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SUNGARD CAPITAL CORP II - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Introduction The following discussion and analysis supplements management's discussion and analysis in the Company's Annual Report on Form 10-K for the year ended December 31, 2011 and presumes that readers have read or have access to the discussion and analysis in that filing. The following discussion and analysis includes historical and certain forward-looking information that should be read together with the accompanying Consolidated Financial Statements, related footnotes, and the discussion below of certain risks and uncertainties that could cause future operating results to differ materially from historical results or from the expected results indicated by forward-looking statements. The following discussion reflects the results of operations and financial condition of SCC, which are materially the same as the results of operations and financial condition of SCCII and SunGard. Therefore, the discussions provided are applicable to each of SCC, SCCII and SunGard unless otherwise noted. Except as otherwise noted, all explanations below exclude the impacts from changes in currency translation, which we refer to as constant currency, a non-GAAP measure. We believe presenting our results on a constant currency basis is meaningful for assessing how our underlying businesses have performed due to the fact that we have international operations that are material to our overall operations. As a result, total revenues and expenses are affected by changes in the U.S. Dollar against international currencies. To present this information, current period results for entities reporting in currencies other than U.S. Dollars are converted to U.S. Dollars at the average exchange rate used in the prior year period rather than the actual exchange rates in effect during the current year period. In each of the tables below, we present the percent change based on actual, unrounded results in reported currency and in constant currency. Also, percentages may not add due to rounding. 30-------------------------------------------------------------------------------- Table of Contents Results of Operations: Three Months Ended September 30, 2012 Compared To Three Months Ended September 30, 2011 The following table sets forth, for the periods indicated, certain amounts included in our Consolidated Statements of Comprehensive Income, the relative percentage that those amounts represent to consolidated revenue (unless otherwise indicated), and the percentage change in those amounts from period to period. Constant Currency Three Months Three Months Percent Three Months Percent Ended Ended Increase Ended Increase September 30, September 30, (Decrease) September 30, (Decrease) 2011 2012 2012 vs. 2011 2012 2012 vs. 2011 percent of percent of percent of revenue revenue revenue (in millions) Revenue Financial Systems (FS) $ 680 62 % $ 640 62 % (6 )% $ 655 62 % (4 )% Availability Services (AS) 365 33 % 345 33 % (5 )% 350 33 % (4 )% Other (1) 52 5 % 50 5 % (3 )% 50 5 % (3 )% Total $ 1,097 100 % $ 1,035 100 % (6 )% $ 1,055 100 % (4 )% Costs and Expenses Cost of sales and direct operating $ 465 42 % $ 430 42 % (7 )% $ 438 42 % (6 )% Sales, marketing and administration 295 27 % 245 24 % (16 )% 252 24 % (14 )% Product development and maintenance 101 9 % 90 9 % (12 )% 96 9 % (6 )% Depreciation and amortization 67 6 % 70 7 % 4 % 70 7 % 4 % Amortization of acquisition-related intangible assets 106 10 % 94 9 % (12 )% 94 9 % (12 )% Goodwill impairment - - % 385 37 % 385 36 % Total $ 1,034 94 % $ 1,314 127 % 27 % $ 1,335 127 % 29 % Operating Income Financial Systems (2) $ 121 17.7 % $ 136 21.2 % 13 % $ 133 20.3 % 10 % Availability Services (2) 80 22.1 % 74 21.4 % (8 )% 76 21.6 % (6 )% Other (1)(2) 15 29.4 % 13 26.2 % (14 )% 13 26.2 % (14 )% Corporate (30 ) (2.7 )% (11 ) (1.0 )% 64 % (11 ) (1.0 )% 64 % Amortization of acquisition-related intangible assets (106 ) (9.7 )% (94 ) (9.1 )% 12 % (94 ) (8.9 )% 12 % Goodwill impairment - - % (385 ) (37.2 )% (385 ) (36.5 )% Stock compensation expense (9 ) (0.8 )% (9 ) (0.9 )% (3 )% (9 ) (0.9 )% (3 )% Other costs (3) (8 ) (0.7 )% (3 ) (0.3 )% 59 % (3 ) (0.3 )% 59 % Total $ 63 5.7 % $ (279 ) (27.0 )% (547 )% $ (280 ) (26.6 )% (548 )% (1) Other includes our Public Sector and K-12 businesses. (2) Percent of revenue is calculated as a percent of revenue from FS, AS and Other, respectively. (3) Other costs include management fees paid to the Sponsors, purchase accounting adjustments and certain other costs, partially offset in each year by capitalized software development costs. 31 -------------------------------------------------------------------------------- Table of Contents The following table sets forth, for the periods indicated, certain supplemental revenue data, the relative percentage that those amounts represent to total revenue and the percentage change in those amounts from period to period. Constant Currency Three Months Three Months Percent Three Months Percent Ended Ended Increase Ended Increase September 30, September 30, (Decrease) September 30, (Decrease) 2011 2012 2012 vs. 2011 2012 2012 vs. 2011 percent percent percent Revenue of of of (in millions) revenue revenue revenue Financial Systems Services $ 626 57 % $ 585 56 % (7 )% $ 599 57 % (5 )% License and resale fees 44 4 % 47 5 % 8 % 48 5 % 11 % Total products and services 670 61 % 632 61 % (6 )% 647 61 % (3 )% Reimbursed expenses 10 1 % 8 1 % (17 )% 8 1 % (16 )% Total $ 680 62 % $ 640 62 % (6 )% $ 655 62 % (4 )% Availability Services Services $ 358 33 % $ 341 33 % (5 )% $ 346 33 % (4 )% License and resale fees 1 - % - - % 2 % - - % 3 % Total products and services 359 33 % 341 33 % (5 )% 346 33 % (4 )% Reimbursed expenses 6 1 % 4 - % (33 )% 4 - % (28 )% Total $ 365 33 % $ 345 33 % (5 )% $ 350 33 % (4 )% Other Services $ 44 4 % $ 43 4 % (2 )% $ 43 4 % (2 )% License and resale fees 7 1 % 6 1 % (11 )% 6 1 % (11 )% Total products and services 51 5 % 49 5 % (3 )% 49 5 % (3 )% Reimbursed expenses 1 - % 1 - % (4 )% 1 - % (4 )% Total $ 52 5 % $ 50 5 % (3 )% $ 50 5 % (3 )% Total Revenue Services $ 1,028 94 % $ 969 94 % (6 )% $ 988 94 % (4 )% License and resale fees 52 5 % 53 5 % 5 % 54 5 % 8 % Total products and services 1,080 98 % 1,022 99 % (5 )% 1,042 99 % (4 )% Reimbursed expenses 17 2 % 13 1 % (22 )% 13 1 % (20 )% Total $ 1,097 100 % $ 1,035 100 % (6 )% $ 1,055 100 % (4 )% Operating Income: Our total operating margin was (26.6)% for the three months ended September 30, 2012, compared to 5.7% for the three months ended September 30, 2011. The most significant factor impacting the 32.3 margin point decrease in operating margin is the $385 million goodwill impairment charge related to AS NA, which had a (36.5) margin point impact. The more significant factors impacting the remaining 4.2 margin point improvement are a $34 million decrease in severance, which had a 3.1 margin point impact on the operating margin; a 1.1 margin point impact, or $13 million, from the decrease in amortization of acquisition-related intangible assets; and the 0.6 margin point impact, or $5 million, from the increase in software license fee revenue. Excluding the severance charges discussed above, FS improved the total operating margin by 0.6 points due mainly to expense management primarily from reduced external services fees and currency transaction losses. Also excluding the severance charges, degradation of total margin by AS of 1.4 points was due primarily to the decrease in recovery services and professional services revenue. Financial Systems: The FS operating margin was 20.3% and 17.7% for the three months ended September 30, 2012 and 2011, respectively. The more significant factors impacting the 2.6 margin point increase in operating margin are a 1.2 margin point impact, or $8 million, from the decrease in external services fees; the 0.9 margin point impact, or $6 million, from the decrease in currency transaction losses; and the 0.7 margin point impact from the $6 million increase in software license fee revenue. 32-------------------------------------------------------------------------------- Table of Contents Availability Services: The AS operating margin was 21.6% and 22.1% for the three months ended September 30, 2012 and 2011, respectively, a decrease of 0.5 margin points. In North America, recovery services, which typically uses shared resources, had a (2.2) margin point impact on AS operating margin in 2012 due primarily to a $14 million decrease in higher margin recovery services revenue, partially offset by a $5 million decrease in equipment expense. Professional services had a (0.5) margin point impact in 2012 due primarily to a $1 million increase in employment-related expenses on $2 million of lower revenue. A decrease in severance of $8 million had a 2.2 margin point impact in 2012. Other: The operating margin from Other was 26.2% and 29.4% for the three months ended September 30, 2012 and 2011, respectively, and operating income decreased $2 million. The operating margin decreased due primarily to unchanged costs on lower revenue. Revenue: Total reported revenue decreased $62 million or 6% for the three months ended September 30, 2012 compared to the third quarter of 2011. On a constant currency basis, revenue decreased $42 million, or 4%. The $42 million decrease is due mainly to a $22 million decrease in FS professional services revenue and a $14 million decrease in AS recovery services, partially offset by an increase in FS software license revenue of $5 million. Also, approximately $6 million of the $42 million decrease was due to a decrease in revenue from one of our FS businesses, a legacy broker/dealer (the "Broker/Dealer,") which was heavily influenced by service to one very large customer. That customer has since begun to self-clear its broker/dealer operations. Financial Systems: FS reported revenue decreased $40 million, or 6%, in the third quarter of 2012 from the prior year period, and decreased $25 million, or 4%, on a constant currency basis. Professional services revenue decreased $22 million, or 15%, due primarily to successful completion of projects during 2011 and relatively lower demand in 2012 driven by economic conditions and related customer budget constraints. One percentage point of the decrease was related to lower revenues from the Broker/Dealer as mentioned above. Reported revenue from license and resale fees included software license revenue of $43 million, an increase of $4 million, or 12%, compared to the same quarter in 2011. On a constant currency basis, software license fees increased $5 million, or 15%, due primarily to an increase in high-value, multi-year license renewal transactions with some scope expansion. Availability Services: AS reported revenue decreased $20 million, or 5%, in the third quarter of 2012 from the prior year period. On a constant currency basis, revenue decreased $15 million, or 4%, in the quarter. In North America, which accounts for over 75% of our AS business, revenue decreased 5%, where decreases in recovery services revenue exceeded growth in managed services revenue. Revenue in Europe, primarily from our U.K. operations, decreased 2%, where a decrease in recovery services revenue was partially offset by an increase in managed services revenue. Our recovery services revenue has been declining due to customers' shifting from traditional backup and recovery to either in-house solutions or disk-, cloud-based or managed recovery solutions. Separately, in managed services, demand has been increasing for outsourced management of IT operations and applications. We expect these trends to continue in the future. Other: Reported revenue and constant currency revenue from Other decreased $2 million, or 3%, for the three months ended September 30, 2012, from the corresponding period in 2011. Reported revenue from license and resale fees included software license revenue of $2 million in the three months ended September 30, 2012, a decrease of approximately $0.5 million from the prior year period. 