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BLACKHAWK NETWORK HOLDINGS, INC - 10-Q - 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 condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q (the Quarterly Report) and our Annual Report filed on Form 10-K filed with the Securities and Exchange Commission on March 17, 2014 (the Annual Report). The following discussion has been updated to reflect the effects of the restatement to the 12 and 24 weeks ended June 15, 2013 disclosed in Note 1 to our condensed consolidated financial statements. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. You should review the "Risk Factors" and "Special Note regarding Forward-Looking Statements" sections of the Annual Report and the "Risk Factors" section of this Quarterly Report for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. Forward Looking Information This Quarterly Report contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. The statements contained in this Quarterly Report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act). Forward-looking statements are often identified by the use of words such as, but not limited to, "anticipate," "believe," "can," "continue," "could," "estimate," "expect," "intend," "may," "plan," "project," "seek," "should," "target," "will," "would," and similar expressions or variations intended to identify forward-looking statements. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties, and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed or referenced in the section titled "Risk Factors" included under Part II, Item 1A below. Furthermore, such forward-looking statements speak only as of the date of this Quarterly Report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. Company Overview Blackhawk Network Holdings, Inc., together with its subsidiaries (we, us or our) is a leading prepaid payment network utilizing proprietary technology to offer a broad range of prepaid gift, telecom and debit cards, in physical and electronic forms, as well as related prepaid products and payment services in the United States and 21 other countries. Our extensive prepaid network provides significant benefits to our key constituents: consumers who purchase or receive the products and services we offer; content providers who offer branded gift cards and other prepaid products that are redeemable for goods and services; distribution partners who sell those products; and business partners that distribute our products as incentives or rewards. For consumers, we provide convenience by offering a broad variety of quality brands and content through retail and online distribution locations or through loyalty, incentive and reward programs offered by our business customers. For our content providers, we drive incremental sales by providing access to millions of consumers and creating new customer relationships. For our retail distribution partners, we provide a significant, high-growth and highly productive product category that drives incremental store traffic and customer loyalty. And for our business partners, we provide a wide array of prepaid products to enhance their customer incentives and employee rewards programs. Our technology platform allows us to efficiently and seamlessly connect our network participants and offer new products and services as payment technologies evolve. We believe the breadth of our distribution network and product content, combined with our consumer reach and technology platform, creates powerful network effects that enhance value for our constituents and drive growth in our business. Prior to April 14, 2014, we were a majority-owned subsidiary of Safeway Inc. (Safeway). On April 14, 2014, Safeway distributed its remaining 37.8 million shares of our Class B common stock to Safeway stockholders (the Spin-Off). As a result of the Spin-Off, we became a stand-alone entity separate from Safeway. 17-------------------------------------------------------------------------------- Table of Contents Quarterly Results of Operations and Seasonality Seasonal consumer spending habits, which are most pronounced in December of each year as a result of the holiday selling season, significantly affect our business. We believe this seasonality is important to understanding our quarterly operating results. A significant portion of gift card sales occurs in late December of each year during the holiday selling season. As a result, we earn a significant portion of our revenues, net income and cash flows during the fourth quarter of each year. We also experience an increase in revenues, net income and cash flows during the second quarter of each year, which we primarily attribute to the Mother's Day, Father's Day and graduation gifting season and the Easter holiday. Depending on when the Easter holiday occurs, the associated increase could occur in either the first or second quarter. Additionally, operating income may fluctuate significantly during the first three fiscal quarters due to lower revenues and timing of certain expenses during such fiscal periods. As a result, quarterly financial results are not necessarily reflective of the results to be expected for the year, any other interim period or other future year. 18-------------------------------------------------------------------------------- Table