ITEM 1. BUSINESS
General
John H. Harland Company (the "Company" or the "Registrant") was founded in 1923 as a general printer and lithographer. The Registrant is incorporated under the laws of Georgia and is headquartered in Atlanta.
The Company works with banks, credit unions, brokerage houses and financial software companies, providing these institutions with products and services that help strengthen relationships with their customers. These offerings range from financial printing (checks, forms and business products) to database marketing software, direct marketing, and loan and deposit origination software. The Company's subsidiary, Scantron Corporation ("Scantron"), sells information management products and services, including optical mark reading equipment, scannable forms, survey services and field maintenance services. Scantron sells these products and services primarily to the commercial and education markets.
The Company serves its major markets through two primary business segments, each of which is described below. Reference is made to Note 13 of the Notes to Consolidated Financial Statements on page of this Annual Report on Form 10-K with respect to information concerning the Company's business segments.
Recent Developments
Timothy C. Tuff was elected president, chief executive officer and director of the Company on October 6, 1998.
In December 1998, the Company announced a restructuring of the organization that is designed to strengthen relationships with customers and increase bottom-line accountability. The reorganization involved separating corporate and line functions, and creating individual business units focused on either product lines or distinct customer groups. The Company believes that the business unit structure will help strengthen the role each unit plays in enhancing shareholder value.
The Company took steps to align the interests of the board of directors with those of shareholders, including a new committee structure for the board and new ownership guidelines for directors. There are now three committees: Audit, Executive and Governance. The Governance Committee, which incorporates the compensation and nominating functions, will also address broader governance issues. The ownership guidlines require directors to own five times the amount of their annual retainer in company stock. This threshold must be achieved within five years. Annual retainers for directors are paid in Company stock.
The Company plans to release a WindowsRM version of its MAX$ELL database management system later in 1999. Recent development efforts had focused on the Harland Relationship ManagerTM system, a next-generation database management system. These development efforts were discontinued in late 1998 due to product performance issues.
Scantron purchased Equitrac Computer Services (ECS) in 1998 to strengthen its service capabilities in several of the 42 states in which it does business. The Company anticipates that growth of the service business will come through internal development and additional acquisitions. Scantron also introduced eListen,TM a universal electronic survey and data collection software system that enables organizations to conduct surveys through popular electronic media, including Intranet, World Wide Web, e-mail and corporate network. In addition to expanding the functionality of a core offering, eListen increases the Company's capabilities for surveying large constituencies.
Financial Services
The Financial Services ("FS") segment focuses on providing products and services to financial institutions, including banks, credit unions, brokerage houses and financial software companies. These offerings range from financial printing (checks, forms and business documents) to database marketing systems, direct marketing campaign management, and loan and deposit origination and compliance software.
FS core printed products are checks, forms and related magnetic ink character recognition ("MICR") documents sold to financial institutions and their customers. These documents include personal, business and computer checks and forms. FS also produces a variety of financial documents, including checks, invoices, statements and other forms, used by individuals in conjunction with personal and/or small business financial software applications. Through a strategic alliance with Bottomline Technologies, Inc.("Bottomline"), FS offers point-of- service capability to produce MICR-readable documents. (The Company has an equity investment in Bottomline totaling 5.9% of Bottomline's outstanding common stock.)
FS primary competitors in the sale of MICR-encoded documents and related forms to financial institutions are two national financial printers specializing in check printing, one of which possesses substantially greater sales and financial resources than FS. While accurate statistics with respect to the aggregate level of check production are not readily available, the Company believes that FS is the second-largest producer of MICR-encoded documents and related forms in the United States.
Recognizing that growth in financial printing is slowing and that its customers have a growing need to improve profitability and increase operational efficiencies, the Company began expanding its offerings several years ago. The Company now also offers financial institutions database marketing systems, direct marketing campaign management, and loan and deposit origination and compliance software.
Product expansion has benefited from a number of acquisitions, including two companies that offer marketing customer information file ("MCIF") software and related services. The Company markets these products and services under the term "Decision Support." Financial institutions use this software to identify profitable customers and prospects, develop sound marketing strategies and execute information- driven plans aimed at building and retaining profitable relationships.
MCIF software enables financial institutions to quickly and accurately gauge profitability potential and target potential customers. Utilization of external and internal data, such as demographic and geographic information, can enhance analysis, which is then merged into multi-contact direct marketing programs. Additional services include consulting, creative services, printing and fulfillment, and campaign management, all of which are designed to deliver a strong return on investment for financial institutions.
The market for the Company's Decision Support products and services is growing within the financial services industry. More than 1,300 financial institutions utilize one of the Company's database marketing products, giving the Company a leadership position in this emerging market.
FS also markets and supports loan and deposit origination and compliance software for the financial institution market. Competition within this market varies by financial institution size.
The Company believes that the primary competitive factor influencing buying decisions within the FS segment is the ability to
help financial institutions improve profitability and increase operational efficiencies. The Company believes that FS compares favorably with its competitors in this respect.
FS markets its products and services primarily in the United States, although there is varying market penetration in the Caribbean, Mexico, Canada and other limited markets. Financial institution customers include community, regional and national banks, credit unions and brokerage houses. Non-financial institution customers include financial software companies, superstores, direct mail check suppliers, catalog merchandisers and affinity groups.
FS markets its products and services primarily through one sales force divided into two groups, with one group focused on national accounts, and the second group servicing the needs of community banks and credit unions. Database marketing and direct marketing specialists support this sales force.
FS principal raw materials are safety paper, form paper and MICR bond paper. Other related products, such as vinyl, inks, checkboards, packaging material and miscellaneous supplies, are purchased from a number of suppliers. The Company believes that adequate raw materials will be available to support FS operations.
The Company believes that the loss of any one FS customer would not have a materially adverse effect on its consolidated results of operations.
Scantron Corporation
Scantron was founded in 1972 and acquired by the Company in 1988. Scantron provides products and services utilized primarily in the areas of surveying, assessment and data collection for commercial and educational institutions. These core offerings include scannable forms, optical mark readers ("OMRs"), application software and maintenance services.
Scantron's brand awareness is strong in the K-12 and post secondary education markets, where the name "Scantron" is readily associated with testing and data collection technology. In addition to test scoring, a Scantron system, which includes a scanner, forms and software, is used to collect and analyze data for surveys, grade reporting and balloting.
Related lines of businesses include the Scantron Survey Group, which offers full-service data collection and survey services; and the Scantron Service Group, a provider of scanner, personal computer, and network systems maintenance, support and installation services.
Scantron is developing new products and services that it believes will help it penetrate emerging high technology markets, including enterprise-wide survey and assessment solutions.
Scantron's markets are diverse and competitive. The Company believes Scantron is the second-largest provider of data collection systems to commercial and educational markets in the United States. The Company also believes that Scantron's scanning technologies are more accurate than other methods of capturing and tabulating high volumes of data.
Scantron's forms printing operation competes with commercial and specialized forms printers, principally on the basis of systems compatibility, product quality, customer services, and availability of a complete product line to the end user.
Scantron's field service operation competes with various organizations that provide installation and maintenance services, including technology manufacturers, other national and local field service and maintenance companies.