33-------------------------------------------------------------------------------- Table of Contents Costs and Expenses: Cost of sales and direct operating expenses as a percentage of total revenue was 42% in each of the three-month periods ended September 30, 2012 and 2011 and decreased $27 million. Impacting the period was a $20 million decrease in FS and AS employment-related expenses, including a decrease of $9 million of severance; and a $6 million decrease in AS equipment costs associated with lower equipment leases, equipment and software maintenance and decreased network costs. Sales, marketing and administration expenses as a percentage of total revenue was 24% and 27% in the three months ended September 30, 2012 and 2011, respectively, and decreased $43 million. Decreases in sales, marketing and administration expenses were due primarily to decreases in corporate and FS employment-related expenses of $22 million due primarily to the impact from severance actions taken in 2011; FS currency transaction losses of $8 million; external services fees of $6 million and FS facilities costs. Because AS product development and maintenance costs are insignificant, it is more meaningful to measure product development and maintenance expenses as a percentage of revenue excluding AS. For the three months ended September 30, 2012 and 2011, product development and maintenance costs were 13% and 14%, respectively, of revenue excluding AS and decreased $6 million. The decrease is primarily related to a $2 million increase in FS costs capitalized as software assets in the third quarter of 2012 from the prior year period. Amortization of acquisition-related intangible assets was 9% and 10% of total revenue in the three months ended September 30, 2012 and 2011, respectively, and decreased $12 million. The decrease is due primarily to the $13 million impact of software assets that were fully amortized in the prior year. We recorded a goodwill impairment charge of $385 million in AS in the three months ended September 30, 2012. See note 3 of Notes to Consolidated Financial Statements for further discussion. Interest expense was $102 million and $130 million for the three months ended September 30, 2012 and 2011, respectively. The decrease in interest expense was due primarily to the repayment in January 2012 of $1.22 billion of our outstanding term loans as a result of the sale of HE, the early extinguishment in April 2012 of $500 million 10.625% senior notes due 2015 ("2015 Notes") and interest rate decreases resulting from the expiration of interest rate swaps in each of February 2011 and 2012. The effective income tax rates for the three months ended September 30, 2012 and 2011 were 3% and 41%, respectively. The Company's effective tax rate fluctuates from period to period due to changes in the mix of income or losses in jurisdictions with a wide range of tax rates, permanent differences between GAAP and local tax laws, and the timing of recording discrete items. The effective tax rate for the three months ended September 30, 2012 was also impacted by the goodwill impairment charge, which is largely nondeductible, and by the application of the loss limitation guidance, which requires that when the interim period loss before taxes exceeds the forecasted loss before taxes for the annual period, the tax benefit recognized associated with the interim period loss should be limited to the tax benefit associated with the loss expected to be recognized for the annual period. Accreted dividends on SCCII's cumulative preferred stock were $64 million and $57 million for the three months ended September 2012 and 2011, respectively. The increase in dividends is due to compounding. No dividends have been declared by SCCII. Nine Months Ended September 30, 2012 Compared To Nine Months Ended September 30, 2011 The following table sets forth, for the periods indicated, certain amounts included in our Consolidated Statements of Comprehensive Income, the relative percentage that those amounts represent to consolidated revenue (unless otherwise indicated), and the percentage change in those amounts from period to period. 34 -------------------------------------------------------------------------------- Table of Contents Constant Currency Percent Percent Nine Months Ended Nine Months Ended Increase Nine Months Ended Increase September 30, September 30, (Decrease) September 30, (Decrease) 2011 2012 2012 vs. 2011 2012 2012 vs. 2011 percent of percent of percent of (in millions) revenue revenue revenue Revenue Financial Systems (FS) $ 2,037 62 % $ 1,928 62 % (5 )% $ 1,965 62 % (4 )% Availability Services (AS) 1,095 33 % 1,052 34 % (4 )% 1,065 33 % (3 )% Other (1) 154 5 % 151 5 % (2 )% 151 5 % (2 )% Total $ 3,286 100 % $ 3,131 100 % (5 )% $ 3,181 100 % (3 )% Costs and Expenses Cost of sales and direct operating $ 1,416 43 % $ 1,321 42 % (7 )% $ 1,340 42 % (5 )% Sales, marketing and administration 842 26 % 768 25 % (9 )% 785 25 % (7 )% Product development and maintenance 302 9 % 273 9 % (10 )% 287 9 % (5 )% Depreciation and amortization 204 6 % 211 7 % 3 % 211 7 % 3 % Amortization of acquisition-related intangible assets 332 10 % 295 9 % (11 )% 295 9 % (11 )% Goodwill impairment - - % 385 12 % 385 12 % Total $ 3,096 94 % $ 3,253 104 % 5 % $ 3,303 104 % 7 % Operating Income Financial Systems (2) $ 374 18.3 % $ 388 20.1 % 4 % $ 383 19.5 % 2 % Availability Services (2) 234 21.4 % 209 19.9 % (11 )% 214 20.1 % (8 )% Other (1)(2) 43 28.2 % 41 26.8 % (7 )% 41 26.8 % (7 )% Corporate (79 ) (2.4 )% (39 ) (1.3 )% 50 % (39 ) (1.2 )% 50 % Amortization of acquisition-related intangible assets (332 ) (10.1 )% (295 ) (9.4 )% 11 % (295 ) (9.3 )% 11 % Goodwill impairment - - % (385 ) (12.3 )% (385 ) (12.1 )% Stock compensation expense (23 ) (0.7 )% (29 ) (0.9 )% (27 )% (29 ) (0.9 )% (27 )% Other costs (3) (27 ) (0.9 )% (12 ) (0.4 )% 58 % (12 ) (0.4 )% 58 % Total $ 190 5.8 % $ (122 ) (3.9 )% (165 )% $ (122 ) (3.9 )% (165 )% (1) Other includes our Public Sector and K-12 businesses. (2) Percent of revenue is calculated as a percent of revenue from FS, AS and Other, respectively. (3) Other costs include management fees paid to the Sponsors, purchase accounting adjustments and certain other costs, partially offset in each year by capitalized software development costs. 