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NETSPEND HOLDINGS, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Form 10-K, particularly in "Risk Factors." Overview NetSpend is a leading program manager for FDIC-insured depository institutions that issue general-purpose reloadable prepaid debit cards, or GPR cards, and provide related alternative financial services to underbanked consumers in the United States. The programs managed by the Company empower underbanked consumers by providing them with innovative and affordable financial products and services tailored to meet their particular financial services needs and preferences in a manner that traditional banking institutions have not historically met. In addition, the products and services we manage provide our distributors an opportunity to enhance their customer relationships and generate incremental, ongoing revenue streams. Cardholders may use their GPR cards to make purchase transactions at any merchant that participates in the MasterCard, Visa or PULSE networks and to withdraw funds from participating ATMs. MetaBank holds the majority of the cardholder funds. We own approximately 3.6% of the outstanding equity interests in Meta Financial Group, Inc. ("MFG"), MetaBank's holding company. Our principal operating company, predecessor and current subsidiary, NetSpend Corporation ("NetSpend"), was incorporated in Texas in 1999. In May 2004, Oak Investment Partners acquired a controlling equity interest in NetSpend through a recapitalization transaction pursuant to which we, as a newly-formed holding company incorporated in Delaware, acquired all of the capital stock of NetSpend. In 2008, we acquired Skylight Financial, Inc. ("Skylight"), a payroll card provider, in a stock-for-stock merger. Entities affiliated with one of our significant shareholders, the JLL Funds, were previously the majority owners of Skylight. We have built an extensive and diverse distribution and reload network in the United States to support the marketing and ongoing use of the GPR cards we manage. We market cards through multiple distribution channels, including alternative financial service providers, traditional retailers, direct-to-consumer and online marketing programs and to corporate employers as an alternative method of wage payment for their employees. Beginning in 2008, we decided to focus primarily on GPR cards and we ceased marketing gift cards entirely in August 2010. We have developed and operate a proprietary technology platform. Our in-house platform is end-to-end in that it encompasses the critical functions required for us to acquire cardholders, process transactions, maintain account-level data, communicate with cardholders, manage risk, ensure regulatory compliance and connect to our Issuing Banks and distributors. These integrated capabilities allow us to customize our products and services for different markets, distribution channels and customer segments. Further, by processing transactions on our own platform, we gain unique and extensive insight into the attitudes, characteristics and purchasing behavior of the holders of the cards we manage. We are pursuing a bank diversification strategy and we are distributing our card issuing activities across three issuing banks, in addition to the banks that issue our payroll cards. We are focused on balancing our diversification strategy with the protection of existing cardholder and direct deposit 37 -------------------------------------------------------------------------------- Table of Contents relationships and other operational considerations. In furtherance of this strategy we entered into an agreement with The Bancorp Bank ("Bancorp") in January 2011 pursuant to which Bancorp serves as an Issuing Bank for some of our new and existing card programs, including the cards we distribute through traditional retailers. We have also signed an agreement with BofI Federal Bank ("BofI") pursuant to which we will manage GPR and payroll cards to be issued by it. BofI began issuing GPR cards in January 2013.We are continuing our discussions with other prospective issuing banks. In May 2011, we amended our agreement with Inter National Bank ("INB") to extend the date by which we agreed to transition the GPR cards issued by INB to another bank from July 2011 to September 2011. We have transitioned the distributors of cards issued by INB to other Issuing Banks and we transferred INB's cardholder portfolio to Bancorp in February 2013. We and INB are engaged in an active dispute regarding the contractual obligations of the parties in connection with the transition of INB's portfolio. U.S. Bank ("USB") and SunTrust Bank ("SunTrust") act as issuers of our payroll cards. We currently intend to transfer the USB portfolio to BofI. Our contract with SunTrust has been extended to September 2015. We are actively seeking to sign agreements with additional banks to act as issuers of payroll cards. As a result of these efforts, we signed an agreement with Regions Bank pursuant to which we will act as the program manager for the payroll cards to be issued by it. Recent Developments Share Repurchase Programs In November 2011, our board of directors approved a $25 million share repurchase program that was completed in February 2012. In June 2012, our board of directors approved a $75 million share repurchase program that was completed in August 2012. The share repurchases were made through a 10b5-1 plan and through block trades. We intend to hold the repurchased shares in treasury for general corporate purposes. During 2012, we repurchased approximately 10.3 million shares of common stock at an average price of $9.00 per share pursuant to these programs. The average price paid per share is calculated on a trade date basis and excludes commissions. Key Business Metrics As a leading manager of providers of GPR card programs and related alternative financial services to underbanked consumers, we evaluate a number of business metrics to monitor our performance and manage our business. We believe the following metrics are the primary indicators of our performance. Number of Active Cards-represents the total number of GPR cards that have had a PIN or signature-based purchase transaction, a point-of-sale load transaction or an ATM withdrawal within three months of the date of determination. The programs we manage had approximately 2,352,000, 2,063,000 and 2,100,000 active cards as of December 31, 2012, 2011 and 2010, respectively. Number of Active Cards with Direct Deposit-represents the number of active cards that have had a direct deposit load within three months of the date of determination. We managed 1,082,000, 865,000 and 719,000 direct deposit active cards as of December 31, 2012, 2011 and 2010, respectively. Our strategy is to focus on increasing the number of cards that receive direct deposits because cardholders who use direct deposit generate more revenue for us than those who do not. Additionally, consumers who receive direct deposits tend to remain in our programs longer than non-direct deposit cardholders. Percentage of Active Cards with Direct Deposit-represents the percentage of active GPR cards that have had a direct deposit load within three months of the date of determination. The percentage of active cards that were direct deposit active cards as of December 31, 2012, 2011 and 2010, was approximately 46%, 42%, and 34%, respectively. 