The Company believes that Scantron's breadth of products and services, brand name, and new product and service offerings compare favorably with competitors.
Scantron markets its products primarily through inside and outside sales and service representatives throughout the United States and Canada. Representatives sell new systems, sell reorders for existing installations, provide scanner servicing, and deliver forms design, development and software customization services. Scantron's products are also marketed internationally through distributorships.
Scantron purchases a majority of its paper from one supplier. It purchases scanner components from equipment manufacturers, supply firms and others. It purchases software for resale from leaders in the software industry. The Company believes Scantron can continue to obtain such materials or suitable substitutes in acceptable quantities and at acceptable prices to continue all operations.
There is a seasonal nature to Scantron's business in the educational market, but it does not significantly affect the Company's consolidated results.
The Company believes that the loss of any one Scantron customer would not have a materially adverse effect on the Company's consolidated results of operations.
Patents and Trademarks
The Company has patents on several products and processes and trademarks on names of several of its products and services. While the Company believes these patents and trademarks to be of value, it does not consider any of them to be critical to its operations.
Employees
As of December 31, 1998, the Company and its subsidiaries employed 5,393 people.
ITEM 2.
ITEM 2. PROPERTIES
As of December 31, 1998, the Company and its subsidiaries owned 16 facilities located in 13 states and in Puerto Rico, all but five of which were primarily production and service facilities. The Company leases 24 facilities for printing and/or warehouse activities. The Company also leases office space for sales and service activities where there are no production facilities, as well as space for two of its subsidiaries. These leases have expiration dates ranging from 1999 to 2012. The Company owns its executive offices in Atlanta, Georgia.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In the ordinary course of business, the Company is subject to various legal proceedings and claims. The Company believes that the ultimate outcome of these matters will not have a material effect on its financial statements.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth information with respect to all executive officers of the Company.
Name Age Office Held John H. Weitnauer Jr. 72 Chairman of the Board Timothy C. Tuff 51 President and Chief Executive Officer S. David Passman III 46 Vice President and General Manager - South/International Region Mark C. Perlberg 42 Vice President and General Manager - North Region Earl W. Rogers Jr. 50 Vice President, Manufacturing Services and Technology John C. Walters 58 Vice President, Secretary and General Counsel
Mr. Weitnauer served as Chairman and Interim President and Chief Executive Officer of the Company from January 1998 until Mr. Tuff joined the Company. He previously served as Chairman and Chief Executive Officer of Richway Stores, a division of Federated Department Stores, Inc., an operator of discount department stores, for seven years until his retirement in 1987.
Mr. Tuff was elected to his present positions with the Company in October 1998. From 1993 to October 1998, he served as President and Chief Executive Officer of Boral Industries, Inc., managing the North American and European operations of Australian-based Boral, Ltd., a world leader in building and construction materials, since 1993.
Mr. Passman joined the Company in October 1996 as Senior Vice President and Chief Financial Officer and assumed his present position in January 1999. He was previously employed by Deloitte & Touche LLP for 20 years, last serving as Managing Partner of its Atlanta office.
Mr. Perlberg joined the Company in February 1996 and served as Senior Vice President and President, Financial Markets Division of the Company until he assumed his present position in January 1999. He was previously employed by New Valley Corporation, a financial services company, and its Western Union Financial Services subsidiary, since 1989, last serving as Vice President in its international operations.
Mr. Rogers has been employed as an executive officer of the Company for more than the past five years.
Mr. Walters joined the Company in January 1996. He previously served as Executive Vice President of First Financial Management Corporation, a diversified information and financial services company, from November 1994 until December 1995. From 1988 until November 1994, he served as Senior Vice President and General Counsel of New Valley Corporation.
Messrs. Tuff and Weitnauer also serve on the Board of Directors. Officers are elected annually and serve at the pleasure of the Board of Directors.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
See the information with respect to the market for and number of holders of the Company's common stock, quarterly market information and dividend information which is set forth on page of this Annual Report on Form 10-K. The Company has an established policy of making quarterly dividend payments to shareholders. The Company expects to pay future cash dividends depending upon the Company's pattern of growth, profitability, financial condition and other factors which the Board of Directors may deem appropriate.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
See the information with respect to selected financial data on page of this Annual Report on Form 10-K.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
See the information under the caption Management's Discussion and Analysis of Results of Operations and Financial Condition on pages through of this Annual Report on Form 10-K.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See the information with respect to Quantitative And Qualitative Disclosures About Market Risk on page under the caption of Market Risk of this Annual Report on Form 10-K.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the information with respect to Financial Statements and Supplementary Data on pages through of this Annual Report on Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information regarding Directors required herein is incorporated by reference to the information under the caption "Election of Directors" in the Registrant's Definitive Proxy Statement for the Annual Meeting of Shareholders' dated March 12, 1999 (the "Proxy Statement").
The information regarding Executive Officers required herein is included in Part I of this report and incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information regarding executive compensation is incorporated by reference to the information under the caption "Executive Compensation and Other Information" in the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required herein is incorporated by reference to the information under the caption "Stock Ownership of Directors and Executive Officers and Certain Other Persons" in the Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not applicable.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K Page in this Annual Report on Form 10-K ------------- (a)1. Financial Statements:
Management's Discussion and Analysis of Operations and Financial Condition Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Cash Flows Consolidated Statements of Shareholders' Equity Notes to Consolidated Financial Statements Quarterly Financial Information (unaudited) Independent Auditors' Report Management Responsibility for Financial Statements
(a)2. Financial Statement Schedule:
Schedule II. Valuation and Qualifying Accounts S1
(a)3. Exhibits (Asterisk indicates exhibit previously filed with the Securities and Exchange Commission as indicated in parentheses and incorporated herein by reference.)
3.1 * Amended and Restated Articles of Incorporation (Exhibit 3.1 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1993 (the "1993 10-K")). 3.2 Bylaws, as amended through February 1, 1999. 4.1 Indenture, as supplemented and amended, relating to 6.75% Convertible Subordinated Debentures due 2011 of Scantron Corporation (omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K; will be furnished to the Commission upon request). 4.2 * Form of Rights Agreement dated as of June 9, 1989, between Registrant and Citizens and Southern Trust Company (Exhibit 1 to Registrant's Current Report on Form 8-K dated June 9, 1989). 4.3 * First Amendment dated June 12, 1992 to Rights Agreement (Exhibit 4.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992). 4.4 * Second Amendment dated July 24, 1992 to Rights Agreement (Exhibit 4.2 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992). 4.5 * Rights Agreement, dated as of December 17, 1998, between Registrant and First Chicago Trust Company of New York (Exhibit 4.1 to Registrant's Current Report on Form 8-K dated December 17, 1998). 4.6 * Note Agreement dated as of December 1, 1993 relating to Registrant's 6.60% Series A Senior Notes Due December 30, 2008 (Exhibit 4.5 to the 1995 10-K). 4.7 See Articles IV, V and VII of Registrant's Amended and Restated Articles of Incorporation, filed as Exhibit 3.1, and Articles I, V and VIII of Registrant's Bylaws, filed as Exhibit 3.2. 10.1 * Form of Deferred Compensation Agreement between Registrant and Robert R. Woodson (Exhibit 10.1 to the 1993 10-K). 10.2 * Form of Monthly Benefit Amendment to Deferred Compensation Agreement between Registrant and Mr. Woodson (Exhibit 10(H) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). 10.3 * Form of Deferred Compensation Agreement between the Registrant and Earl W. Rogers Jr. (Exhibit 10.3 to the 1993 10-K).