35 -------------------------------------------------------------------------------- Table of Contents The following table sets forth, for the periods indicated, certain supplemental revenue data, the relative percentage that those amounts represent to total revenue and the percentage change in those amounts from period to period. Constant Currency Percent Percent Nine Months Ended Nine Months Ended Increase Nine Months Ended Increase September 30, September 30, (Decrease) September 30, (Decrease) 2011 2012 2012 vs. 2011 2012 2012 vs. 2011 percent percent percent Revenue of of of (in millions) revenue revenue revenue Financial Systems Services $ 1,805 55 % $ 1,750 56 % (3 )% $ 1,780 56 % (1 )% License and resale fees 171 5 % 148 5 % (13 )% 155 5 % (10 )% Total products and services 1,976 60 % 1,898 61 % (4 )% 1,935 61 % (2 )% Reimbursed expenses 61 2 % 30 1 % (51 )% 30 1 % (51 )% Total $ 2,037 62 % $ 1,928 62 % (5 )% $ 1,965 62 % (4 )% Availability Services Services $ 1,081 33 % $ 1,036 33 % (4 )% $ 1,048 33 % (3 )% License and resale fees 1 - % 1 - % 30 % 1 - % 31 % Total products and services 1,082 33 % 1,037 33 % (4 )% 1,049 33 % (3 )% Reimbursed expenses 13 - % 15 - % 18 % 16 - % 23 % Total $ 1,095 33 % $ 1,052 34 % (4 )% $ 1,065 33 % (3 )% Other Services $ 130 4 % $ 130 4 % (1 )% $ 130 4 % (1 )% License and resale fees 21 1 % 19 1 % (7 )% 19 1 % (7 )% Total products and services 151 5 % 149 5 % (2 )% 149 5 % (2 )% Reimbursed expenses 3 - % 2 - % (14 )% 2 - % (14 )% Total $ 154 5 % $ 151 5 % (2 )% $ 151 5 % (2 )% Total Revenue Services $ 3,016 92 % $ 2,916 93 % (3 )% $ 2,958 93 % (2 )% License and resale fees 193 6 % 168 5 % (13 )% 175 6 % (9 )% Total products and services 3,209 98 % 3,084 98 % (4 )% 3,133 98 % (2 )% Reimbursed expenses 77 2 % 47 2 % (39 )% 48 2 % (37 )% Total $ 3,286 100 % $ 3,131 100 % (5 )% $ 3,181 100 % (3 )% Operating Income: Our total operating margin was (3.9)% for the nine months ended September 30, 2012, compared to 5.8% for the nine months ended September 30, 2011. The most significant factor impacting the 9.7 margin point decrease is the $385 million goodwill impairment charge related to AS NA, which had a (12.1) margin point impact. The more significant factors impacting the remaining 2.4 margin point improvement are a $52 million decrease in severance and corporate executive transition and other employment-related costs, which had a 1.6 margin point impact; a 1.2 margin point impact, or $37 million, from the decrease in amortization of acquisition-related intangible assets; a 0.5 margin point impact, or $16 million, from the decrease in other costs, primarily from capitalizing more software costs in 2012; partially offset by a (0.8) margin point impact from the decrease in the AS margin, which excludes the impact of severance; and a (0.4) margin point impact, or $15 million, from the decrease in software license fee revenue. Excluding the severance charges discussed above, FS improved the total operating margin by 0.2 points due mainly to expense management primarily from reduced external services fees and consultant expenses. Also excluding the severance charges, degradation of total margin by AS of 0.9 points was due primarily to the decrease in recovery services and professional services revenue, partially offset by an increase in revenue from managed services. Financial Systems: The FS operating margin was 19.5% and 18.3% for the nine months ended September 30, 2012 and 2011, respectively. The more significant factors impacting the 1.2 margin point change in the operating margin are the 0.8 margin point impact, or $15 million, from the decrease in external services fees; the 0.5 margin point impact, or $9 million, from the decrease in consultant expense; the 0.3 margin point impact from the lower activity level of the Broker/Dealer; partially offset by the (0.6) margin point impact from the $15 million decrease in software license fee revenue. 36-------------------------------------------------------------------------------- Table of Contents Availability Services: The AS operating margin was 20.1% and 21.4% for the nine months ended September 30, 2012 and 2011, respectively, a decrease of 1.3 margin points. In North America, recovery services, which typically uses shared resources, had a (2.4) margin point impact on AS operating margin in 2012 due primarily to a $43 million decrease in higher margin recovery services revenue, partially offset by a $14 million decrease in equipment expense. Professional services had a (0.3) margin point impact in 2012 due primarily to a $2 million increase in employment-related expenses on $2 million of lower revenue. A decrease in severance of $8 million had a 0.7 margin point impact in 2012. Managed services helped the margin in 2012 by 0.7 margin points due primarily to a $13 million increase in typically lower margin managed services revenue, which uses dedicated resources, and a $2 million decrease in facilities costs, partially offset by a $2 million increase in depreciation and amortization and a $4 million increase in employment-related expenses. Other: The operating margin from Other was 26.8% and 28.2% for the nine months ended September 30, 2012 and 2011, respectively. The operating margin decreased 1.4 margin points due primarily to a $3 million decrease in revenue and a $2 million increase in employment-related expenses, partially offset by a $1 million decrease in external services fees. Revenue: Total reported revenue decreased $155 million or 5% for the nine months ended September 30, 2012 compared to the third quarter of 2011. On a constant currency basis, revenue decreased $105 million, or 3%. Approximately $53 million of the $105 million decrease, or 1.5 of the three percentage points of decrease, was due to a decrease in revenue from the Broker/Dealer discussed above. The remaining decrease is due mainly to a $42 