38 -------------------------------------------------------------------------------- Table of Contents Gross Dollar Volume ("GDV")-represents the total dollar volume of debit transactions and cash withdrawals made using the GPR cards we manage. Our gross dollar volume, also known in the industry as purchase volume, was $13.2 billion, $11.2 billion and $9.8 billion for the years ended December 31, 2012, 2011 and 2010, respectively. Approximately 82.7%, 78.0% and 71.8% of the gross dollar volume for the years ended December 31, 2012, 2011 and 2010, respectively, was made using active cards with direct deposit. Key Components of Our Results of Operations Operating Revenues Our operating revenues primarily consist of a portion of the service fees and interchange revenues received by our Issuing Banks in connection with the programs we manage. Cardholders are charged fees in connection with our programs, as follows: º • º Transactions-Cardholders are typically charged a fee for each PIN and signature-based purchase transaction made using their GPR cards, unless the cardholder is on a monthly or annual service plan, in which case the cardholder is instead charged a monthly or annual subscription fee, as applicable. Cardholders are also charged fees for ATM withdrawals and other transactions conducted at ATMs. º • º Customer Service and Maintenance-Cardholders are typically charged fees for balance inquiries made through our call centers. Cardholders are also charged a monthly maintenance fee after a specified period of inactivity. º • º Additional Products and Services-Cardholders are charged fees associated with additional products and services offered in connection with certain of our cards, including the use of overdraft features, a variety of bill payment options, custom card designs and card-to-card transfers of funds initiated through our call centers. º • º Other-Cardholders are charged fees in connection with the acquisition and reloading of our GPR cards at distributors and we receive a portion of these amounts in some cases. Revenue resulting from the service fees charged to our cardholders described above is recognized when the fees are charged because the earnings process is substantially complete, except for revenue resulting from the initial activation of our cards and annual subscription fees. Revenue resulting from the initial activation of our cards is recognized ratably, net of commissions paid to our distributors, over the average account life, which is approximately one year for our GPR cards (three months for the gift cards we marketed prior to August 2010). Revenue resulting from annual subscription fees is recognized ratably over the annual period to which the fees relate. Our revenues also include fees charged in connection with program management and processing services we provide for private-label programs, as well as fees charged to MetaBank based on interest earned on cardholder funds. Under our current arrangement with MetaBank, we would only be entitled to receive interest on cardholder funds if market interest rates rose significantly above current levels. Revenue resulting from these fees is recognized when we have fulfilled our obligations under the underlying service agreements. We earn revenues from a portion of the interchange fees remitted by merchants when cardholders make purchase transactions using their cards. Subject to applicable law, interchange fees are fixed by the Networks. Interchange revenues are recognized net of sponsorship, licensing and processing fees charged by the Networks for services they provide in processing transactions routed through them. Interchange revenue is recognized during the period that the purchase transactions occur. Also included in interchange revenue are fees earned from branding agreements with the Networks. 39 -------------------------------------------------------------------------------- Table of Contents Our quarterly operating revenues fluctuate as a result of certain seasonal factors. The most significant increases in the number of our active cards and our GDV typically occur in the first three months of each year as a result of consumers acquiring new cards and loading them with their tax refunds. We expect this seasonal variance to become more pronounced in 2013 due to an agreement with Intuit, Inc. ("Intuit") pursuant to which we will provide the only GPR card that can be ordered through the use of its TurboTax software. We began marketing cards under this program in early 2013. Operating Expenses We classify our operating expenses into the following categories: Direct Operating Costs-Direct operating costs consist primarily of the commissions we pay to members of our distribution and reload network for their services, ATM processing fees, card supply costs, costs for fraud and other losses related to the card programs we manage, customer verification costs, customer service costs and fees paid to our Issuing Banks. These costs are driven by transaction volumes and the number of active cards. Salaries, Benefits and Other Personnel Costs-Salaries, benefits and other personnel costs consist of the compensation costs associated with our employees, including base salaries, benefits, bonus compensation and stock-based compensation. This excludes any personnel costs associated with customer service personnel. Costs associated with these employees are included in direct operating costs. Advertising, Marketing and Promotion Costs-Advertising, marketing and promotion costs primarily consist of the costs of our efforts to market the products we manage to potential cardholders including direct mailings, internet and television advertising, promotional events run in conjunction with our distributors, conferences, trade shows and the creation of marketing collateral and other materials. Other General and Administrative Costs-Other general and administrative costs primarily consist of costs for legal, accounting, information technology, travel, facility and other corporate expenses. Depreciation and Amortization-Depreciation and amortization consists of depreciation of our long-lived assets and amortization of finite-lived intangibles. Other Losses-Other losses consist of legal contingencies and settlements and other infrequent losses. Other Income (Expense) Other income (expense) primarily consists of interest income and interest expense. Interest income represents interest we receive on our cash and cash equivalents. Interest expense is associated with our long-term debt and capital leases. Income Tax Expense Income tax expense primarily consists of corporate income taxes on our profits. 