of Contents Description of Our Revenues Commissions and Fees-Commissions and fees consist of content provider commissions, consumer purchase fees, GPR load and reload fees and other transaction-based commissions. We account for total commissions and fees as revenues. The portion of commissions and fees that we pay to our distribution partners is accounted for as Distribution partner commissions in operating expenses. • Content Provider Commissions-We earn the majority of our revenues from commissions paid by content providers for the marketing and distribution of their prepaid cards, which we refer to as closed loop gift cards. For closed loop gift cards and prepaid telecom cards, our commissions are based on a contractual percentage of the aggregate load value of the cards recognized during a defined period. This contractual percentage is individually negotiated with each content provider and is generally a fixed percentage. After a closed loop gift card or telecom card is activated, we have no further service obligations and recognize the commissions received as revenue at the time of activation. • Purchase Fees-We generate a portion of our revenue from fees related to open loop gift cards, including our proprietary Visa gift card, American Express and MasterCard network-branded gift cards and GPR cards provided by Green Dot and NetSpend, the industry leaders in this product category, as well as PayPower, our own GPR card. The consumer pays a purchase fee upon activation of a network-branded card or the initial load to the GPR cards. These purchase fees vary based on the type of card purchased and the dollar amount of the load transaction. We serve as the program manager, in conjunction with the issuing banks, for our proprietary Visa gift card and PayPower GPR card and have ongoing customer service obligations after card activation. We recognize revenue for our proprietary Visa gift card purchase fee ratably in proportion to the historical redemption patterns of the card portfolio over the estimated life of the card (currently 12 months), which presently results in the recognition of approximately 90% of the purchase fee within four months of card activation. We recognize the initial load fee on the PayPower GPR card on a straight-line basis over the estimated life of the card (currently four months). For the American Express and MasterCard network-branded gift cards and the Green Dot and NetSpend branded GPR cards, we receive a contractual percentage of the consumer purchase fee, which is recognized as revenue at the time of card activation as we have no future customer service obligations. • Reload Fees-The consumer pays a purchase fee and we earn the fee when consumers reload funds onto their PayPower GPR card or another GPR card through our Reloadit network. Revenue is recognized when the reload is processed. • Incentive Program Fees-We receive fees from our business partners for the activation of incentive cards and the overall management of our incentives and rewards business. Incentive cards include Visa and MasterCard network-branded cards, for which we serve as program manager in conjunction with issuing banks, and Discover network-branded cards that we issue. We defer initial program fees for incentive cards ratably over the estimated card life for single use cards (currently nine months) and on a straight-line basis for reloadable cards (currently 24 months), and we recognize fees for reloading cards when the reload is processed. We may grant price concessions to certain business partners for the purchase of incentive cards. Such concessions are presented as a reduction of Commissions and fees revenue. If such concessions exceed the revenues received from the business partner, we present the net amounts in Operating expenses in Distribution partner commissions • Merchant Commissions-Certain open-loop incentive cards are redeemable only at certain merchants utilizing our proprietary restricted authorization network technology. We receive commissions from such merchants based on a contractual percentage of the amount redeemed. Revenue is recognized when the cardholders make purchases. • Transaction-Based and Other Fees-We receive transaction-based fees from certain telecom partners related to the use of our proprietary network. These fees vary with usage or volumes and are recognized at the time our network is accessed. We also receive fees for certain services related to our local, regional and sports team card programs such as balance tracking, customer service calls and financial settlement. Revenue is recognized in the period the services are performed. Program, Interchange, Marketing and Other Fees-Program, interchange, marketing and other fees consist of post-activation program management fees, settlement network interchange fees, marketing revenues from our content providers, account service fees, fund expiration fees, fund expiration revenues and other fees. • Post-Activation Program Management Fees-We receive a program management fee from certain of our issuing banks related to our proprietary Visa gift card and certain open-loop incentive cards. This fee is based on a contractually stated percentage of load value and represents a portion of our compensation for the overall