (“ACS”) was completed on August 29, 2001 for $43.0 million in cash ($41.3 million after transaction related expenses).
During 2001, the Company recorded charges of $3.9 million ($4.6 million after-tax, or $0.09 per diluted share) related to the BPO divestiture. These charges consisted of a loss of $3.3 million ($4.2 million after-tax, or $0.08 per diluted share) on the sale of the business and a $0.6 million ($0.4 million after-tax, or $0.01 per diluted share) charge for severance costs related to fourth quarter organizational restructuring actions taken to reduce support costs associated with the BPO unit.
In 2000, the Company recorded charges of $8.6 million ($5.6 million after-tax, or $0.11 per diluted share) related to these business units. These charges consisted of $7.1 million ($4.6 million after-tax, or $0.09 per diluted share) to write-off goodwill and fixed assets for the Denver collections business and $1.5 million ($1.0 million after-tax, or $0.02 per diluted share) for site consolidation initiatives in the BPO unit.
In 1999, the Company recorded charges of $71.7 million ($71.7 million after-tax, or $1.42 per diluted share) related to divested business units. These charges consisted of $69.5 million for ($69.9 million after-tax, or $1.38 per diluted share) for impairment and associated expenses related to the sale of the Freight, Payables, Remittance, and Check Acceptance business lines and a $2.2 million ($1.8 million after-tax, or $0.04 per diluted share) restructuring charge related to the closure of a BPO facility. The Freight, Payables, Remittance, and Check Acceptance business lines were sold in the first half of 1999 for $62.6 million in cash.
NATIONAL PROCESSING, INC.
Notes to Consolidated Financial Statements - (Continued)
F. Transactions with Affiliates
The Company leases certain facilities from National City Bank of Kentucky (“NCBK”), a wholly owned subsidiary of National City, under long-term agreements classified as “Property Leased From Affiliate” in the accompanying balance sheets. Future minimum payments under this lease, which expires in 2019, are $3.2 million, including interest of $1.3 million. Future minimum payments under these leases, including interest, for the next five years are $0.2 million per year.
Substantially all of the Company’s cash and Eurodollar deposits are held by NCBK. The majority of interest income and earnings on customer balances included in the Consolidated Statements of Operations are derived from NCBK accounts.
Prior to the divestiture of the Remittance business line, the Company used the proof and transit department of NCBK to provide processing for remittances. The charges for these services, which are included in operating expenses, were $1.6 million in 1999.
The Company receives certain administrative services, such as internal audit and legal services, from National City and its affiliates. The Company also utilizes NCBK for the majority of its banking services. Charges for these services are included in general and administrative expenses and totaled $1.6 million, $1.8 million, and $1.6 million in 2001, 2000, and 1999, respectively. As of December 31, 2001 and 2000, no amounts were due to or from National City.
On January 8, 2001, the Company acquired the merchant services business units from several National City banking subsidiaries for $44.0 million, which was paid in cash at closing (see Note D).
G. Operating Leases
The Company leases various offices, facilities, and equipment under noncancellable lease agreements with expiration dates through 2019. During the normal course of business, most of these leases will be renewed or replaced by other leases. Future minimum rental payments under these leases are $1.5 million in 2002, $1.3 million in 2003, $1.1 million in 2004, $1.0 million in 2005, $0.9 million in 2006 and $6.7 million thereafter. Rent expense under operating leases was $2.9 million, $3.7 million, and $4.8 million in 2001, 2000, and 1999, respectively.
H. Income Taxes
The provision for income taxes consists of the following (in thousands):
NATIONAL PROCESSING, INC.
Notes to Consolidated Financial Statements - (Continued)
The temporary differences that gave rise to deferred tax assets and liabilities at December 31 are as follows (in thousands):
The reconciliation of the Company’s income tax provisions and the amounts computed by applying the U.S. statutory income tax rate to income before taxes is as follows (in thousands):
For 2001 and 2000, income tax benefits of $4.6 million and $0.1 million respectively, were received related to the exercise of nonqualified employee stock options. This benefit is recorded directly to shareholders’ equity.
As of December 31, 2001, the Company has approximately $21.0 million of state net operating loss carryforwards for income tax purposes available to offset future taxable income in the related states which expire through 2014. The Company believes that it is more likely than not that future taxable income will be generated in these states sufficient to justify the deferred tax assets recorded. The valuation allowance decreased in both 2001 and 2000 as the result of changes in the estimated realizability of the related deferred tax assets due to improved operating results.
NATIONAL PROCESSING, INC.
Notes to Consolidated Financial Statements - (Continued)
Income before taxes from foreign operations was $1.3 million, $2.6 million and $6.8 million, respectively, in 2001, 2000 and 1999. Income (loss) before income taxes from U.S. operations was $88.0 million, $67.9 million, and ($26.5) million, respectively, in 2001, 2000, and 1999.