40 -------------------------------------------------------------------------------- Table of Contents Consolidated Statements of Operations Data Year Ended December 31, 2012 2011 2010 (in thousands of dollars) Operating Revenues $ 351,332 $ 306,255 $ 275,387 Operating Expenses Direct operating costs 169,066 146,199 130,783 Salaries, benefits and other personnel costs 56,328 52,736 54,032 Advertising, marketing and promotion costs 20,127 14,230 14,038 Other general and administrative costs 21,116 20,135 18,234 Depreciation and amortization 13,778 15,031 12,725 Other losses 36,988 515 4,300 Total operating expenses 317,403 248,846 234,112 Operating income 33,929 57,409 41,275 Other Income (Expense) Interest income 139 108 85 Interest expense (2,598 ) (2,457 ) (3,526 ) Loss on extinguishment of debt - - (734 ) Total other expense (2,459 ) (2,349 ) (4,175 ) Income before income taxes 31,470 55,060 37,100 Provision for income taxes 12,603 21,814 14,368 Net income $ 18,867 $ 33,246 $ 22,732 As a Percentage of Total Operating Revenues Year Ended December 31, 2012 2011 2010 Operating Revenues 100.0 % 100.0 % 100.0 % Operating Expenses Direct operating costs 48.1 47.7 47.5 Salaries, benefits and other personnel costs 16.1 17.2 19.6 Advertising, marketing and promotion costs 5.7 4.7 5.1 Other general and administrative costs 6.0 6.6 6.6 Depreciation and amortization 3.9 4.9 4.6 Other losses 10.5 0.2 1.6 Total operating expenses 90.3 81.3 85.0 Operating income 9.7 18.7 15.0 Other Income (Expense) Interest income 0.1 0.1 - Interest expense (0.8 ) (0.8 ) (1.3 ) Loss on extinguishment of debt - - (0.2 ) Total other expense (0.7 ) (0.7 ) (1.5 ) Income before income taxes 9.0 18.0 13.5 Provision for income taxes 3.6 7.1 5.2 Net income 5.4 % 10.9 % 8.3 % 41 -------------------------------------------------------------------------------- Table of Contents Comparison of Fiscal 2012 and 2011 Operating Revenues Our operating revenues totaled $351.3 million in fiscal 2012, an increase of $45.0 million, or 14.7%, from the $306.3 million seen in fiscal 2011. Service fees represented approximately 77.5% of our revenue for fiscal 2012 with the balance of our revenue consisting of interchange fees. Service fee revenue increased $34.5 million, or 14.5%, from $237.6 million in fiscal 2011 to $272.1 million in fiscal 2012. This year-over-year increase in service fee revenue was substantially driven by the increase in direct deposit accounts (cardholders with direct deposit generally initiate more transactions and generate more revenues for us than those that do not take advantage of this feature) and, to a lesser extent, the expansion of product features across our direct deposit customer base. Interchange revenue represented approximately 22.5% of our revenue for fiscal 2012 and 22.4% of our revenue for fiscal 2011. Interchange revenue increased $10.6 million, or 15.5%, from $68.6 million in fiscal 2011 to $79.2 million in fiscal 2012. This increase was primarily the result of a 17.9% year-over-year increase in our gross dollar volume. Operating Expenses The following table presents the breakdown of operating expenses among direct operating costs, personnel costs, advertising and marketing costs, other general and administrative costs, depreciation and amortization and other components of operating expenses: Year Ended December 31, 2012 2011 Percentage of Percentage of Total Total Operating Operating Amount Revenues Amount Revenues Change (in thousands of dollars) Operating Expenses Direct operating costs $ 169,066 48.1 % $ 146,199 47.7 % $ 22,867 Salaries, benefits and other personnel costs 56,328 16.1 52,736 17.2 3,592 Advertising, marketing and promotion costs 20,127 5.7 14,230 4.7 5,897 Other general and administrative costs 21,116 6.0 20,135 6.6 981 Depreciation and amortization 13,778 3.9 15,031 4.9 (1,253 ) Other losses 36,988 10.5 515 0.2 36,473 Total operating expenses $ 317,403 90.3 % $ 248,846 81.3 % $ 68,557 Direct Operating Costs-Our direct operating costs were $169.1 million in fiscal 2012, an increase of $22.9 million, or 15.7%, from fiscal 2011. As a percentage of revenues, our direct operating costs increased from 47.7% in fiscal 2011 to 48.1% in fiscal 2012. This net increase, as a percentage of revenue, was primarily caused by an increase in investment in our distribution activities through traditional retailers and direct-to-consumer acquisition activities and an increase in our provision for fraud-related losses. This percentage increase was partially offset by a decrease, as a percentage of revenue, in commissions paid to our distributors caused by a greater proportion of cardholder loads being generated through our online, direct marketing and traditional retail channels because we do not pay distributor commissions on these loads. Salaries, Benefits and Other Personnel Costs-Our salaries, benefits and other personnel costs were $56.3 million in fiscal 2012, an increase of $3.6 million, or 6.8%, from fiscal 2011. As a percentage of revenues, our salaries, benefits and other personnel costs decreased from 17.2% of revenues in fiscal 2011 to 16.1% in fiscal 2012. This decrease was primarily the result of relatively consistent levels of 42 -------------------------------------------------------------------------------- Table of Contents stock based compensation expenses during a period of increasing revenues, and, to a lesser extent, an increase in capitalized personnel costs (which has the effect of reducing salaries, benefits and other personnel costs) associated with the internal development of software for our processing platforms. Advertising, Marketing and Promotion Costs-Our advertising, marketing and promotion costs were $20.1 million in fiscal 2012, an increase of $5.9 million, or 41.5% from fiscal 2011. This increase was largely due to an increase in our investment in direct-to-consumer marketing through internet, television and direct mail advertising. We expect to see increased investment in our advertising costs in future periods. Other General and Administrative Costs-Our other general and administrative costs were $21.1 million in fiscal 2012, an increase of $1.0 million, or 5.0%, from fiscal 2011. As a percentage of revenues, our other general and administrative costs decreased from 6.6% in fiscal 2011 to 6.0% in fiscal 2012. This decrease, as a percentage of revenue, was primarily a result of greater efficiencies of scale. Depreciation and Amortization-Our depreciation and amortization costs were $13.8 million in fiscal 2012, a decrease of $1.2 million, or 8.0%, from fiscal 2011. This decrease was primarily the result of fully amortizing certain long-lived assets during 2012. Other Losses-Other losses of $37.0 during fiscal 2012 related to accruals for legal contingencies and settlements, primarily Alexsam ($24.0 million) and INB ($10.5 million) (see "Item 3. Legal Proceedings" contained in this Annual Report on Form 10-K). Other losses of $0.5 million during fiscal 2011 primarily related to severance and other related restructuring costs incurred in connection with the consolidation of some of our processing platforms and call center activities. Income Tax Expense The following table presents the breakdown of our effective tax rate among federal, state and other taxes: Year Ended December 31, 2012 2011 U.S. federal income tax 35.0 % 35.0 % State income taxes, net of federal benefit 2.4 2.8 Other 2.6 1.8 Income tax expense 40.0 % 39.6 % Our income tax expense was $12.6 million in fiscal 2012, a decrease of $9.2 million from fiscal 2011. This decrease was primarily