million decrease in AS recovery services, a $30 million decrease in FS professional services revenue, and a $15 million decrease in FS software license revenue, partially offset by a $13 million increase in AS managed services, an $11 million increase from FS acquisitions, and an $8 million increase in FS processing revenue. Financial Systems: FS reported revenue decreased $109 million or 5% in the nine months ended September 30, 2012 from the prior year period, and decreased 4% on a constant currency basis. Three percentage points of the decrease was related to lower revenues from the Broker/Dealer discussed above. Professional services revenue decreased $30 million, or 7%, due primarily to successful completion of projects during 2011 and relatively lower demand in 2012 driven by economic conditions and related customer budget constraints, and was offset in part by a $4 million increase from acquisitions. Reported revenue from license and resale fees included software license revenue of $136 million, a decrease of $21 million, or 13%, compared to the nine months of 2011. On a constant currency basis, software license revenue decreased $15 million, or 9%, due mainly to high-value, multi-year license renewal transactions with some scope expansion recognized in 2011. Also, one deal in 2011 worth $14 million was recognized for which there were no similarly sized transactions in 2012. Processing revenue increased $8 million, or 1%, due mainly to the impact of new business signed in 2011, higher volumes in 2012 and annual rate increases and increased $4 million due to acquisitions. Availability Services: AS reported revenue decreased $43 million, or 4%, in the nine months ended September 30, 2012 from the prior year period. On a constant currency basis, revenue decreased 3% in the nine month period ended September 30, 2012. In North America, which accounts for over 75% of our AS business, revenue decreased 4%, where decreases in recovery services revenue exceeded growth in managed services revenue. Revenue in Europe, primarily from our U.K. operations, increased 1%, where an increase in managed services revenue was mostly offset by a decrease in recovery services revenue. Our recovery services revenue has been declining due to customers' shifting from traditional backup and recovery to either in-house solutions or disk-, cloud-based or managed recovery solutions. Separately, in managed services, demand has been increasing for outsourced management of IT operations and applications. We expect these trends to continue in the future. 37 -------------------------------------------------------------------------------- Table of Contents Other: Reported revenue and constant currency revenue from Other decreased $3 million, or 2%, for the nine months ended September 30, 2012, from the corresponding period in 2011. Reported revenue from license and resale fees included software license revenue of $6 million in the nine months ended September 30, 2012, a decrease of $1 million from the prior year period. Costs and Expenses: Cost of sales and direct operating expenses as a percentage of total revenue was 42% and 43% in the nine months ended September 30, 2012 and 2011, respectively, and decreased $76 million. Impacting the period was a $42 million decrease in reimbursed expenses relating to the operations of the Broker/Dealer businesses due primarily to no longer providing correspondent clearing services for a large, former Broker/Dealer customer that has since begun to self-clear its broker/dealer operations; a $31 million decrease in FS employment-related expenses; a $19 million decrease in AS equipment costs associated with lower equipment leases, equipment and software maintenance and decreased network costs; partially offset by a $7 million increase from FS acquisitions. Sales, marketing and administration expenses as a percentage of total revenue was 25% and 26% in the nine months ended September 30, 2012 and 2011, and decreased $57 million. Decreases in sales, marketing and administration expenses were due primarily to decreases of $37 million of corporate and FS employment-related expenses mainly as a result of executive transition costs incurred in the second quarter of 2011 and other severance actions taken in 2011; $12 million of external services fees; $10 million of advertising expense and related costs mainly resulting from cost savings initiatives; and $4 million of costs related to the shutdown of the Broker/Dealer professional trading business in 2011; partially offset by increases of $6 million of stock compensation expense. Because AS product development and maintenance costs are insignificant, it is more meaningful to measure product development and maintenance expenses as a percentage of revenue excluding AS. For the nine months ended September 30, 2012 and 2011, product development and maintenance costs were 13% and 14%, respectively, of revenue excluding AS, respectively, and decreased $15 million. The decrease is primarily related to a $8 million increase in FS costs capitalized as software assets. Depreciation and amortization was 7% and 6% of total revenue in the nine months ended September 30, 2012 and 2011, respectively, and increased $7 million due mainly to AS capital expenditures over the past twelve months. Amortization of acquisition-related intangible assets was 9% and 10% of total revenue in the nine months ended September 30, 2012 and 2011, respectively, and decreased $37 million. The decrease is due primarily to the $33 million impact of software assets that were fully amortized in the prior year and $7 million of impairment charges in the prior year period. We recorded a goodwill impairment charge of $385 million in AS in the nine months ended September 30, 2012. See note 3 of Notes to Consolidated Financial Statements for further discussion. Interest expense was $325 million and $396 million for the nine months ended September 30, 2012 and 2011, respectively. The decrease in interest expense was due primarily to the repayment in January 2012 of $1.22 billion of our