10.4 * Form of Amendment to Deferred Compensation Agreement between Registrant and Messrs. Woodson and Rogers (Exhibit 10.6 to the 1993 10-K). 10.5 * Form of Noncompete and Termination Agreement between Registrant and S. David Passman III, Mark C. Perlberg, Mr. Rogers and John C. Walters (Exhibit 10.6 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1995 (the "1995 10-K"). 10.6 * Form of Executive Life Insurance Plan between Registrant and Messrs. Woodson and Rogers (Exhibit 10.8 to the 1993 10-K). 10.7 Noncompete and Termination Agreement, dated as of October 6, 1998, between Registrant and Timothy C. Tuff. 10.8 Restricted Stock Agreement, dated October 6, 1998, between Registrant and Mr. Tuff. 10.9 Supplemental Retirement Agreement, dated as of January 14, 1999, between Registrant and Mr. Tuff. 10.10 * John H. Harland Company 1981 Incentive Stock Option Plan, as Extended (Exhibit 10.9 to the 1995 10-K). 10.11 John H. Harland Company 1999 Stock Option Plan. 10.12 * John H. Harland Company Employee Stock Purchase Plan, as amended (Exhibit 10.10 to the 1995 10-K). 10.13 * John H. Harland Company Deferred Compensation Plan for Outside Directors (Exhibit 10.10 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1996). 21 Subsidiaries of the Registrant. 23 Independent Auditors' Consent. 27 Financial Data Schedule for the year ending December 31, 1998 10-K.
(b) Reports on Form 8-K
The Registrant filed a Form 8-K dated December 17, 1998 with respect to the adoption of a Rights Agreement. See Exhibit 4.5.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
JOHN H. HARLAND COMPANY
/s/William M. Dollar 3/30/1999 - - ---------------------- -------- William M. Dollar Date Vice President Corporate Controller (Principal Financial and Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
/s/John H. Weitnauer Jr 3/29/1999 /s/Timothy C. Tuff 3/30/1999 - - ---------------------- -------- ---------------------- -------- John H. Weitnauer Jr. Date Timothy C. Tuff Date Chairman President and Chief Executive Officer (Principal Executive Officer)
/s/Juanita P. Baranco 3/26/1999 /s/Edward J. Hawie 3/26/1999 - - ---------------------- -------- ---------------------- -------- Juanita P. Baranco Date Edward J. Hawie Date Director Director
- - ---------------------- -------- ---------------------- -------- Richard K. Lochridge Date John J. McMahon Jr. Date Director Director
/s/H.G. Pattillo 3/26/1999 - - ---------------------- -------- ---------------------- -------- G. Harold Northrop Date H.G. Pattillo Date Director Director
/s/Larry L. Prince 3/25/1999 /s/Robert R. Woodson 3/29/1999 - - ---------------------- -------- ---------------------- -------- Larry L. Prince Date Robert R. Woodson Date Director Director
/s/Robert A. Yellowlees 3/28/1999 - - ---------------------- -------- Robert A. Yellowlees Date Director
JOHN H. HARLAND COMPANY AND SUBSIDIARIES
Index to Information For Inclusion in the Annual Report on Form 10-K for the year ended December 31, 1998
Management's Discussion and Analysis of of Operations and Financial Condition
Consolidated Financial Statements and Notes to Consolidated Financial Statements
Independent Auditors' Report
Management Responsibility For Financial Statements
Supplemental Financial Information
Supplemental Financial Statement Schedule S1
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JOHN H. HARLAND COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
The Company operates its business in two segments. The Financial Services segment ("FS") includes checks and forms, database marketing software, direct marketing, and loan and deposit origination software sold primarily to financial institutions.
The Scantron segment represents products and services sold by the Company's Scantron subsidiary including optical mark reading equipment, scannable forms, survey services and field maintenance services. Scantron sells these products and services primarily to the commercial and education markets.
Results Of Operations 1998 Versus 1997
Consolidated net sales for the year ended December 31, 1998 were $566.7 million compared to $562.7 million for the year ended December 31, 1997. FS sales were flat in 1998 in relation to 1997 totaling $478.3 million versus the previous year total of $477.5 million. Traditional check volumes increased 7.4% due to the implementation of large contracts during 1998, but the impact was offset by a decrease in average check unit pricing of 10.5%. The decline in pricing reflects a continued trend in discounting in traditional check markets, along with the impact of higher volume, lower priced national accounts. Revenue from marketing services, including database marketing software, direct marketing, and loan and deposit origination software was $61.6 million in 1998, an increase of $3.0 million over 1997. The increase resulted from growth in direct marketing, which was offset partially by a decline in installation of database marketing software. The decline in database marketing software revenue was due to a delay in introduction of new products (see Note 2 to Financial Statements). Scantron's sales increased $3.2 million or 3.8% over 1997, due to expansion of field maintenance operations.
Consolidated gross profit increased from 42.3% of sales in 1997 to 44.3% in 1998. FS gross profit increased to 43.9% in 1998 from 40.9% in 1997. This increase resulted from lower costs for printed products in 1998 due to improvements in operations from plant consolidations and process improvements. Scantron's gross profit as a percentage of sales increased to 50.7% in 1998 from 50.1% in 1997, due primarily to an improvement in core product margins.
Consolidated selling, general and administrative expenses ("SG&A") increased $3.4 million in 1998 in comparison to the previous year with the largest increases related to upgrading technology and management bonuses. Selling expenses were lower in 1998 as a result of headcount reductions made early in 1998. SG&A expenses increased as a percentage of sales from 32.3% in 1997 to 32.7% in 1998.
In 1998, the Company expensed $12.8 million of costs primarily associated with the development of the Harland Relationship Manager software system. Development costs for this product had been previously capitalized. In December 1998, the Company decided to discontinue development of this product. In 1997, the Company expensed $4.5 million for research and development related to equipment development.
During 1998, the Company recognized restructuring charges totaling $51.1 million. Of this total, $4.9 million was incurred during the first nine months of 1998 and was primarily for severance-related expenses applicable to the plant network restructuring announced in 1996 and certain other organizational changes. The Company recognized $46.2 million in the quarter ended December 31, 1998. These costs were related
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primarily to organizational changes announced in December and impairment of assets due to the decision to discontinue development of Harland Relationship Manager.
Amortization of intangibles decreased by $3.1 million from 1997 compared to 1998 due to certain intangible assets becoming fully amortized in 1997.
Other income (expense) was a net expense of $5.2 million in 1997 versus a net expense of $3.1 million in 1998. This decrease of $2.1 million in net expense was due primarily to gains from the sale of production facilities and the Company aircraft as well as lower interest expense from short-term debt.
The Company had a net tax expense of $9.7 million on a pre-tax loss of $11.0 million in 1998. The Company incurred tax expense due to the effects of permanent tax differences associated with certain intangible assets which made up a large portion of the restructuring charges incurred in 1998. The consolidated effective income tax rate for 1997 was 41.5%.