I. Employee Benefit Plans
The Company offers a 401(k) savings plan to all employees who meet certain age and eligibility requirements. The plan is funded by employee contributions and discretionary matching contributions by the Company. The Company recorded $2.1 million, $1.4 million, and $2.5 million in matching contribution expense during 2001, 2000, and 1999, respectively.
J. Net Income (Loss) Per Common Share
The calculation of net income (loss) per common share follows (in thousands, except per share amounts):
For 1999 the effect of stock options was antidilutive.
K. Stock Options
The Company maintains various stock-based compensation plans that allow for the granting of stock options to eligible employees and directors. The Company has elected not to adopt the recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, which requires a fair-value based method of accounting for stock options and similar equity awards, and continues to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations to account for its stock-based compensation plans.
The stock option plans originally authorized the issuance to officers, directors, and key employees of up to 9,200,000 options to purchase shares of common stock at the fair value of the common stock on the date of grant. These options generally become exercisable 33% annually beginning one year from the date of grant and expire not later than ten years from the date of grant.
NATIONAL PROCESSING, INC.
Notes to Consolidated Financial Statements - (Continued)
A summary of stock option activity follows:
Information about stock options outstanding at December 31, 2001 follows:
For purposes of providing the pro forma disclosures required under SFAS 123, the fair value of stock options granted in 2001, 2000, and 1999 was estimated at the date of grant using a Black-Scholes option pricing model. The Black-Scholes option pricing model was originally developed for use in estimating the fair value of traded options, which have different characteristics than the Company’s employee stock options. The model is also sensitive to changes in the subjective assumptions, which can materially affect the fair value estimate. As a result, management believes the Black-Scholes model may not necessarily provide a reliable single measure of the fair value of employee stock options.
Had compensation cost for the Company’s stock-based compensation plans been determined consistent with SFAS 123, net income (loss) and diluted earnings (loss) per share would have been $48.2 million and $0.93 for 2001, $41.7 million and $0.82 for 2000, and $(35.0) million and $(0.69) for 1999, respectively. The effects of applying SFAS 123 in 2001, 2000, and 1999 may not be representative of the pro forma impact in future years.
NATIONAL PROCESSING, INC.
Notes to Consolidated Financial Statements - (Continued)
The following weighted-average assumptions were used in the option-pricing model:
On May 10, 2001 the shareholders of the Company approved the National Processing, Inc. 2001 Restricted Stock Plan. Under the terms of the plan, the Company may issue up to 500,000 shares of common stock to officers and key employees. In the third quarter of 2001, the Company issued 32,500 shares of restricted stock. The stock awards were provided in recognition of future contributions to the continuing success of the company. In general, the restrictions on shares granted expire within a four year period. The Company recognized $0.2 million of compensation expense in 2001 related to these restricted stock awards. As of December 31, 2001, 29,000 shares of restricted stock were outstanding.
L. Commitments and Contingencies
Chargebacks - General
Under the rules of Visa® and MasterCard ® , when a merchant processor acquires card transactions, it has certain contingent liabilities for the transactions processed. This contingent liability arises in the event of a billing dispute between the merchant and a cardholder that is not ultimately resolved in the merchant’s favor. In such a case, the transaction is “charged back” to the merchant and the disputed amount is credited or otherwise refunded to the cardholder. If the Company is unable to collect this amount from the merchant’s account, and if the merchant refuses or is unable to reimburse the Company for the chargeback due to bankruptcy or other reasons, the Company will bear the loss for the amount of the refund paid to the cardholder. In most cases, this contingent liability situation is unlikely to arise because most products or services are delivered when purchased, and credits are issued on returned items. However, where the product or service is not provided until some later time following the purchase, the contingent liability could be more likely. The Company mitigates its contingent liability risk by instructing NCBK to withhold certain settlement funds due to merchants based on contractual terms. As of December 31, 2001, NCBK had $64.7 million of customer deposits and withheld settlement funds. Management believes the likelihood of any material loss under the chargeback rules is remote.
Chargebacks - Airline Exposure
The terrorist attacks in New York and Washington on September 11, 2001, led to reduced levels of air travel. The Company currently processes credit card transactions for six of the top ten United States airlines, and the majority of its Payment Services business is also tied to the travel industry. Travel-related customers, principally airlines, represented approximately 13% of revenue from continuing businesses for the year ended December 31, 2001, 6% from Merchant Card Services and 7% from Payment Services. To the extent future air travel continues at levels below historical trends, that portion of Merchant Card Services and Payment Services revenue will be impacted. There is less revenue exposure in the Payment Services business due to the cost-plus contract with the Airlines Reporting Corporation and contractual minimums with other travel-related customers.