outstanding term loans as a result of the sale of HE, the early extinguishment in April 2012 of the 2015 Notes and interest rate decreases resulting from the expiration of interest rate swaps in each of February 2011 and 2012. Loss on extinguishment of debt was $51 million and $2 million for the nine months ended September 30, 2012 and 2011, respectively. This increase was due primarily to the partial repayment of term loans in January 2012 and the early extinguishment of the 2015 Notes discussed above. The effective income tax rates for the nine months ended September 30, 2012 and 2011 were 9% and 28%, respectively. The rate fluctuates from period to period due to changes in the mix of income or losses in jurisdictions with a wide range of tax rates, permanent differences between GAAP and local tax laws and the timing of recording discrete items. The effective tax rate for the nine months ended September 30, 2012 was also impacted by the goodwill impairment charge, which is largely nondeductible, and the application of the loss limitation guidance, which requires that when the interim period loss before taxes exceeds the forecasted loss before taxes for the annual period, the tax benefit recognized associated with the interim period loss should be limited to the tax benefit associated with the loss expected to be recognized for the annual period. Accreted dividends on SCCII's cumulative preferred stock were $186 million and $166 million for the nine months ended September 30, 2012 and 2011, respectively. The increase in dividends is due to compounding. No dividends have been declared by SCCII. 38 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources: At September 30, 2012, cash and equivalents were $752 million. Cash flow from continuing operations was $426 million in the nine months ended September 30, 2012 compared to $362 million in the nine months ended September 30, 2011. Impacting cash flow from continuing operations was a $49 million increase in cash earned from operations, defined as operating income adjusted for certain noncash expenses and the cash portion of other income (expense), $44 million less of interest payments made in the nine months ended September 30, 2012 from the prior year period, due primarily to the partial repayment in January 2012 of $1.22 billion of term loans resulting from the sale of HE, the retirement of $500 million 10.625% senior notes due 2015 in April 2012 and the expiration of certain of our interest rate swaps, partially offset by an $18 million increase in income tax payments, net of refunds, and $11 million less cash provided by working capital. Net cash used by continuing operations in investing activities was $180 million in the nine months ended September 30, 2012, comprised of cash paid for property and equipment and other assets and one business acquired in our FS segment. Net cash used by continuing operations in investing activities was $220 million in the nine months ended September 30, 2011, comprised mainly of cash paid for property and equipment and other assets and five businesses acquired in our FS segment. In January 2012, we sold our HE business for gross proceeds of approximately $1.775 billion less applicable taxes and fees. We expect to pay approximately $450 million of income taxes in 2012 as a result of the HE sale, of which approximately 75% has been paid through the third quarter, and the remainder is expected to be paid in the fourth quarter net of any benefit from continuing operations. Net cash used by continuing operations in financing activities was $1.79 billion for the nine months ended September 30, 2012, primarily related to repayments of $1.22 billion of term loans resulting from the sale of HE and $527 million related to the early retirement of the 10.625% senior notes due 2015. Net cash provided by continuing operations in financing activities was $227 million for the nine months ended September 30, 2011, primarily related to repayments under the revolving portion of our receivables facility and the partial retirement of $100 million of £-denominated term loans. At September 30, 2012, no amount was outstanding under the revolving credit facility, and $200 million was outstanding under the receivables facility. On March 2, 2012, SunGard amended its Credit Agreement to, among other things, extend the maturity date of approximately $908 million of tranche A and incremental term loans from February 28, 2014 to February 28, 2017, extend the maturity of $880 million of revolving credit facility commitments from May 11, 2013 to November 29, 2016, and amend certain covenants and other provisions, in order to, among other things, permit the potential spin-off of AS. The tranche B, tranche C and revolving credit facility each have certain springing maturity provisions which are described in the Company's Credit Agreement as amended and filed with the Company's Form 8-K dated March 2, 2012. On April 2, 2012, SunGard redeemed for $527 million plus accrued and unpaid interest to the redemption date all of its outstanding 10.625% senior notes due 2015 under the Indenture dated as of September 29, 2008 (as amended or supplemented from time to time, the "2015 Indenture") among SunGard, the guarantors named therein, and The Bank of New York Mellon, as trustee. In July 2012, we sold one of our European consulting businesses for approximately €14 million. On August 10, 2012, SunGard executed an interest rate swap derivative with a notional amount of $200 million. This swap, which matures on February 28, 2017, is designated as a cash flow hedge, and it effectively swaps floating rate debt (1-month LIBOR) to fixed rate debt of 0.73%. On September 14, 2012, SunGard executed an interest rate swap derivative with a notional amount of $200 million. This swap, which matures on February 28, 2017, is designated as a cash flow hedge, and it effectively swaps floating rate debt (1-month LIBOR) to fixed rate debt of 0.66%. At September 30, 2012, we have outstanding $6.11 billion in aggregate indebtedness, with additional borrowing