management and customer support of our proprietary Visa gift and incentive card programs. The fees are deferred and recognized 19-------------------------------------------------------------------------------- Table of Contents over the estimated life of the card in proportion to historical redemption patterns. The fee percentages are subject to quarterly adjustment based on changes in the underlying redemption patterns, escheat obligations, regulations and other factors that change the underlying economics of the card portfolio. • Interchange Fees-We earn payment network fees related to the cardholder's usage of our proprietary Visa gift, PayPower GPR and open loop incentive cards. Merchants are charged at varying rates established by Visa, MasterCard and Discover. These fees are contractually passed through to us by the issuing banks net of any fees paid to Visa or MasterCard, or paid directly to us by Discover for the cards that we issue. We recognize revenues when cardholders make purchases. • Marketing Revenue-We receive funds from our content providers to promote their prepaid cards throughout our retail distribution partner network. We generally recognize revenue ratably over the period of the related marketing campaign. • Account Service Fees-We earn a monthly fee and other transaction-based service fees on the PayPower GPR card and earn monthly fees for certain Visa gift and incentive cards, which we charge only after a predetermined amount of time has transpired since card activation. These consumer-paid service fees are collected by reducing card balances and are recognized as revenue at the time the card balance is reduced. For certain incentive cards, we earn these fees only to the extent that the fees exceed post-activation program management fees paid to us for such cards. • Fund Expiration Revenue-We serve as issuer of Discover network-branded incentive cards and present the cardholder liability in Consumer and Customer Deposits in our consolidated balance sheets. When funds expire, we recognize revenue and derecognize the liability. • Fund Expiration Fees-We receive fees from our issuing banks for certain Visa gift and Visa and MasterCard incentive cards, based on a contractual percentage of the unredeemed funds when the funds expire. We recognize revenue when the funds expire. For certain incentive cards, we earn these fees only to the extent that the fees exceed post-activation program management fees paid to us for such cards. • Other Fees-In some instances, we may receive a portion of other fees such as account maintenance, interchange or referral fees for open loop cards and GPR cards other than our proprietary Visa gift card and PayPower GPR card. We also receive fees related to Safeway-branded gift cards and local, regional and sports team card programs. Typically, these fees are recognized when earned. For one open loop content provider, we receive a fee, under deferred payment terms, based on a percentage of load value and pay the content provider a fee (a portion of which is also under deferred payment terms) for meeting certain activation targets. We recognize the net amount of these fees upon activation. Product Sales-Product sales consist of our card production sales, secondary card market sales and telecom handset sales. • Card Production-We provide card design, development and third-party production services for certain content providers that are separate from the standard content provider contract. We outsource the physical card production to a third party and charge the content provider actual cost plus a margin for managing this process. Revenue is recognized when the cards are received by our content providers, at our distribution partners' locations or by us at our third-party warehouse. • Secondary Card Market-We generate revenue through our wholly owned subsidiary, Cardpool, by acquiring previously owned closed loop gift cards at a discount from the remaining value on the card and then selling them at a mark-up over our costs (but still at a discount to the value on the card) to consumers. Revenue is recognized when the cards are delivered to the purchaser. • Telecom Handsets-We earn revenue from the sale of telecom handsets to our distribution partners to facilitate and supplement the sale of our prepaid telecom content providers' airtime cards. Revenue is generally recognized upon handset shipment to or receipt by the distribution partner based upon the shipping terms, net of estimated returns. We may grant price discounts to distribution partners to increase sales of the distribution partners' remaining inventory, which we recognize as a reduction of revenue. 