The unprecedented slowdown in air travel, combined with the costs of additional security measures, has raised questions about the ongoing financial viability of the airline industry. In the event of bankruptcy liquidation of one or more of the Company’s airline customers, the Company could become financially
NATIONAL PROCESSING, INC.
Notes to Consolidated Financial Statements - (Continued)
responsible for refunding tickets purchased through VISA® or MasterCard ® under the chargeback rules of those associations.
In the near term, management believes that airline bankruptcy liquidations are highly unlikely given the recent Federal financial support for the airline industry. In November 2001, Congress passed the Aviation and Transportation Security Act which requires airlines to honor tickets for other airlines that may suspend, interrupt or discontinue service due to insolvency or bankruptcy. Considering the foregoing and in light of other actions taken to mitigate the situation, management believes the likelihood of any material loss under the chargeback rules is remote.
Litigation
In the normal course of business, the Company is involved in litigation from time to time. In the opinion of management, the ultimate liability, if any, arising from this litigation is not expected to have a material adverse effect on the Company’s financial condition, results of operations, or liquidity.
M. Quarterly Results of Operations (Unaudited):
Selected quarterly data for 2001 and 2000 are as follows (in thousands, except per share amounts):
The above financial data for 2001 includes a net charge of $3.9 million ($4.6 million after-tax, or $0.09 per diluted share). This net charge consists of a second quarter charge of $6.3 million ($6.2 million after-tax, or $0.12 per diluted share), which was partially offset by a net positive adjustment of $2.4 million ($1.5 million after-tax, or $0.03 per diluted share) in the fourth quarter. The second quarter charge related to the Company’s divestiture of its BPO unit. The net fourth quarter gain represented a $3.0 million ($1.9 million after-tax) favorable adjustment to the BPO divestiture charge, partially offset by $0.6 million ($0.4 million after-tax) charge for severance costs related to fourth quarter organizational restructuring actions taken to reduce support costs associated with the BPO unit.
The above financial data for 2000 includes total nonrecurring charges of $8.6 million ($5.6 million after-tax, or $0.11 per diluted share). These charges consisted of a second quarter charge of $1.5 million ($1.0 million after-tax, or $0.02 per diluted share) for site consolidation initiatives in the BPO unit and a fourth quarter impairment charge of $7.1 million ($4.6 million after-tax, or $0.09 per diluted share) related to the Company’s decision to exit its Denver collections business.
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Notes to Consolidated Financial Statements - (Continued)
N. Segment Reporting
The Company operates two business segments, Merchant Card Services and Payment Services. Merchant Card Services authorizes, processes, and performs financial settlement and reporting of card transactions including credit, debit, stored value, and EBT. Payment Services provides financial settlement and reporting solutions to large and mid-size corporate customers in the travel service and healthcare industries.
Reportable segments are identified by the services they offer. General and administrative expenses are allocated to the segments based upon various methods determined by the nature of the expenses. There is no intersegment revenue. Depreciation expense for corporate fixed assets is allocated to the two segments. Corporate assets are comprised primarily of cash, Eurodollar deposits, income tax balances, and fixed assets used by both segments or by support service areas. The accounting policies of the reportable segments are the same as those of the Company. Prior period amounts have been classified to conform to the current line of business reporting structure.
(1)
Merchant Card Services was formerly an operating 	unit within the Company’s Merchant Services segment. Upon 	the sale of the Check Acceptance business unit in 1999, this 	segment was renamed Merchant Card Services. The historical 	segment disclosures include the divested Check Acceptance 	business unit through June 1, 1999, the date of the sale. 	
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Notes to Consolidated Financial Statements - (Continued)
(2)
Payment Services was formerly an operating unit 	within the Company’s Corporate Outsourcing Solutions 	segment. This segment was renamed Payment Services in 2001 after 	the sale of the BPO business unit. The historical segment 	disclosures include the results of various divested business 	units formerly classified as part of the Corporate Outsourcing 	Solutions segment. 	
Revenue from foreign operations in 2001, 2000, and 1999, was $40.3 million, $69.8 million and $63.9 million, respectively. The net book value of foreign long-lived assets, primarily in Juarez, Mexico, was approximately $1.4 million, $16.6 million and $13.7 million at December 31, 2001, 2000, and 1999, respectively.
NATIONAL PROCESSING, INC.
PART IV ITEM 14: EXHIBIT INDEX
(A)
Exhibit is incorporated herein by reference to 	the applicable exhibit in the Registrant’s Registration 	Statement on Form S-1 (Registration No. 333-05507) filed on 	June 7, 1996. 	
(B)
Exhibit is incorporated herein by reference to 	the applicable exhibit in the Registrant’s Amendment 	No. 1 to Form S-1 Registration Statement (Registration 	No. 333-05507) filed on July 18, 1996. 	
**
Represents a management contract or compensatory 	plan required to be filed pursuant to Item 14 of 	Form 10-K.