capacity of $858 million under the revolving credit facility (after giving effect to outstanding letters of credit). Under the receivables facility, there was an additional borrowing capacity of $39 million at September 30, 2012. Also at September 30, 2012, we have outstanding letters of credit and bid bonds that total approximately $42 million. On November 1, 2012, SunGard successfully issued $1 billion aggregate principal amount of 6.625% Senior Subordinated Notes due 2019 ("Senior Subordinated Notes") and used a portion of the proceeds from this offering to repurchase approximately $490 million of its 10.25% Senior Subordinated Notes due 2015 ("Existing 10.25% Senior Subordinated Notes"). SunGard intends to repurchase or redeem the remaining Existing 10.25% Senior Subordinated Notes in the fourth quarter of 2012. As a result of this transaction, the Company expects to incur a $30 million loss on the extinguishment of debt which will be reflected in the statement of comprehensive income in the fourth quarter of 2012. On November 1, 2012, SunGard and the guarantors of the Senior Subordinated Notes entered into a registration rights agreement and have agreed that they will (i) file a registration statement with respect to a registered offer to exchange the Senior Subordinated Notes for new notes guaranteed by the guarantors on a senior subordinated unsecured basis, with terms substantially identical in all material respects to the Senior Subordinated Notes, and (ii) use their reasonable best efforts to cause the exchange offer registration statement to be declared effective under the Securities Act of 1933, as amended. 39-------------------------------------------------------------------------------- Table of Contents SunGard and the guarantors have agreed to use their reasonable best efforts to cause the exchange offer to be completed or, if required, to have one or more shelf registration statements declared effective, within 360 days after the issue date. If SunGard fails to satisfy this obligation (a "registration default"), the annual interest rate on the Senior Subordinated Notes will increase by an additional 0.25% for each subsequent 90-day period during which the registration default continues, up to a maximum additional interest rate of 1.00% per year. If the registration default is corrected, the applicable interest rate will revert to the original level. We expect our available cash balances and cash flows from operations, combined with availability under the revolving credit facility and receivables facility, to provide sufficient liquidity to fund our current obligations, projected working capital requirements and capital spending for a period that includes at least the next 12 months. Covenant Compliance Adjusted EBITDA is used to determine compliance with certain covenants contained in the indentures governing SunGard's senior notes due 2018 and 2020 and senior subordinated notes due 2015 and in SunGard's senior secured credit facilities. Adjusted EBITDA is defined as EBITDA, which we define as earnings before interest, taxes, depreciation and amortization, further adjusted to exclude certain adjustments permitted in calculating covenant compliance under the indentures and senior secured credit facilities. We believe that the inclusion of supplementary adjustments to EBITDA applied in presenting Adjusted EBITDA are appropriate to provide additional information to investors to demonstrate compliance with the financing covenants. A breach of covenants in SunGard's senior secured credit facilities that are tied to ratios based on Adjusted EBITDA could result in a default under that agreement and the lenders could elect to declare all amounts borrowed due and payable. Any such acceleration would also result in a default under the indentures. Additionally, under SunGard's debt agreements, our ability to engage in activities such as incurring additional indebtedness, making investments and paying dividends is also tied to ratios based on Adjusted EBITDA. Adjusted EBITDA is calculated as follows (in millions): Last Twelve Months Three Months Ended September 30, Nine Months Ended September 30, September 30, 2011 2012 2011 2012 2012 Income (loss) from continuing operations $ (39 ) $ (367 ) $ (148 ) $ (451 ) $ (372 ) Interest expense, net 129 101 393 324 452 Taxes (27 ) (13 ) (57 ) (44 ) (105 ) Depreciation and amortization 173 164 536 506 676 EBITDA 236 (115 ) 724 335 651 Goodwill impairment charge - 385 - 385 433 Purchase accounting adjustments (a) 3 2 8 7 9 Non-cash charges (b) 9 10 23 30 41 Restructuring and other (c) 53 16 79 29 45 Acquired EBITDA, net of disposed EBITDA - - - - 1 Loss on extinguishment of debt (d) - - 2 51 52 Adjusted EBITDA-senior secured credit facilities, senior notes due 2018 and 2020 and senior subordinated notes due 2015 $ 301 $ 298 $ 836 $ 837 $ 1,232 (a) Purchase accounting adjustments include the adjustment of deferred revenue and lease reserves to fair value at the date of the LBO and subsequent acquisitions made by the Company and certain acquisition-related compensation expense. (b) Non-cash charges include stock-based compensation and loss on the sale of assets. (c) Restructuring and other charges include severance and related payroll taxes, reserves to consolidate or exit certain facilities, strategic initiative expenses, certain other expenses associated with acquisitions made by the Company, management fees paid to the Sponsors (see Note 9 of Notes to Financial Statements) and franchise and similar taxes reported in operating expenses, partially offset by certain charges relating to the receivables facility. (d) Loss on extinguishment of debt includes the write-off of deferred financing fees associated with the January 2012 repayment of $1.22 billion of our US$-denominated term loans and the April 2, 2012 retirement of $500 million, 10.625% senior notes due 2015. 