The Company's net loss for 1998 was $20.6 million compared to net income of $17.3 million for 1997. Basic and diluted earnings (loss) per share for 1998 were ($0.66) in 1998 compared to $0.56 in 1997. Included in the calculation of earnings per share for 1998 were costs related to the development of software and restructuring charges, which reduced earnings per share by approximately $0.23 and $1.41 per share, respectively, offset partially by a gain on the sale of assets, which increased earnings per share by approximately $0.07. Net income in 1997 included restructuring charges and other development costs, which reduced earnings per share by approximately $0.07 and $0.08 per share, respectively, offset by a gain on the sale of buildings, which increased earnings per share by approximately $0.05.
Results of Operations 1997 versus 1996
Consolidated net sales for the year ended December 31, 1997 were $562.7 million compared to $609.4 million for the year ended December 31, 1996. FS sales totaled $477.5 million and $527.2 million for 1997 and 1996, respectively. Traditional check volumes, decreased 3.7% from 1996, and the average check unit price decreased by 10.0%. The volume decrease is attributable to the loss of accounts through merger of certain customers into non-customer banks, partially offset by the addition of a large direct mail check supplier. The price and product mix decrease is attributable primarily to lower prices experienced as a result of the level of discounting occurring in traditional check markets and lower prices associated with checks sold to a direct mail supplier. Revenue from marketing services, including database marketing software, direct marketing and loan and deposit compliance services, was $58.6 million in 1997, an increase of $4.6 million over 1996. Scantron's sales increased $3.0 million or 3.7% over 1996, due to increases in its core optical mark reading equipment and forms and expansion of field maintenance operations.
Consolidated gross profit decreased by 15.7% and gross margin decreased from 46.3% in 1996 to 42.3% in 1997. The consolidated gross margin decrease resulted from a decrease in FS gross margin, offset partially by an increase in Scantron's gross margin. FS gross margin decreased from 46.5% in 1996 to 40.9% in 1997 due to the decline in check pricing resulting from discounting and to transition costs related to plant consolidations and customer service centralization. Scantron's gross margin increased from 45.3% in 1996 to 50.1% in 1997 principally due to changes in product mix.
Consolidated SG&A expenses increased by $9.8 million due primarily to increased costs related to restructuring the sales organization and to costs of upgrading technology. These increases were offset by a $9.4 million reduction in marketing expense related to the winding down of the
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Company's direct check operations. SG&A expenses increased as a percentage of sales from 28.2% in 1996 to 32.3% in 1997.
In 1997, the Company expensed $4.5 million for research and development related to equipment development.
Amortization of intangibles decreased by $3.1 million from 1996 compared to 1997 as certain intangible assets were fully amortized, and certain balances were written down in connection with the Company's restructuring recorded in 1996.
Other income (expense) decreased from $7.4 million in 1996 to $5.2 million in 1997 due primarily to the reduction in interest expense associated with the repayment of short-term borrowings during 1997 and gains on sales of closed imprint facilities.
The Company's consolidated effective income tax rate for 1997 was 41.5% compared to 10.5% for 1996. The effective income tax rate of 10.5% in 1996 and the associated benefit was lower because of the effects of permanent tax differences in 1996 related to the restructuring charge, non-deductible acquired in-process research and development charge and non-deductible amortization of intangibles.
The Company's net income for 1997 was $17.3 million compared to a net loss of $13.9 million for 1996. Basic and diluted earnings per share were $.56 in 1997 compared to a loss per share of $.45 in 1996. Included in the calculation of earnings per share of $.56 were research and development and restructuring charges, which reduced earnings per share by approximately $.08 and $.07 per share, respectively, offset by a gain on the disposal of assets, which increased earnings per share by approximately $.05. The net loss in 1996 included restructuring charges for plant consolidations and other strategic decisions related to product development and a charge for acquired in-process research and development costs. The total pre-tax impact of these charges in 1996 was $102.1 million or a reduction in earnings per share of $2.09.
Financial Condition, Capital Resources and Liquidity
Cash flows provided by operations in 1998 were $81.4 million compared to $66.4 million for 1997. The primary uses of funds in 1998 were for capital expenditures, software development cost, dividends paid and customer incentive payments.
Purchases of property, plant and equipment totaled $33.5 million in 1998, compared to $45.4 million in 1997. Proceeds from the sale of property, plant and equipment totaled $10.6 million in 1998 compared to $27.5 million in 1997.
In April 1997, the Company's board of directors authorized the repurchase of up to 1.5 million shares of the Company's outstanding common stock. In May 1997, the Company paid $2.0 million to repurchase 100,000 shares. In August 1998, the Company paid $2.9 million to repurchase 200,000 shares. The Company also had other transactions related to treasury stock for its employee stock plans.
The Company has unsecured lines of credit which provide for borrowings up to $61.0 million. As of December 31, 1998, the Company had no outstanding balances under these lines of credit.
On December 31, 1998, the Company had $42.5 million in cash and cash equivalents. The Company believes that its current cash position, funds from operations and the availability of funds under its lines of credit will be sufficient to meet anticipated requirements for working capital, dividends, capital expenditures and other corporate needs for the 1999
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operating period. Management is not aware of any condition that would materially alter this trend. The Company also believes that it possesses sufficient unused debt capacity and access to equity capital markets to pursue additional acquisition opportunities.
Outlook
The Company's operating results have been positively impacted by a number of factors, including continued cost reductions in labor, materials and overhead in the Company's check printing operations. SG&A costs were reduced in the latter portion of 1998 due primarily to the Company's efforts to reduce SG&A, both as a percentage of sales and in aggregate dollars.
To improve service and quality, further reduce costs and increase the profitability of its check printing operations, the Company will continue to consolidate printing facilities, install new equipment and develop systems and processes for its production facilities.
Six printing facilities remain to be closed as part of the Company's plant consolidation program. The final phase of this program began in the fourth quarter of 1998, and is expected to be completed during 2000. The Company expects to incur duplicate costs as part of plant consolidation.
The Company anticipates revenue to soften slightly as a result of overall pricing erosion and a continued shift to a higher percentage of large national accounts during 1999 as new contracts acquired during 1998 are in effect a full year. In an effort to increase volume and pricing, the Company is strengthening its marketing efforts with regional and community accounts.
The Company's decision to discontinue development of Harland Relationship Manager and begin development of a Windows version of its MAX$ELL system will delay the introduction of a new database marketing software product and will have a negative impact on revenues for this product for most of 1999.
To support the current business strategies, the Company expects to incur additional charges, predominantly related to employee severance, of approximately $1.0 million in 1999.
Market Risk
Year 2000 Compliance
Background
The Year 2000 issue is the result of potential problems with computer systems or any equipment with computer chips using just two
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digits rather than four to identify years (e.g., 98 for 1998). On January 1, 2000, any clock or date-recording mechanism, including date-sensitive software using only two digits to represent the year, may recognize a date using 00 as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruption of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar activities. Therefore, a program was instituted by the Company to assess and fix all potentially significant Year 2000 problems.