the results of a period-over-period decrease in our taxable income. Comparison of Fiscal 2011 and 2010 Operating Revenues Our operating revenues totaled $306.3 million in fiscal 2011, an increase of $30.9 million, or 11.2%, from $275.4 million seen in fiscal 2010. Service fees represented approximately 77.6% of our revenue for fiscal 2011 with the balance of our revenue consisting of interchange fees. Service fee revenue increased $21.8 million, or 10.1%, from $215.8 million in fiscal 2010 to $237.6 million in fiscal 2011. This year-over-year increase in service fee revenue was substantially driven by the increase in direct deposit accounts (cardholders with direct deposit generally initiate more transactions and generate more revenues for us than those that do not take advantage of this feature) and, to a lesser extent, the expansion of product features across our direct deposit customer base. 43 -------------------------------------------------------------------------------- Table of Contents Interchange revenue represented approximately 22.4% of our revenue for fiscal 2011 and 21.6% of our revenue for fiscal 2010. Interchange revenue increased $9.0 million, or 15.1%, from $59.6 million in fiscal 2010 to $68.6 million in fiscal 2011. This increase was primarily the result of a 14.3% year-over-year increase in our gross dollar volume, combined with more favorable rates on some of our interchange revenue contracts negotiated during the later part of 2010. Our total operating revenues of $306.3 million in fiscal 2011 was comprised of $305.1 million related to our GPR cards and the remaining $1.2 million related to our gift cards. Our GPR card related revenues increased by $36.0 million, or 13.4%, from fiscal 2010. Our gift card related revenues decreased by $5.1 million, or 81.0%, from fiscal 2010 as we ceased marketing gift cards in August 2010. Operating Expenses The following table presents the breakdown of operating expenses among direct operating costs, personnel costs, advertising and marketing costs, other general and administrative costs, depreciation and amortization and other components of operating expenses: Year Ended December 31, 2011 2010 Percentage of Percentage of Total Total Operating Operating Amount Revenues Amount Revenues Change (in thousands of dollars) Operating Expenses Direct operating costs $ 146,199 47.7 % $ 130,783 47.5 % $ 15,416 Salaries, benefits and other personnel costs 52,736 17.2 54,032 19.6 (1,296 ) Advertising, marketing and promotion costs 14,230 4.7 14,038 5.1 192 Other general and administrative costs 20,135 6.6 18,234 6.6 1,901 Depreciation and amortization 15,031 4.9 12,725 4.6 2,306 Other losses 515 0.2 4,300 1.6 (3,785 ) Total operating expenses $ 248,846 81.3 % $ 234,112 85.0 % $ 14,734 Direct Operating Costs-Our direct operating costs were $146.2 million in fiscal 2011, an increase of $15.4 million, or 11.8%, from fiscal 2010. As a percentage of revenues, our direct operating costs increased from 47.5% in fiscal 2010 to 47.7% in fiscal 2011. These increases were primarily due to an increase in our provision for fraud-related losses, increased overdraft defaults and an increase in commissions we paid to our distributors because ACE, our largest distribution partner, reached their maximum commission tier more often in 2011 due to increasing volumes. We also saw an increase in ATM processing fees resulting from an increase in the number of ATM transactions by our cardholders. Partially offsetting these increases was a decline in call center costs as a result of greater efficiencies of scale from our back office systems as well as cost savings achieved on some of our outsourced call center contracts negotiated in late 2010. Salaries, Benefits and Other Personnel Costs-Our salaries, benefits and other personnel costs were $52.7 million in fiscal 2011, a decrease of $1.3 million, or 2.4%, from fiscal 2010. This year-over-year change reflects a $4.5 million decrease in bonus expense as we significantly exceeded our performance targets in 2010 but were somewhat below our 2011 targets, offset by a $4.0 million increase in stock-based compensation expense as a result of awards issued in 2010 and 2011 and the accelerated vesting of previously issued equity awards following the completion of our initial public offering in October 2010. In addition, we also saw an increase in capitalized personnel costs (which has the effect of reducing salaries, benefits and other personnel costs) for internally developed fixed assets in connection with the consolidation of some of our processing platforms and call center activities. 44 -------------------------------------------------------------------------------- Table of Contents Advertising, Marketing and Promotion Costs-Our advertising, marketing and promotion costs were $14.2 million in fiscal 2011, which was relatively consistent with the $14.0 spent in fiscal 2010. Other General and Administrative Costs-Our other general and administrative costs were $20.1 million in fiscal 2011, an increase of $1.9 million, or 10.4%, from fiscal 2010. This year-over-year increase was primarily the result of an increase in legal and other professional expenses, insurance costs and other corporate expenses related to our status as a public reporting company during 2011. We were a private company during the first nine months of 2010. In addition, we incurred greater software maintenance, licensing and support fees in fiscal 2011 compared to fiscal 2010 as a result of capital expenditures and assets placed into service in 2010. Depreciation and Amortization-Our depreciation and amortization costs were $15.0 million in fiscal 2011, an increase of $2.3 million, or 18.1%, from fiscal 2010. This increase was primarily the result of increased depreciation resulting from capital expenditures and assets placed into service in 2010. Other Losses-Other losses of $0.5 million during fiscal 2011 primarily related to severance and other related restructuring costs incurred in connection with the consolidation of some of our processing platforms and call center activities. In fiscal 2010, other losses of $4.3 million related to a $3.5 million loss related to a patent infringement dispute and $0.8 million related to a contractual dispute with an Issuing Bank. Income Tax Expense The following table presents the breakdown of our effective tax rate among federal, state and other taxes: Year Ended December 31, 2011 2010 U.S. federal income tax 35.0 % 35.0 % State income taxes, net of federal benefit 2.8 3.2 Other 1.8 0.5 Income tax expense 39.6 % 38.7 % Our income tax expense was $21.8 million in fiscal 2011, an increase of $7.4 million from fiscal 2010. This increase in expense is due to an increase in income before taxes combined with an increase in our effective tax rate. The increase in the effective rate from 2010 to 2011 was primarily caused by a reduced amount of benefits related to research and development tax credits for internally developed software in 2011 as compared to 2010. 