40 -------------------------------------------------------------------------------- Table of Contents The covenant requirements and actual ratios for the twelve months ended September 30, 2012 are as follows. All covenants are in compliance. Covenant Actual Requirements Ratios Senior secured credit facilities (1) Minimum Adjusted EBITDA to consolidated interest expense ratio 1.95 x 3.39 x Maximum total debt to Adjusted EBITDA 5.75 x 4.23 x Senior notes due 2018 and 2020 and senior subordinated notes due 2015 (2) Minimum Adjusted EBITDA to fixed charges ratio required to incur additional debt pursuant to ratio provisions 2.00 x 3.38 x (1) The senior secured credit facilities require us to maintain an Adjusted EBITDA to consolidated interest expense ratio starting at a minimum of 1.95x for the four-quarter period ended December 31, 2011 and increasing over time to 2.10x by the end of 2012 and 2.20x by the end of 2013. Consolidated interest expense is defined in the senior secured credit facilities as consolidated cash interest expense less cash interest income further adjusted for certain non-cash or non-recurring interest expense and the elimination of interest expense and fees associated with SunGard's receivables facility. Beginning with the four-quarter period ending December 31, 2011, we are required to maintain a consolidated total debt to Adjusted EBITDA ratio of 5.75x and decreasing over time to 5.25x by the end of 2012 and to 4.75x by the end of 2013. Consolidated total debt is defined in the senior secured credit facilities as total debt less certain indebtedness and further adjusted for cash and cash equivalents on our balance sheet in excess of $50 million. Failure to satisfy these ratio requirements would constitute a default under the senior secured credit facilities. If our lenders failed to waive any such default, our repayment obligations under the senior secured credit facilities could be accelerated, which would also constitute a default under our indentures. (2) SunGard's ability to incur additional debt and make certain restricted payments under our indentures, subject to specified exceptions, is tied to an Adjusted EBITDA to fixed charges ratio of at least 2.0x, except that we may incur certain debt and make certain restricted payments and certain permitted investments without regard to the ratio, such as the ability to incur up to an aggregate principal amount of $5.75 billion under credit facilities (inclusive of amounts outstanding under the senior credit facilities from time to time; as of September 30, 2012, we had $3.05 billion outstanding under the term loan facilities and available commitments of $858 million under the revolving credit facility), to acquire persons engaged in a similar business that become restricted subsidiaries and to make other investments equal to 6% of our consolidated assets. Fixed charges is defined in the indentures governing the Senior Notes due 2018 and 2020 and the Senior Subordinated Notes due 2015 as consolidated interest expense less interest income, adjusted for acquisitions, and further adjusted for non-cash interest and the elimination of interest expense and fees associated with the receivables facility. Certain Risks and Uncertainties Certain of the matters we discuss in this Report on Form 10-Q may constitute forward-looking statements. You can identify forward-looking statements because they contain words such as "believes," "expects," "may," "will," "should," "seeks," "approximately," "intends," "plans," "estimates," or "anticipates" or similar expressions which concern our strategy, plans or intentions. All statements we make relating to estimated and projected earnings, margins, costs, expenditures, cash flows, growth rates and financial results are forward-looking statements. In addition, we, through our senior management, from time to time make forward-looking public statements concerning our expected future operations and performance and other developments. All of these forward-looking statements are subject to risks and uncertainties that may change at any time, and, therefore, our actual results may differ materially from those we expected. We derive most of our forward-looking statements from our operating budgets and forecasts, which are based upon many detailed assumptions. While we believe that our assumptions are reasonable, we caution that it is very difficult to predict the 41 -------------------------------------------------------------------------------- Table of Contents impact of known factors, and, of course, it is impossible for us to anticipate all factors that could affect our actual results. Some of the factors that we believe could affect our results include: general economic and market conditions; the overall condition of the financial services industry, including the effect of any further consolidation among financial services firms; our high degree of leverage; the effect of war, terrorism, natural disasters or other catastrophic events; the effect of disruptions to our systems and infrastructure; the timing and magnitude of software sales; the timing and scope of technological advances; customers taking their information availability solutions in-house; the trend in information availability toward solutions utilizing more dedicated resources; the market and credit risks associated with broker/dealer operations; the ability to retain and attract customers and key personnel; risks relating to the foreign countries where we transact business; the integration and performance of acquired businesses; the ability to obtain patent protection and avoid patent-related liabilities in the context of a rapidly developing legal framework for software and business-method patents; a material weakness in our internal controls; and unanticipated changes in our tax provision or the adoption of new tax legislation. The factors described in this paragraph and other factors that may affect our business or future financial results are discussed in our filings with the Securities and Exchange Commission, including this Form 10-Q. We assume no obligation to update any written or oral forward-looking statement made by us or on our behalf as a result of new information, future events or other factors. |