The program consists of three phases: (1) identification and assessment (including prioritization) in relation to the Company's business processes of all information technology ("IT") systems and non- information technology systems, including buildings, plant equipment, telephone systems, and other infrastructure systems which contain microcontroller technology (non-IT systems) that may be sensitive to the Year 2000 issue; (2) remediation (including modification, upgrade and replacement) of systems that have a Year 2000 problem; and (3) testing the systems for compliance.
The Company is also reviewing the Year 2000 readiness of third parties which provide goods or services that are mission critical to the Company's operations, as well as its relationship with other key strategic partners (including large customers). The Company's senior management and Board of Directors receive regular updates on the status of the Year 2000 program.
State of Readiness
The Company has completed the Phase 1 identification and readiness assessment of all IT and non-IT systems. A risk assessment was utilized to assign priorities to all IT components. Phase 3 compliance testing began in August 1998. All mission-critical applications are in Phase 3 compliance testing and have been 100% remediated. The majority (96%) of these applications are scheduled to be fully tested during the first quarter of 1999 with the few exceptions (4%) being scheduled for completion no later than June 30, 1999. A risk assessment is also underway for all non-IT systems to include manufacturing and facility components. Plans to upgrade or replace non-compliant components are expected to be in place by March 31, 1999. The Company believes that all significant Year 2000 problems related to IT and non-IT systems will be resolved with the completion of Phase 3 compliance testing.
The Company estimates that the cost of repairing and testing IT and non-IT systems will approximate $5.0 to $7.0 million which will be funded through operating cash flows. Of such costs, approximately $3.0 million was incurred through December 31, 1998. Costs associated with correcting and testing existing systems are expensed as incurred. The Company believes that such costs will not have a material effect on its liquidity, financial condition or results of operations. The Company is replacing certain systems in the normal course of business with new systems, which are expected to improve functionality, usefulness and efficiency. Approximately $7.0 million will be spent on these activities in 1999, most of which will be capitalized. The timing of the replacement of systems was not accelerated as a result of Year 2000 issues.
Third Party Suppliers
The Company has initiated and is reviewing formal communications with mission-critical third parties which provide goods or services essential to the Company's operations. These communications are to determine the extent to which the Company is vulnerable to any failure by such third parties to remediate their respective Year 2000 problems and to resolve such problems to the extent practicable.
In July 1998 the Company surveyed key suppliers and utilities initially identified as potentially mission critical to the Company.
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Follow-up communication was sent to vendors and service providers that did not initially respond or whose initial responses were deemed unsatisfactory in some respect by the Company. As of December 31, 1998, the Company had received survey responses from 83% of such third parties, each of which has provided written assurances that it expects to address all significant Year 2000 issues on a timely basis. The Company plans to continue to follow up by telephone with third parties from whom it has not yet received responses and will update its risk assessment quarterly. The Company will then develop contingency plans, including a selection of alternate providers, as and if necessary.
The Company has initiated formal communications with key large customers to determine the extent to which electronic interfaces with such entities are vulnerable to the Year 2000 issue and the steps needed to be Year 2000 compliant.
Risks and Contingency Planning
To the extent practicable, the Company is revising its existing business interruption contingency plans to address internal and external issues specific to the Year 2000 problem. These plans, which are intended to enable the Company to continue to operate effectively, include performing certain processes manually, repairing or obtaining replacement systems, changing suppliers, and reducing or suspending operations. The Company expects to finalize its contingency planning by September 30, 1999.
The Company is conducting a comprehensive analysis and risk assessment of the operational problems, customer disruption and costs (including loss of revenues) that would be most likely to result from the failure by the Company or certain third parties to complete efforts necessary to achieve Year 2000 compliance on a timely basis. Contingency plans are being developed for dealing with the most reasonably likely worst case scenarios for IT systems, non-IT systems, including manufacturing systems, facilities, vendors and customers. In regard to the IT systems risk assessment, the most reasonably likely worst case scenario is that the Company's billing system will fail to function properly. Should the billing system fail completely, the Company would be unable to submit invoices to the customers for a period of time. In this situation the Company would expect to recover all or most of the unbilled revenue upon resolving the causes of the system failure. The most reasonably likely worst case scenarios for non-IT systems, vendors and suppliers will be developed upon completion of the risk assessments.
In April 1998, the Company organized a Program Management Office ("PMO") focusing on developing and implementing a best practice Year 2000 remediation and testing methodology, and retained a third party consulting group to manage the Year 2000 PMO. In addition, the Company has engaged another independent party to provide feedback on its approach and planning activities.
Possible Consequences of Year 2000 Problems
To date, the Company has not identified any IT or non-IT system that presents a material risk of not being Year 2000 compliant or for which a suitable alternative cannot be implemented. However, as the initiative moves through the testing phase, it is possible that the Company may identify potential risks of Year 2000 disruption. It is also possible that such a disruption could have a material effect on its financial condition and results of operations. In addition, if any key third parties who provide goods or services that are mission critical to the Company's business activities fail to appropriately address their Year 2000 issues, there could be a material adverse effect on the Company's financial condition and results of operations.
Risk Factors and Cautionary Statements
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When used in this report and in subsequent filings by the Company with the Securities and Exchange Commission, in the Company's press releases and in written or oral statements made by authorized representatives of the Company, the words or phrases "should result", "are expected to", "will continue", "is anticipated", "estimate", "project" or similar expressions are intended to identify "forward- looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are necessarily subject to certain risks and uncertainties, including, but not limited to, those discussed below that could cause actual results to differ materially from the Company's historical experience and its present expectations or projections. Caution should be taken not to place undue reliance on any such forward-looking statements, which speak only as of the date such statements are made and which may or may not be based on historical experiences and/or trends which may or may not continue in the future. The Company does not undertake and specifically declines any obligation to publicly release the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances occurring after the date of such statements or to reflect the occurrence of unanticipated events.
Various factors may affect the Company's financial performance, including, but not limited to, those factors discussed below and could cause the Company's actual results for future periods to differ from any opinions, statements or projections expressed with respect thereto. Such differences could be material and adverse.
Regarding the rebuilding of the Company's manufacturing operations, there can be no assurances that the printing plant consolidation will occur within a projected time frame and that it, combined with the centralization of customer service, will result in the anticipated quality improvements or projected costs savings. Many variables will impact the ability to improve production efficiencies and reduce redundant expenses. These include, but are not limited to, the development and implementation of new manufacturing technology and information systems used in the Company's data entry and production operations and the successful development of software to enhance call center operations. Further, there can be no assurance that the Company can reproduce or improve upon historic profit margin trends. Many factors can affect the Company's ability to improve profitability, including, among other factors, competitive pricing trends, the ability to secure similar materials prices and labor rates, and the ability to reduce the cost of manufacturing. Competition among suppliers, restricted supply of materials, labor and services, and other such factors outside of the Company's control, may adversely affect prices and may materially impact the Company's results.
Several factors outside the Company's control, could negatively impact check revenue. These include the continuing expansion of alternative payment systems such as credit cards, debit cards and other forms of electronic commerce or on-line payment systems. Check revenues could also be adversely affected by continued consolidation of financial institutions and competitive check pricing, among other factors. There can be no assurances that the Company will not lose significant customers or that any such loss could be offset by the addition of new customers. Also, there can be no assurance that the Company will experience similar or higher revenue compared to prior years, or that any targets or projections made relating to check revenues will be achieved.