45 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Our primary sources of liquidity are cash flow from our operating activities and access to borrowings under our revolving credit facility. We believe our current level of cash and short-term financing capabilities, along with the expected future cash flows from our operations, are sufficient to meet the needs of our business for at least the next twelve months. Comparison of Fiscal 2012, 2011 and 2010 Year Ended December 31, 2012 2011 2010 (in thousands of dollars) Net cash provided by operating activities $ 37,978 $ 48,847 $ 52,101 Net cash used in investing activities (16,525 ) (10,088 ) (9,259 ) Net cash provided by (used in) financing activities (62,910 ) (34,184 ) 3,505 Net change in cash and cash equivalents $ (41,457 ) $ 4,575 $ 46,347 Cash Flows from Operating Activities During fiscal 2012, our operating activities provided $38.0 million of cash, resulting from $18.9 million of net income and an adjustment of $45.5 million for non-cash items, offset by $26.4 million in cash used by operating assets and liabilities. The $45.5 million adjustment for non-cash items primarily relates to $10.9 million of litigation contingency reserves, $13.8 million of depreciation and amortization expense, an $18.7 million provision for cardholder losses and $11.5 million of non-cash stock-based compensation expense, offset by $6.8 million in deferred income taxes and a $2.7 million tax benefit associated with the exercise of stock options. The $26.4 million in cash used by changes in operating assets and liabilities was primarily the result of $19.0 million of payments against our cardholders' reserve, a $9.8 million increase in other long-term assets driven primarily by prepaid commissions to distributors that will be amortized over the terms of the related contracts, a $1.5 million increase in prepaid card supply and a $3.1 million increase in accounts receivable. These changes were partially offset by a $7.2 million increase in our accounts payable and accrued liabilities. The $38.0 million of 2012 operating cash flows represents a $10.8 million decrease over 2011 operating cash flows of $48.8 million. The $10.8 million decrease in operating cash flows primarily relates to $14.4 million decrease in net income and a $5.1 million decrease in cash provided by changes in operating assets and liabilities, partially offset by an $8.7 million increase in non-cash adjustments to net income. During 2011, $21.3 million of cash was used by changes in operating assets and liabilities while $26.4 million of cash was used by changes in operating assets and liabilities during 2012. This $5.1 million increase in cash used by changes in operating assets and liabilities was primarily caused by an $11.1 million increase in cash provided by changes in accounts payable and accrued liabilities, partially offset by an $7.4 million increase in cash used in payment for long-term assets. During fiscal 2011, our operating activities provided $48.8 million of cash, resulting from $33.2 million of net income and an adjustment of $36.9 million for non-cash items, offset by $21.3 million in cash used by operating assets and liabilities. The $36.9 million adjustment for non-cash items primarily relates to $15.0 million of depreciation and amortization expense, a $14.4 million provision for cardholder losses and $11.2 million of stock-based compensation expense, offset by $2.6 million in deferred income taxes and $1.5 million of tax benefits associated with stock options. The $21.3 million in cash used by changes in operating assets and liabilities was primarily the result of a $3.8 million decrease in our accounts payable and accrued liabilities primarily caused by the payout in 2011 of bonuses earned in 2010 as well as final payout in 2011 of a 2010 settlement loss related to a patent infringement dispute, $15.3 million of write-offs flowing against our cardholders' reserve, a $2.3 million 46 -------------------------------------------------------------------------------- Table of Contents increase in other long-term assets and a $2.1 million increase in accounts receivable, offset by a $2.9 million increase in income tax payable. The $48.8 million of 2011 operating cash flows represents a $3.3 million decrease over 2010 operating cash flows of $52.1 million. The $3.3 million decrease in operating cash flows primarily relates to a $23.3 million decrease in cash provided by changes in operating assets and liabilities, partially offset by a $10.5 million increase in net income and a $9.5 million increase in non-cash item adjustments. During 2010, $2.0 million of cash was provided by changes in operating assets and liabilities while $21.3 million of cash was used by changes in operating assets and liabilities during 2011. This $23.3 million decrease in cash provided by changes in operating assets and liabilities was primarily due to a $6.7 million decrease in cash provided by accounts payable and accrued liabilities as well as $8.3 million of incremental write-offs flowing against our cardholders' reserve during 2011 as compared to 2010 due to incremental fraud losses and the expansion of our overdraft program. During fiscal 2010, our operating activities provided $52.1 million of cash, resulting from $22.7 million of net income and an adjustment of $27.4 million for non-cash items and $2.0 million in cash provided by operating assets and liabilities. The $27.4 million adjustment for non-cash items primarily relates to $12.7 million of depreciation and amortization expense, a $10.3 million provision for cardholder losses, $7.3 million of stock-based compensation expense offset by $1.5 million in deferred income taxes and $2.5 million in tax benefits associated with stock options. Cash Flows from Investing Activities Investing activities used $16.5 million of cash in fiscal 2012, primarily for purchases of property, equipment and software ($14.6 million), a long-term investment in Meta Financial Group, Inc., the holding company for one of our Issuing Banks ($1.1 million) and premiums paid on the life insurance policies issued to support our obligations under our deferred compensation plan ($0.5 million). Investing activities used $10.1 million of cash in fiscal 2011, primarily for purchases of property equipment and software ($9.2 million) and premiums paid on the life insurance policies issued to support our obligations under our deferred compensation plan ($0.9 million). Investing activities used $9.3 million of cash in fiscal 2010, which related primarily to $6.0 million of purchases of property equipment and software and a $3.2 million long-term investment in Meta Financial Group, Inc., the holding company for one of our Issuing Banks. Cash Flows from Financing Activities Financing activities used $63.0 million of cash in fiscal 2012, primarily related to $68.5 million in principal payments on debt and $92.6 million used to repurchase outstanding shares of common stock. These cash outflows were partially offset by $90.0 million in proceeds drawn from our revolving line of credit, $5.3 million of cash received upon the exercise of stock options and a $2.7 million tax benefit associated with stock options. Financing activities used $34.2 million of cash in fiscal 2011, primarily to repurchase outstanding shares of common stock ($32.7 million) and for payments under a capital lease ($3.3 