20-------------------------------------------------------------------------------- Table of Contents Description of Our Expenses Distribution Partner Commissions-Distribution partner commissions represent the amounts paid to members of our distribution partner network for their distribution services related to our content providers' cards and our proprietary Visa gift card and PayPower GPR card. We compensate our distribution partners by paying them a negotiated share of the commission we receive from our content providers or the consumer purchase fee associated with open loop cards. The percentage shared is generally fixed, but may vary based on annual load value per store location. We recognize pricing concessions in excess of revenue from incentive business partners in Distribution partner commission expense. Distribution partner commission expense is recognized upon card activation, except for Visa gift, PayPower GPR and incentive cards where commission expense is capitalized and then amortized based on the same redemption pattern as the related revenue. Processing and Services-Processing and services costs are the direct costs of generating commissions and fees, and program, interchange, marketing and other fees and include costs of development, integration, maintenance, depreciation and amortization of technology platforms and related hardware; card distribution, fulfillment, merchandising and fixture display amortization; card production for our Visa gift, PayPower GPR and incentive cards and certain other content providers' cards, data communication costs, customer support services, third-party processing, data center facilities costs and compensation costs for processing and services personnel. These costs are expensed as incurred. However, for the Visa gift, incentive and PayPower GPR cards, card production costs and upfront transaction processing fees are capitalized and expensed based on the same redemption pattern as the related revenue. We also incur significant costs to develop new technology platforms and to add functionality to our existing technology platforms. Those costs are capitalized and included in Property, equipment and technology, net and amortized to Processing and services expense over the project's estimated useful life, which is typically five years. Some costs related to operating our technology platform, including certain technology personnel costs and the cost of our in-store displays and merchandising, are fixed in nature, not increasing directly with increasing prepaid product sales, but certain costs will increase based on general growth of our business. Sales and Marketing-We incur costs, both discretionary and contractual, in the form of marketing allowances, direct advertising campaigns, general marketing and trade promotions to promote content providers' prepaid cards and our Visa gift card and PayPower GPR card at our distribution partner locations. Sales and marketing expenses consist of program marketing and advertising costs, distribution partner program development expenses, compensation and travel costs for marketing and sales personnel, communication costs, mark-to-market charges and intangible amortization expense resulting from equity instruments issued to certain distribution partners, facilities costs and outside consulting fees. Additionally, sales and marketing expenses include additional compensation to certain distribution partners for the sale of certain prepaid products, for which the Company earns revenues included in Program, interchange, marketing and other fees. Program development expenses are generally contractually fixed and do not increase based on volume of prepaid product sales. Other sales and marketing costs do not vary directly with the volume of prepaid product sales, but certain costs will increase based on general growth of our business. Costs of Products Sold-Costs of products sold include the direct costs of card production efforts, the costs to acquire previously issued prepaid cards and other direct costs related to our Cardpool secondary gift card market business and costs to acquire telecom handsets. We may receive pricing concessions from our telecom handset vendors to increase sales of remaining inventory at distribution partners, which we recognize as a reduction of expense and pass onto our distribution partners as a reduction of revenue. Most costs of products sold are variable based on the volume of product sales. General and Administrative-General and administrative expenses include compensation and benefits for administrative staff, facilities costs, telecommunications costs and professional service fees. These costs do not vary directly with the volume of prepaid product sales, but certain costs will increase based on general growth of our business. General and administrative expenses may also include bad debt and legal expenses, which may cause significant fluctuations from period to period. Business acquisition expense (benefit) and amortization of acquisition intangibles- Business acquisition expense and amortization of acquisition intangibles includes the change in the estimated fair value of the Cardpool contingent consideration liability, amortization of intangible assets acquired in a business acquisition and acquisition-related costs, such as legal, tax, audit and valuation services. 