While the Company believes substantial growth opportunities exist in FS, specifically marketing services such as database marketing software and direct marketing, there can be no assurances that the Company will achieve its growth targets. There are many variables relating to the development of database marketing software, including the timing and costs of the development effort, product performance, functionality, product acceptance and competition. In 1998, the Company expensed $12.8
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million of costs primarily associated with the development of the Harland Relationship Manager system. Also, no assurance can be made as to market acceptance and to the potential impact of governmental regulations on the Company's ability to expand its direct marketing business and meet projected growth targets.
There can also be no assurance that all or some of the anticipated cost savings expected from rebuilding the manufacturing operation will not be offset by increased expenses from other areas or be shared with customers in the form of discounted prices. As a result, the full impact of the cost savings may not be reflected in operating income.
New Accounting Standard
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The Company plans to adopt SFAS 133 in 2000. The Company has not determined what effect, if any, adoption of SFAS 133 will have on the Company's financial statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES:
Consolidation
The consolidated financial statements include the financial statements of John H. Harland Company and its majority-owned subsidiaries (the "Company"). Intercompany balances and transactions have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash Equivalents
The Company considers all highly liquid debt instruments with a maturity, when purchased, of three months or less to be cash equivalents.
Inventories
Inventories are stated at the lower of cost or market. Cost of inventory for checks and related forms is determined by average costing. Cost of scannable forms and hardware component parts inventories is determined by the first-in, first-out method. Cost of data entry terminals is determined by the specific identification method.
Impairment of Long-Lived Assets
Assets held for disposal are carried at the lower of carrying amount or fair value, less estimated cost to sell such assets in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of". The Company reviews long-lived assets and certain intangibles for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, and any impairment losses are reported in the period in which the recognition criteria are first applied based on the fair value of the asset. See Note 2.
Investments
Short-term investments are carried at cost plus accrued interest, which approximates market, and consist primarily of certificates of deposit and demand notes with original maturities in excess of three months. Marketable equity securities and other long-term investments are carried at cost, which approximates market. The Company classifies its investments as available-for-sale securities.
Goodwill and Other Intangibles
Goodwill represents the excess of acquisition costs over the fair value of net assets of businesses acquired and is amortized on a straight-line basis over periods from 12 to 40 years. Other intangible assets consist primarily of purchased customer lists and non-compete covenants, which are amortized on a straight-line basis over periods ranging from two to eight years. Carrying values of goodwill and other intangibles are periodically reviewed to assess recoverability based on expectations of undiscounted cash flows and operating income for each related business unit. Impairments are recognized in operating results if a permanent diminution in value is indicated. See Note 2. Amortization periods of intangible assets are also reviewed to determine whether events or circumstances warrant revision to estimated useful lives.
Other Assets
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Other assets consist primarily of prepaid customer incentive payments, which are amortized as a reduction of sales over the life of the related contract.
Property, Plant and Equipment
Property, plant and equipment are carried at cost. Depreciation of buildings is computed primarily by the declining balance method. Depreciation of equipment, furniture and fixtures is calculated by the straight-line or sum-of-the-years digits methods. Leasehold improvements are amortized by the straight-line method over the life of the lease or the life of the property, whichever is shorter. Accelerated methods are used for income tax purposes for all property where allowed. The Company capitalizes the qualifying costs of software developed or obtained for internal use. Depreciation is computed for internal use software by using the straight-line method over three to five years.
Revenue Recognition
Sales of products and services are recorded based on shipment of products or performance of services. Revenue from maintenance contracts is deferred and recognized over the period of the agreements.
Earnings Per Common Share
Earnings per common share for all periods have been computed under the provisions of Statement of Financial Accounting Standards No. 128 "Earnings Per Share". The net income (loss) used in the calculation of diluted earnings per common share is adjusted for the effect of the interest on the conversion of the subordinated debt. The net income (loss) used for the calculation of diluted earnings (loss) per common share for 1998, 1997 and 1996 was $(20,647,000), $17,702,000 and $(13,854,000), respectively. The average number of common shares used in the calculation of basic earnings per common share for 1998, 1997 and 1996 was 31,087,214, 30,970,900 and 31,056,200, respectively. The average number of common share equivalents used in the calculation of diluted earnings per common share for 1998, 1997 and 1996 was 31,087,214, 31,445,500 and 31,056,200, respectively. The common share equivalents relate to options under stock compensation plans and the effect of the conversion of the subordinated debt.
Software and Other Development
The Company expenses research and development costs, including expenditures related to development of software that do not qualify for capitalization.
Income Taxes
Deferred tax liabilities and assets are determined based on the difference between financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which differences are expected to reverse.
Reclassifications
Certain reclassifications have been made in the 1996 and 1997 financial statements and notes to financial statements to conform to the 1998 classifications.
New Accounting Standards
Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"), which establishes new rules for the reporting and display of comprehensive income and its components. SFAS 130 requires currency translation adjustments and certain other items, which prior to adoption were reported separately in shareholders' equity, to be included in other comprehensive income. Prior year financial statements have been reclassified to conform to the requirements of SFAS 130. The only component of accumulated other comprehensive income is foreign currency translation adjustments at December 31, 1998 and 1997. -F16-
Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"), which changes the method used by the Company to report information about its operating segments. SFAS 131 establishes standards to be used by enterprises to identify and report information about operating segments and for related disclosures about products and services, geographic areas and major customers. The adoption of SFAS 131 did not affect results of operations or financial position, but did affect the disclosure of segment information contained in Note 13.
Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits-an amendment of FASB Statements No. 87, 88, and 106" ("SFAS 132"). SFAS 132 revised employers' disclosures about pension and other postretirement benefit plans.
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The Company plans to adopt SFAS 133 in 2000. The Company has not determined the effect, if any, of adoption of SFAS 133 will have on the Company's financial statements.
2. RESTRUCTURING CHARGE In 1998, the Company recorded a pre-tax restructuring charge of $51.1 million, a result of certain actions taken by the Company in 1998 (the "1998 Restructuring"), and including certain costs related to actions initiated by the Company in 1996 (the "1996 Restructuring").
The most significant portion of the 1998 Restructuring was the decision to discontinue development of the Harland Relationship Manager ("HRM") system. The discontinuance of the development of the HRM system prompted a revision of projected operations for this business and an assessment of the recoverability of certain long-term assets, including acquisition-related intangibles. The Company adjusted the carrying value of assets to the calculated value based on discounted projected cash flows. The 1998 Restructuring also includes a reorganization which eliminated approximately 100 positions, consolidation of its database marketing operations, recognition of the impairment of certain assets and reductions in selling and marketing personnel. In 1998 and 1997, the Company also incurred $2.9 million and $3.2 million, respectively, in severance-related expenses related to the 1996 Restructuring. All of the 1998 and 1997 charges were incurred in the Financial Services segment with the exception of a write-down of $1.9 million in 1998 of intangible assets in the Scantron segment (see Note 13).