million). These cash outflows were partially offset by $1.5 million of tax benefits associated with stock options and $1.4 million of cash received upon the exercise of stock options. Financing activities provided $3.5 million of cash in fiscal 2010, primarily related to $21.0 million in proceeds, net of offering costs, from our initial public offering in October 2010, a $2.5 million income tax benefit associated with stock options and $0.9 million of cash received upon the exercise of stock options and warrants. These proceeds were partially offset by $6.5 million in scheduled debt payments and a $9.0 million revolving debt payment. In September 2010 we entered into a new credit facility. The initial borrowings under this new credit facility of $58.5 million were used to repay the remaining $56.3 million outstanding indebtedness under our prior credit facility, $0.7 million of accrued 47 -------------------------------------------------------------------------------- Table of Contents interest and $1.5 million of debt issuance costs associated with the new credit facility. The remainder of the cash used in financing activities for fiscal 2010 was comprised primarily of a $5.7 million repurchase of common stock. Sources of Financing Since the inception of NetSpend Holdings in February 2004, we have primarily financed our operations through cash flows from operations, debt financing and the net proceeds received from our initial public offering in October 2010. We believe that our existing cash balances, together with the amounts we expect to generate from operations and the amounts available through our revolving credit facility will be sufficient to meet our operating needs for the next twelve months, including working capital requirements, capital expenditures and debt repayment obligations. In connection with the acquisition of Skylight on July 15, 2008, we entered into a credit agreement (the "prior credit facility"), which provided financing of $105.0 million, consisting of a $30.0 million revolving credit facility and a $75.0 million term loan. In September 2010, we repaid our borrowings under the prior credit facility. The weighted average interest rate for outstanding borrowings under the prior credit facility was 6.0%. In September 2010, we entered into a new credit facility with a syndicate of banks with SunTrust Bank as administrative agent. The new credit facility provides a $135.0 million revolving credit facility with the ability to request increases to the facility of up to $50.0 million. The initial borrowings under this credit facility of $58.5 million were used to repay the outstanding indebtedness under our prior credit facility and $1.5 million of debt issuance costs associated with the new credit facility. Our current credit facility has a maturity date in September 2015 and includes a $5.0 million swingline facility and $15.0 million letter of credit facility. At our option, we may prepay any borrowings in whole or in part, without any prepayment penalty or premium. As of December 31, 2012, we owed $80.0 million in outstanding borrowings under our current credit facility. During the year ended December 31, 2012, the weighted average interest rate applicable to the outstanding borrowings on this credit facility was 3.2%. The outstanding borrowings under the current credit facility bear interest, at our election, at either a base rate or a Eurodollar loan rate. Base rate loans bear annual interest at the base rate (the greater of the federal funds rate plus 0.50%, the prime rate or one-month LIBOR plus 1.00%) plus a spread of 1.50% to 2.25%, depending on our leverage ratio. Eurodollar loans bear interest at the adjusted LIBOR for the interest period in effect for such borrowings plus a spread of 2.50% to 3.25%, depending on our leverage ratio. Our interest rate on Eurodollar loans, which comprised all of our outstanding borrowings as of December 31, 2012, was 2.7% as of that date. The agreement related to our current credit facility contains certain financial and non-financial covenants and requirements, including a leverage ratio, fixed charge ratio and certain restrictions on our ability to make investments, pay dividends or sell assets. It also provides for customary events of default as defined in the agreement, including failure to pay any principal or interest when due, failure to comply with covenants and a change of control. We were in compliance with these covenants as of December 31, 2012. Under our current credit facility, letters of credit may be issued for a period of up to one year (subject to any automatic renewal provisions), although all such letters of credit must expire at least ten business days prior to the current credit facility's maturity date. As of December 31, 2012, we had issued $6.9 million in letters of credit to two of our Issuing Banks as security for our settlement obligations. During 2009, we entered into a capital lease arrangement with a software provider for perpetual database licenses. The capital lease arrangement resulted in the recording of $3.4 million in capitalized 48 -------------------------------------------------------------------------------- Table of Contents computer software. During 2011, we modified the capital lease arrangement, extending it for one year and purchasing $1.9 million of additional computer software. During the years ended December 31, 2011 and 2010, we made payments of $3.3 million and $1.4 million, respectively, towards the capital lease, which included interest payments at an effective interest rate of 6.0%. The capital lease was paid in full in 2011. Off-Balance Sheet Arrangements Our off-balance sheet arrangements are comprised of settlement indemnifications and overdraft guarantees issued in favor of our Issuing Banks. We have no off-balance sheet debt, other than operating leases, purchase orders and other commitments entered into in the ordinary course of business as discussed below and reflected in our contractual obligations and commitments table. A significant portion of our business is conducted through distributors that provide load and reload services to cardholders at their locations. Members of our distribution and reload network collect cardholder funds and remit them by electronic transfer to our Issuing Banks for deposit in the cardholder accounts. Our Issuing Banks typically receive cardholders' funds no earlier than three business days after they are collected by the distributor. If any distributor fails to remit cardholders' funds to our Issuing Banks, we typically reimburse our Issuing Banks for the shortfall created thereby. We manage the risk associated with this process through a formalized set of credit standards, volume limits and deposit requirements for certain distributors and by typically maintaining the right to offset any settlement shortfall against the commissions payable to the relevant distributor. To date, we have not experienced any significant losses associated with settlement failures and we have not recorded a settlement guarantee liability as of December 31, 2012. As of December 31, 2012, our estimated gross settlement exposure was $13.5 million. Cardholders can incur charges in excess of