21-------------------------------------------------------------------------------- Table of Contents Key Operating Statistics The following table sets forth key operating statistics that directly affect our financial performance for the 12 and 24 weeks ended June 14, 2014 and June 15, 2013: 12 Weeks Ended 24 Weeks Ended June 14, 2014 June 15, 2013 June 14, 2014 June 15, 2013 (in thousands, except percentages and average load transaction value) Load value $ 2,619,658 $ 1,919,384 $ 4,807,362 $ 3,529,225 Commissions and fees as a % of load value 8.3 % 9.2 % 8.2 % 9.1 % Distribution partner commissions paid as a % of commissions and fees 66.6 % 66.8 % 66.6 % 66.6 % Number of load transactions 57,538 46,640 102,176 83,446 Average load transaction value $ 45.53 $ 41.15 $ 47.05 $ 42.29 Adjusted operating revenues(1) $ 138,596 $ 107,709 $ 254,442 $ 196,777 Adjusted EBITDA(1) $ 21,096 $ 18,528 $ 32,418 $ 25,884 Adjusted EBITDA margin(1) 15.2 % 17.2 % 12.7 % 13.2 % Adjusted net income(1) $ 8,940 $ 8,737 $ 12,334 $ 10,698 Adjusted diluted earnings per share(1) $ 0.17 $ 0.16 $ 0.23 $ 0.20 ______________________(1) Our Adjusted operating revenues, EBITDA, Adjusted EBITDA, Adjusted EBITDA margin, Adjusted net income and Adjusted diluted earnings per share are non-GAAP financial measures. Generally, a non-GAAP financial measure is a numerical measure of a company's performance, financial position or cash flow that either excludes or includes amounts that are not normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP. These measures, however, should be considered in addition to, and not as a substitute for or superior to, operating revenues, operating income, operating margin, cash flows, or other measures of the financial performance prepared in accordance with GAAP. Load Value-Represents the total dollar amount of value loaded onto any of our prepaid products during the period. The dollar amount and volume of card sales directly affect the amount of our revenues and direct costs. We measure and monitor Load value by distribution partner channel and content provider program. The significant growth in Load value over the past two years has been driven by increased consumer use of prepaid products, partly in response to distribution partner loyalty and incentive programs, expansion of product content and services we offer and expansion of Selling stores in our distribution partner network in the United States and internationally. Commissions and Fees as a Percentage of Load Value-Represents the total amount of Commissions and fees recognized during the period as a percentage of Load value for the same period. Commissions as a percentage of load value is generally higher for closed loop and telecom products than the purchase, load and incentive program fees as a percentage of load value for open loop, financial services and incentive products. As a result, overall Commissions and fees as a percentage of load value is directly affected by the mix of Load value among our product offerings. This metric helps us understand and manage overall margins from our product offerings. Distribution Partner Commissions Paid as a Percentage of Commissions and Fees-Represents Distribution partner commissions expense divided by Commissions and fees revenue during the period. This metric represents the expense recognized for the share of content provider commissions and purchase or load fees we pay to our distribution partners as a percentage of total Commissions and fees revenue recognized during the period. Distribution partner commission share percentages are individually negotiated with our distribution partners and are independent of the commission rates negotiated between us and our content providers. The distribution partner commissions paid percentage is affected by changes in the proportion of Load value and resulting Commissions and fees revenue between distribution partners with differing share percentages. Number of Load Transactions-Represents the total number of load transactions (including reloads) for all of our prepaid products during the period. Average Load Transaction Value-Represents Load value divided by the Number of load transactions during the period. 22-------------------------------------------------------------------------------- Table of Contents We regard Adjusted operating revenues, EBITDA, Adjusted EBITDA, Adjusted EBITDA margin, Adjusted net income and Adjusted diluted earnings per share as useful measures of operational and financial performance of the business. We regard Adjusted EBITDA margin as an important financial metric that we use to evaluate the operating efficiency of our business. Adjusted EBITDA, Adjusted net income and Adjusted diluted earnings per share measures are prepared and presented to eliminate the effect of items from EBITDA, Net income and Diluted earnings per share that we do not consider indicative of our core operating performance within the period presented. Adjusted operating revenues are prepared and presented to offset the commissions paid to our distribution partners. Adjusted EBITDA margin represents Adjusted EBITDA as a percentage of Adjusted operating revenues. Our Adjusted operating revenues, Adjusted EBITDA, Adjusted EBITDA margin, Adjusted net income and Adjusted diluted earnings per share may not be comparable to similarly titled measures of other organizations because other organizations may not calculate these measures in the same manner as we do. You are encouraged to evaluate our adjustments and the reasons we consider them appropriate. We believe Adjusted operating revenues, EBITDA, Adjusted EBITDA, Adjusted EBITDA margin, Adjusted net income and Adjusted diluted earnings per share are useful to evaluate our operating performance for the following reasons: • adjusting our operating revenues for the issuing bank contract amendment and the commissions