The 1996 Restructuring related to consolidation of manufacturing operations, including severance and associated revaluation of assets, and valuation adjustments related to discontinuing certain subsidiary product lines. Of the total 1996 charge, $84.7 million was incurred in the Financial Services segment and $9.4 million in the Scantron segment.
The cash and non-cash elements of the restructuring charge for each of the years ended December 31, 1998, 1997 and 1996, as well as the beginning and ending balances of accrued restructuring costs, consisted of the following components (in thousands):
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Accrued restructuring costs are expected to be paid primarily in 1999.
3. ACQUISITIONS The Company acquired the businesses described below, which were accounted for using the purchase method of accounting. The results of operations of each acquisition are included in the consolidated financial statements from the date of acquisition.
In 1998, the Company's subsidiary, Scantron, acquired the Equitrac Computer Services ("ECS") division of Equitrac Corporation for cash of $2.3 million. The purchase price was funded from operating cash flows. ECS provides computer maintenance and integration services. Of the total acquisition costs, $1.9 million was allocated to goodwill which is being amortized on a straight line basis over 15 years.
On May 31, 1996, a subsidiary of the Company acquired the common stock of Florida-based OKRA Marketing Corporation ("OKRA") for cash. OKRA designs, develops, markets and supports proprietary application software products and systems, and provides data processing services utilizing such products and systems. Cash paid for this acquisition totaled $24.6 million, net of related acquisition costs of $0.4 million and was funded with proceeds from short-term borrowings. As part of this acquisition, the Company acquired in-process research and development costs of $8.0 million, which was expensed at acquisition. Of the total acquisition costs, approximately $19.4 million was allocated to intangible assets, of which $11.5 million represented goodwill which is being amortized on a straight-line basis over 15 years.
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The following represents the unaudited pro forma results of operations which assume the acquisitions occurred at the beginning of the respective year in which the assets were acquired as well as the beginning of the immediately preceding year. These results include certain adjustments, primarily increased amortization of intangible assets, increased interest expense, reduced interest income and depreciation expense, offset by in-process research and development costs expensed in 1996 (in thousands, except per share amounts):
The unaudited pro forma financial information presented does not purport to be indicative of either the results of operations that would have occurred had the acquisitions taken place at the beginning of the periods presented or of future results.
4. SHORT-TERM DEBT As of December 31, 1998, the Company had available unsecured lines of credit under which it could borrow up to $61.0 million in the form of short-term notes, for which no compensating balances or commitment fees are required. There were no amounts outstanding under these unsecured lines of credit at December 31, 1998 or December 31, 1997.
5. LONG-TERM DEBT
The Company has outstanding $85 million of Series A Senior Notes ("Senior Notes") and a $15 million Term Loan ("Term Loan"), which bear interest at fixed interest rates of 6.60% and 6.63%, respectively. The Senior Notes mature from 2004 to 2008 and the Term Loan is due in 2003.
The Company's 6.75% Convertible Subordinated Debentures ("the
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("Debentures") are convertible into common stock of the Company at any time prior to maturity at a conversion price of $25.17 per share subject to adjustment under certain circumstances. As of December 31, 1998, 282,916 shares of common stock were reserved for conversion of the Debentures. The Debentures are entitled to an annual mandatory sinking fund, which commenced June 1, 1996, calculated to retire 75% of the Debentures prior to maturity in 2011. The Debentures are redeemable, in whole or in part, at any time at the option of the Company at par plus accrued interest. The Debentures are subordinated to all senior debt.
The debt agreements relating to the Senior Notes and the Term Loan contain certain covenants, the most restrictive of which limit the amount of funded indebtedness of the Company and require the Company to maintain a minimum fixed charge coverage ratio. At December 31, 1998, management believes the Company was in compliance with the covenants associated with these debt instruments. Other long-term debt relates principally to capitalized lease obligations.
There are no annual maturities of long-term debt and all sinking fund requirements have been met for the years 1999, 2000 and 2001. Annual maturities of long-term debt and sinking fund requirements are $.3 million in 2002 and $15.6 million in 2003.
6. INCOME TAXES
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7. SHAREHOLDERS' EQUITY Each share of common stock includes a stock purchase right, which is not currently exercisable but would become exercisable upon occurrence of certain events as provided for in the Shareholder Rights Agreement. The rights expire on July 5, 1999.
In December 1998, the Company announced it had renewed its Shareholder Rights Agreement to take effect when the existing rights expire. The renewed plan is substantially similar to the current plan. Rights will be distributed as a dividend at the rate of one Right for each share of common stock of the Company held by shareholders of record at the close of business on July 5, 1999. Each Right will entitle shareholders to buy, upon occurrence of certain events, one share of common stock for $90.00 (compared to $80.00 under the current plan). The Rights generally will be exercisable only if a person or group acquires beneficial ownership of 15 percent or more of the Company's common stock, or commences a tender or exchange offer that, upon consummation, would result in a person or group owning 30 percent or more of the Company's common stock. Under certain circumstances the new Rights are redeemable at a price of $.001 per Right and will expire on July 5, 2009.
8. STOCK COMPENSATION PLANS The Company applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its stock-based compensation plans. Effective January 1, 1996, the Company adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant dates consistent with the method of SFAS 123, the Company's net income (loss) and earnings (loss) per share would have changed to the pro forma amounts listed below (in thousands, except per share amounts):
Under the John H. Harland Company Employee Stock Purchase Plan ("ESPP"), the Company is authorized to issue up to 4,350,000 shares of common stock to its employees, most of whom are eligible to participate. Under the ESPP, eligible employees may exercise an option to purchase shares of Company stock with earnings, which have been withheld during each quarter. The option price is 85% of the lower of the beginning-of- quarter or end-of-quarter market price. During 1998, 1997 and 1996,
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employees exercised options to purchase 200,033 shares, 194,003 shares and 196,458 shares, respectively. Options granted under the ESPP were at prices ranging from $11.42 to $13.79 in 1998, $17.64 to $20.77 in 1997, and $17.80 to $25.87 in 1996. Pro forma compensation cost associated with options granted under the ESPP is estimated based on the discount from market value. At December 31, 1998, there were 421,596 shares of common stock reserved for purchase under the ESPP.
Under the John H. Harland Company 1981 Incentive Stock Option Plan, As Extended ("ISOP"), the Company may grant stock options to certain key employees to purchase shares of Company stock at no less than the fair market value of the stock on the date of the grant. The Company is authorized to issue up to 2,685,955 shares of common stock under the ISOP. Options granted under the ISOP through July 1995 became fully exercisable one year from the date of the grant, with a maximum life of five years. Options granted under the ISOP after July 1995 vest ratably over a five-year period beginning on the first anniversary of the date of the grant, and have a maximum life of 10 years
In December 1998, the board of directors of the Company adopted a new stock option plan covering the issuance of options to purchase up to 2,000,000 shares of common stock to employees at no less than fair market value on the date of grant. On December 17, 1998, options covering an aggregate of 483,340 shares were issued under this plan. Such options are exercisable ratably over a five year period beginning on the first anniversary of the date of grant, and have a maximum life of ten years.