the funds available in their accounts and are liable for the resulting overdrawn account balance. Although we generally decline authorization attempts for amounts that exceed the available balance in a cardholder's account, the application of the rules and regulations of the Networks, the timing of the settlement of transactions and the assessment of subscription, maintenance or other fees can, among other things, result in overdrawn card accounts. We also provide, as a courtesy and at our discretion, certain cardholders with a "cushion" which allows them to overdraw their card accounts by up to $10. In addition, certain eligible cardholders may enroll in our Issuing Banks' overdraft protection programs and fund transactions that exceed the available balance in their accounts. We generally provide the funds used as part of these overdraft programs (MetaBank will advance the first $1.0 million on behalf of its cardholders) and are responsible to our Issuing Banks for any losses associated with any overdrawn account balances. As of December 31, 2012, our cardholders' overdrawn account balances totaled $11.7 million. As of December 31, 2012, our reserve for the losses we estimate will arise from processing customer transactions, debit card overdrafts, chargebacks for unauthorized card use and merchant-related chargebacks due to non-delivery of goods or services was approximately $3.6 million. Contractual Obligations and Commitments During the year ended December 31, 2010 we entered into a credit facility with a syndicate of banks with SunTrust Bank as administrative agent. The initial borrowings under this facility of $58.5 million were used to repay the $56.3 million outstanding indebtedness under our prior credit facility, $0.7 million of accrued interest on such indebtedness and $1.5 million of debt issuance costs associated with the credit facility. See "Note 9-Debt" to the consolidated financial statements included in this Form 10-K for a discussion of the terms of our credit facility. 49 -------------------------------------------------------------------------------- Table of Contents Our contractual commitments and contingencies will have an impact on our future liquidity. The following table summarizes our contractual obligations that represent material expected or contractually committed future obligations as of December 31, 2012: Payments Due by Period As Of December 31, 2012 Less than More than Total 1 Year 1 - 3 Years 3 - 5 Years 5 Years (in thousands of dollars) Long-term debt obligations(1) $ 89,017 $ 12,729 $ 76,288 $ - $ - Operating lease obligations(2) 6,891 1,553 3,165 2,173 - Other long-term obligations(3) 34,075 17,965 14,863 1,247 - Total $ 129,983 $ 32,247 $ 94,316 $ 3,420 $ - -------------------------------------------------------------------------------- º (1) º Long-term debt obligations consisted of outstanding principal and expected interest payments under our credit facility as of December 31, 2012. These future expected payments include $80.0 million of principal that is expected to be repaid upon or prior to the maturity of this facility in September 2015 and $9.0 million in future interest payments applicable to the currently outstanding borrowings at an expected interest rate of 4.7% per year through September 2015. º (2) º Operating lease obligations primarily include future payments related to the lease for our offices in Austin, Texas. This lease expires in 2017. º (3) º Other long-term obligations consist of required minimum future payments under contracts with our distributors and other service providers. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP and does not require management's judgment in its application. In other cases management's judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. The preparation of consolidated financial statements also requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Accordingly, actual results could differ significantly from our estimates. To the extent that there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe that the accounting policies discussed below are critical to understanding our historical and future performance because these policies relate to the more significant areas involving management's judgments and estimates. Revenue Recognition Our operating revenues principally consist of a portion of the service fees and interchange revenues received by our Issuing Banks in connection with the programs we manage. Revenue is recognized when there is persuasive evidence of an arrangement, the relevant services have been rendered, the price is fixed or determinable and collectability is reasonably assured. Cardholders are charged fees in connection with our products and services as follows: º • º Transactions-Cardholders are typically charged a fee for each PIN and signature-based purchase transaction made using their GPR cards, unless the cardholder is on a monthly or 50 -------------------------------------------------------------------------------- Table of Contents annual service plan, in which case the cardholder is instead charged a monthly or annual subscription fee, as applicable. Cardholders are also charged fees for ATM withdrawals and other transactions conducted at ATMs. º • º Customer Service and Maintenance-Cardholders are typically charged fees for balance inquiries made through our call centers. Cardholders are also charged a monthly maintenance fee after a specified period of inactivity. º • º Additional Products and Services-Cardholders are charged fees associated with additional products and services offered in connection with certain of our GPR cards, including the use of overdraft features, a variety of bill payment options, custom card designs and card-to-card transfers of funds initiated through our call centers. º • º Other-Cardholders are charged fees in connection with the acquisition and reloading of our GPR cards at retailers and we receive a portion of these amounts in some cases. Revenue resulting from the service fees charged to our cardholders described above is recognized when the fees are charged because the earnings process is substantially complete, except for revenue resulting from the initial activation of our cards and annual subscription fees. Revenue resulting from the initial activation of our cards is recognized ratably, net of commissions paid to our distributors, over the average account life, which is approximately one year for our GPR cards (three months for the gift cards we marketed prior to August 2010). Revenue resulting from annual subscription fees is recognized ratably over the annual period to which the fees relate. Our revenues also include fees charged in connection with program management and processing services we provide for private-label programs, as well as fees charged to MetaBank based on interest earned on cardholder funds. Under our current arrangement with MetaBank, we would only be entitled to receive interest on cardholder funds if market interest rates rose significantly above current levels. Revenue resulting from these fees is recognized when we have fulfilled our obligations under the underlying service agreements. We earn revenues from a portion of