paid to our distribution partners is useful to understanding our operating margin; • EBITDA and Adjusted EBITDA are widely used by investors and securities analysts to measure a company's operating performance without regard to items that can vary substantially from company to company and from period to period depending upon their financing, accounting and tax methods, the book value of their assets, their capital structures and the method by which their assets were acquired; • Adjusted EBITDA margin provides a measure of operating efficiency based on Adjusted operating revenues and without regard to items that can vary substantially from company to company and from period to period depending upon their financing, accounting and tax methods, the book value of their assets, their capital structures and the method by which their assets were acquired; • non-cash equity grants made to employees and distribution partners at a certain price and point in time do not necessarily reflect how our business is performing at any particular time and the related expenses are not key measures of our core operating performance; • the issuing bank contract amendment fee adjustments are necessary to adjust operating revenues, EBITDA and Net income to recognize the revenues from these fees as if the contract amendments had been in place as of the beginning of the fiscal year, which we believe better reflects our core operating performance during those periods; • intangible asset amortization expenses can vary substantially from company to company and from period to period depending upon the applicable financing and accounting methods, the fair value and average expected life of the acquired intangible assets, the capital structure and the method by which the intangible assets were acquired and, as such, we do not believe that these adjustments are reflective of our core operating performance; and • non-cash fair value adjustments to contingent business acquisition liability do not directly reflect how our business is performing at any particular time and the related expense adjustment amounts are not key measures of our core operating performance. 23-------------------------------------------------------------------------------- Table of Contents Reconciliation of Non-GAAP Measures: The following tables present a reconciliation of Total operating revenues to Adjusted operating revenues, a reconciliation of Net income to EBITDA and Adjusted EBITDA, a reconciliation of Operating income margin to Adjusted EBITDA margin, a reconciliation of Net income to Adjusted net income and a reconciliation of Diluted earnings per share to Adjusted diluted earnings per share, in each case reconciling the most comparable GAAP measure to the adjusted measure, for each of the periods indicated. 12 Weeks Ended 24 Weeks Ended June 14, 2014 June 15, 2013 June 14, 2014 June 15, 2013 (in thousands, except percentages and per share amounts) Adjusted operating revenues: Total operating revenues $ 283,944 $ 225,862 $ 517,059 $ 410,912 Issuing bank contract amendment fee adjustment (b) (1,325 ) - - - Distribution partner commissions (144,023 ) (118,153 ) (262,617 ) (214,135 ) Adjusted operating revenues $ 138,596 $ 107,709 $ 254,442 $ 196,777 Adjusted EBITDA: Net income before allocation to non-controlling interest $ 5,063 $ 2,005 $ 2,179 $ 2,264 Interest income and other income (expense), net (353 ) (96 ) 56 (373 ) Interest expense 956 - 1,001 - Income tax expense 3,275 3,470 1,492 3,788 Depreciation and amortization 10,770 5,924 21,688 10,651 EBITDA 19,711 11,303 26,416 16,330 Adjustments to EBITDA: Employee stock-based compensation 3,420 1,828 6,090 3,462 Distribution partner mark-to-market expense(a) (710 ) 6,878 (88 ) 6,995 Issuing bank contract amendment fee adjustment (b) (1,325 ) - - - Change in fair value of contingent consideration(c) - (1,481 ) - (903 ) Adjusted EBITDA $ 21,096 $ 18,528 $ 32,418 $ 25,884 Adjusted EBITDA margin: Total operating revenues $ 283,944 $ 225,862 $ 517,059 $ 410,912 Operating income $ 8,941 $ 5,379 $ 4,728 $ 5,679 Operating margin 3.1 % 2.4 % 0.9 % 1.4 % Adjusted operating revenues $ 138,596 $ 107,709 $ 254,442 $ 196,777 Adjusted EBITDA $ 21,096 $ 18,528 $ 32,418 $ 25,884 Adjusted EBITDA margin 15.2 % 17.2 % 12.7 % 13.2 % Adjusted net income: Income before income tax expense $ 8,338 $ 5,475 $ 3,671 $ 6,052 Employee stock-based compensation 3,420 1,828 6,090 3,462 Distribution partner mark-to-market expense(a) (710 ) 6,878 (88 ) 6,995 Issuing bank contract amendment fee adjustment (b) (1,325 ) - - - Change in fair value of contingent consideration(c) - (1,481 ) - (903 ) Amortization of intangibles(d) 4,585 897 10,117 1,078 Adjusted income before income tax expense 14,308 13,597 19,790 16,684 Income tax expense 3,275 3,470 1,492 3,788 Tax expense on adjustments(e) 2,146 1,516 6,060 2,411 Adjusted income tax expense 5,421 4,986 7,552 6,199 Adjusted net income before allocation to non-controlling interest 8,887 8,611 12,238 10,485 Add: Net loss attributable to non-controlling interests (net of tax) 53 126 96 213 Adjusted net income attributable to Blackhawk Network Holdings, Inc. $ 8,940 $ 8,737 $ 12,334 $ 10,698 24 -------------------------------------------------------------------------------- Table of Contents 12 Weeks Ended 24 