The fair value of options granted during 1998 was estimated as $4.36, using the Black-Scholes option pricing model and the following weighted average assumptions: dividend yield 2.2%, expected volatility of 26.0%, risk-free interest rate of 5.4%, assumed forfeiture rate of 3.0% and an expected life of eight years. The fair value of options granted during 1997 was estimated as $7.47, using the Black-Scholes option pricing model and the following weighted average assumptions: dividend yield 2.3%, expected volatility of 24.1%, risk-free interest rate of 6.3%, assumed forfeiture rate of 3.0% and an expected life of eight years. The fair value of options granted during 1996 was estimated as $7.40, using the following weighted average assumptions: dividend yield 3.9%, expected volatility of 25.4%, risk-free interest rate of 6.4%, assumed forfeiture rate of 3.0% and an expected life of eight years.
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In October 1998, the board of directors granted 50,000 restricted shares of the Company's common stock to the Company's chief executive officer. Of this amount, 39,596 shares were immediately issued in the name of the individual with the remainder being issued in January 1999. The shares have all the rights of other shares of common stock, subject to certain restrictions and forfeiture provisions. The restriction expires as follows: 25,000 shares in October 2001; 12,500 shares in October 2002; and 12,500 shares in October 2003. Unearned compensation was recorded at the date of the award based on the market value of shares issued and is being amortized over the periods of restriction.
9. EMPLOYEE RETIREMENT AND SAVINGS PLANS Effective April 1, 1996, the Company merged substantially all of the Company's profit sharing plan assets with the Company's Master 401(k) Plan and Trust ("401(k) plan"). John H. Harland Company of Puerto Rico ("Harland PR") assumed sponsorship of the profit sharing plan since remaining assets relate only to Harland PR employees.
Harland PR's profit sharing plan is a non-contributory plan to provide retirement income for Harland PR employees. In 1996, contributions to the profit sharing plan were $0.4 million.
The 401(k) plan is a defined contribution 401(k) plan with an employer match covering any employee of the Company or a participating affiliate of the Company who is not a non-resident alien. Participants may contribute on a pre-tax and after-tax basis, subject to maximum IRS limits and not exceeding 17% of annual compensation. The Company matches employee contributions $0.50 for every dollar up to a maximum Company- matching contribution of 3% of qualified annual compensation. Additional contributions may be made from accumulated or current net profits at the discretion of the board of directors. Contributions to the 401(k) plan were $2.9 million in 1998, $3.4 million in 1997 and $3.5 million in 1996.
The Company has unfunded deferred compensation agreements with certain officers. The present value of cash benefits payable under the agreements is being provided over the periods of active employment and totaled $3.7 million and $3.9 million at December 31, 1998 and 1997, respectively. The charge to expense for these agreements is not significant.
10. POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS The Company sponsors two defined postretirement benefit plans that cover qualifying salaried and non-salaried employees. One plan provides health care benefits and the other provides life insurance benefits. The medical plan is contributory and contributions are adjusted annually based on actual claims experience. The life insurance plan is non-
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contributory. The Company's intent is that the retiree provide the majority of the actual cost of providing the medical plan. Neither plan is funded.
The cost of providing medical benefits was assumed to increase by 7.0% in 1999 with a reduction of 0.5% each year until a 5.5% rate is reached in 2002. The medical cost trend rate assumption could have a significant effect on amounts reported. An increase of 1.0% in the assumed trend rates would have had the effect of increasing the APBO by $1.7 million and the NPPC by $158,000. A decrease of 1.0% in the assumed trend rates would have had the effect of decreasing the APBO by $1.7 million and the NPPC by $143,000. The weighted average discount rate used in determining the APBO was 6.75% in 1998, 7.25% in 1997 and 7.75% in 1996, and employee earnings were estimated to increase 3.5% annually until age 65.
11. FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
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Short-term investments The carrying value approximates fair value because of the short maturity of those instruments.
Long-term investments The fair values of certain investments are estimated based on quoted market prices. The fair values of the Company's investments in limited partnerships are based on estimates by general partners in the absence of readily ascertainable market values. The fair value of the Company's other investments, which are not actively traded and are immaterial, is based on an estimate of the net realizable value of those investments.
Short-term debt The carrying value approximates fair value.
Long-term debt The fair value of the Company's convertible debentures is based on recent market quotes. The fair value of other long-term debt is based on estimated rates currently available to the Company for debt with similar terms and maturities.
12. COMMITMENTS AND CONTINGENCIES In the ordinary course of business, the Company is subject to various legal proceedings and claims. The Company believes that the ultimate outcome of these matters will not have a material effect on its financial statements.
The Company has an agreement with a vendor who will perform certain customer-related functions through 2001. Annual costs under this relationship are estimated to be $12.0 million per year through 2001.
13. BUSINESS SEGMENTS The Company operates its business in two segments. The Financial Services segment ("FS") includes checks and forms, database marketing software, direct marketing and loan and deposit origination software sold primarily to financial institutions.
The Scantron segment includes optical mark reading equipment, scannable forms, survey services and field maintenance services. Scantron sells these products and services primarily to the commercial and education markets.
The Company's operations are primarily in the United States and Puerto Rico. There were no significant inter-segment sales and no material amounts of the Company's sales are dependent upon a single
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customer. Equity investments as well as foreign assets are not significant to the consolidated results of the Company. The Company's accounting policies for segments are the same as those described in Note 1. Management evaluates segment performance based on segment income or loss before income taxes. Segment income or loss includes restructuring charges, software and other development and acquired in-process research and development costs written off but excludes interest income, interest expense and certain other non-operating gains and losses which are considered corporate items. Corporate assets consist primarily of cash and cash equivalents, investments and other assets not employed in production.
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INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of John H. Harland Company:
We have audited the consolidated balance sheets of John H. Harland Company and its subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, cash flows and shareholders' equity for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed in Item 14(a)2. These financial statements and financial schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. 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, such consolidated financial statements present fairly, in all material respects, the financial position of John H. Harland Company and its subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/DELOITTE & TOUCHE LLP
Atlanta, Georgia January 29, 1999
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JOHN H. HARLAND COMPANY AND SUBSIDIARIES
MANAGEMENT RESPONSIBILITY FOR FINANCIAL STATEMENTS
The financial statements included in this report were prepared by the Company in conformity with generally accepted accounting principles consistently applied. Management's best estimates and judgments were used, where appropriate. Management is responsible for the integrity of the financial statements and for other financial information included in this report. The financial statements have been audited by the Company's independent auditors, Deloitte & Touche LLP. As set forth in their report, their audits were conducted in accordance with generally accepted auditing standards and formed the basis for their opinion on the accompanying financial statements. They consider the Company's control structure and perform such tests and other procedures as they deem necessary to express an opinion on the fairness of the financial statements.
The Company maintains a control structure which is designed to provide reasonable assurance that assets are safeguarded and that the financial records reflect the authorized transactions of the Company. As a part of this process, the Company has an internal audit function which assists management in evaluating the adequacy and effectiveness of the control structure.
The Audit Committee of the Board of Directors is composed of directors who are neither officers nor employees of the Company. The Committee meets periodically with management, Internal Audit and the independent auditors to discuss auditing, the Company's control structure and financial reporting matters. Internal Audit and the independent auditors have full and free access to the Audit Committee.
/s/William M. Dollar Corporate Controller
January 29, 1999
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