the interchange fees remitted by merchants when cardholders make purchases at their locations using their GPR cards. Subject to applicable law, interchange fees are fixed by the Networks. Interchange revenues are recognized net of sponsorship, licensing and processing fees charged by the Networks for services they provide in processing purchase transactions routed through them. Interchange revenue is recognized during the period that the purchase transactions occur. Also included in interchange revenue are fees earned from branding agreements with the Networks. Litigation In the normal course of business, we are at times subject to pending and threatened legal actions and proceedings. It is our policy to routinely assess the likelihood of any adverse judgments or outcomes related to legal or regulatory matters as well as ranges of probable losses. A determination of the amount of the reserves required, if any, for these contingencies is made after analysis of each known issue and consultation our internal and external legal counsel. We record reserves related to legal matters when it is determined that a loss is probable and the range of such loss can be reasonably estimated. Management discloses facts regarding material matters assessed as reasonably possible and the associated potential exposure, if estimable. We expense legal costs as incurred. Stock-Based Compensation In October 2010, we adopted a new equity incentive plan, the Amended and Restated NetSpend Holdings, Inc. 2004 Equity Incentive Plan (the "2004 Plan"), which amended and replaced our prior option plan. We measure stock options at fair value on the date of grant using the Binomial Lattice 51 -------------------------------------------------------------------------------- Table of Contents model for determining fair value. Compensation expense is recognized on a straight-line basis over the requisite service period, net of estimated forfeitures. We consider many factors when estimating expected forfeitures, including the award type, the employee class and historical experience. We present excess tax benefits from the exercise of stock options as financing cash flows. In April 2012, our stockholders approved the NetSpend Holdings, Inc. 2012 Employee Stock Purchase Plan (the "ESPP"). Subject to certain limitations, the ESPP enables eligible employees to utilize after-tax payroll deductions to purchase shares of our common stock at the lesser of 85% of its fair market value on the first or last business day of each quarterly purchase period (six months with respect to the first purchase period in 2012). The discount associated with the stock purchased by participants in the ESPP is expensed as incurred. Goodwill Goodwill represents the excess of the purchase price of an acquired company over the fair value of the assets acquired and liabilities assumed. We evaluate goodwill and intangible assets with indefinite lives for impairment annually or at an interim period if events occur or circumstances indicate it is more likely than not that the carrying value of the associated reporting unit exceeds its fair value. We assign goodwill to our reporting units for the purpose of impairment testing. In 2011, we adopted amendments to the guidelines for testing goodwill for impairment contained in Accounting Standards Update ("ASU") 2011-08 issued by the Financial Accounting Standard Board (the "FASB"). The amendments permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform a subsequent two-step goodwill impairment test. If an entity concludes that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it does not need to perform the two-step impairment test for that reporting unit. In the first step of the two step impairment test, the estimated fair value of the respective reporting unit is compared to its carrying amount. If the carrying value is less than fair value, no indication of impairment exists and no impairment loss is recorded. If the carrying value of the reporting unit is greater than fair value, a second step in the impairment test is performed to determine the implied fair value of goodwill and the amount of the impairment loss, if any. Cardholders' Reserve We are exposed to losses due to cardholder fraud, payment defaults and other forms of cardholder activity as well as losses due to non-performance of third parties who receive cardholder funds for transmittal to our Issuing Banks. We have established a reserve for the losses we estimate will arise from processing customer transactions, debit card overdrafts, chargebacks for unauthorized card use and merchant-related chargebacks due to non-delivery of goods or services. We establish these reserves based upon historical loss and recovery rates and cardholder activity for which specific losses can be identified. We regularly update our reserve estimates as new facts become known and events occur that may impact the settlement or recovery of losses. Establishing the reserve for cardholder losses is an inherently uncertain process and the actual losses experienced by us may vary from the current estimate. Income Taxes We recognize tax benefits or expenses on the temporary difference between the financial reporting and tax basis of our assets and liabilities. We measure deferred tax assets and liabilities using statutorily enacted tax rates expected to apply to taxable income in the years in which we expect those temporary differences to be recovered or settled. We are required to adjust our deferred tax assets and liabilities in the period in which tax rates or the provisions of the income tax laws change. Valuation allowances 52 -------------------------------------------------------------------------------- Table of Contents are established when necessary to reduce deferred tax assets to the amount for which we believe recovery is more likely than not. We classify interest and penalties associated with uncertain tax positions as a component of income tax expense. Recent Accounting Pronouncements New accounting pronouncements or changes in existing accounting pronouncements may have a significant effect on our results of operations financial condition and on the net worth of our business operations. In June 2011, the FASB issued amendments to the guidelines on presenting comprehensive income. The amendments require that all nonowner changes in stockholders' equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The amendments are effective for the first reporting period beginning after December 15, 2011 and are to be applied retrospectively. We adopted these amendments during 2012. The adoption of these amendments did not have a material effect on our consolidated financial statements. In July 2012, the FASB issued amendments to the guidelines for testing indefinite-lived intangible assets other than goodwill. The amendments permit an entity to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test described in FASB ASC Topic 350. The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted. We adopted these amendments for our quarterly and annual reporting periods ending December 31, 2012. The adoption of these amendments did not have a material effect on our consolidated financial statements. |