Weeks Ended June 14, 2014 June 15, 2013 June 14, 2014 June 15, 2013 (in thousands, except percentages and per share amounts) Adjusted diluted earnings per share: Net income attributable to Blackhawk Network Holdings, Inc. $ 5,116 $ 2,131 $ 2,275 $ 2,477 Distributed and undistributed income allocated to participating securities (13 ) (52 ) (47 ) (118 ) Net income attributable to common shareholders $ 5,103 $ 2,079 $ 2,228 $ 2,359 Diluted weighted-average shares outstanding 53,740 52,240 53,725 51,746 Diluted earnings per share $ 0.09 $ 0.04 $ 0.04 $ 0.05 Adjusted net income attributable to Blackhawk Network Holdings, Inc. $ 8,940 $ 8,737 $ 12,334 $ 10,698 Adjusted distributed and undistributed income allocated to participating securities (21 ) (138 ) (68 ) (267 ) Adjusted net income attributable to common shareholders $ 8,919 $ 8,599 $ 12,266 $ 10,431 Diluted weighted average shares outstanding 53,740 52,240 53,725 51,746 Adjusted diluted earnings per share $ 0.17 $ 0.16 $ 0.23 $ 0.20 ______________________ (a) Distribution partner equity instruments are generally marked to market at each reporting date to fair value until the instrument is vested. (b) In June 2014, we entered into a contractual amendment with one of our issuing banks that substituted a program management fee for account service fees or card expiration fees for certain open-loop incentive cards. A portion of the fees related to cards sold in the 12 weeks ended March 22, 2014. Adjusted operating revenues, Adjusted EBITDA and Adjusted net income for the 12 weeks ended June 14, 2014 have been adjusted to recognized the revenues as if the contract amendment had been in force at the beginning of the fiscal year. (c) Adjustments to reflect a contingent business acquisition liability at its estimated fair value. (d) Non-cash expense resulting from the amortization of intangible assets, including the amortization of distribution partner relationships resulting from the issuance of fully vested warrants, recorded in Sales and marketing expense, and the amortization of intangible assets from business acquisitions, recorded in Business acquisition expense (benefit) and amortization of acquisition intangibles. (e) Assumes our statutory tax rate adjusted for certain amounts that are not deductible for tax purposes. 25-------------------------------------------------------------------------------- Table of Contents Results of Operations Comparison of the 12 Weeks Ended June 14, 2014 and June 15, 2013 The fiscal periods presented in the accompanying tables below and throughout this Results of Operations section consist of the 12-week periods ended June 14, 2014 and June 15, 2013. The following table sets forth the revenue and expense amounts as a percentage of total operating revenues by the line items in our condensed consolidated statements of income for the 12 weeks ended June 14, 2014 and June 15, 2013. 12 Weeks 12 Weeks Ended % of Total Ended % of Total June 14, Operating June 15, Operating 2014 Revenues 2013 Revenues (in thousands, except percentages) OPERATING REVENUES: Commissions and fees $ 216,341 76.2 % $ 176,819 78.3 % Program, interchange, marketing and other fees 40,421 14.2 % 28,907 12.8 % Product sales 27,182 9.6 % 20,136 8.9 % Total operating revenues 283,944 100.0 % 225,862 100.0 % OPERATING EXPENSES: Distribution partner commissions 144,023 50.7 % 118,153 52.3 % Processing and services 45,314 16.0 % 34,258 15.2 % Sales and marketing 45,779 16.1 % 39,932 17.7 % Costs of products sold 25,495 9.0 % 18,509 8.2 % General and administrative 10,934 3.9 % 11,015 4.9 % Business acquisition expense (benefit) and amortization of acquisition intangibles 3,458 1.2 % (1,384 ) (0.6 )% Total operating expenses 275,003 96.9 % 220,483 97.6 % OPERATING INCOME 8,941 3.1 % 5,379 2.4 % OTHER INCOME (EXPENSE): Interest income and other income (expense), net 353 0.1 % 96 - % Interest expense (956 ) (0.3 )% - - % INCOME BEFORE INCOME TAX EXPENSE 8,338 2.9 % 5,475 2.4 % INCOME TAX EXPENSE 3,275 1.2 % 3,470 1.5 % NET INCOME BEFORE ALLOCATION TO NON-CONTROLLING INTEREST 5,063 1.8 % 2,005 0.9 % Add: Net loss attributable to non-controlling interests (net of tax) 53 - % 126 - % NET INCOME ATTRIBUTABLE TO BLACKHAWK $ 5,116 1.8 % $ 2,131 0.9 % 26-------------------------------------------------------------------------------- Table of Contents 12 Weeks Ended June 14, 2014 and June 15, 2013: Operating Revenues The following table sets forth our consolidated operating revenues for the 12 weeks ended June 14, 2014 and June 15, 2013. 12 Weeks Ended June 14, 2014 June 15, 2013 Change (in thousands, except percentages) OPERATING REVENUES: Commissions and fees $ 216,341 $ 176,819 $ 39,522 22.4 % Program, interchange, marketing and other fees 40,421 28,907 11,514 39.8 % Product sales 27,182 20,136 7,046 35.0 % Total operating revenues $ 283,944 $ 225,862 $ 58,082 25.7 % Commissions and Fees Commissions and fees revenue increased primarily due to a 36.5%, or $700.3 million, increase in Load value, partially offset by a decrease in Commissions and fees as a percentage of load value of 90 basis points, to 8.3% for the 12 weeks ended June 14, 2014 from 9.2% for the 12 weeks ended June 15, 2013. The increase in Load value was primarily due to a 23.4% increase in the Number of load transactions and a 10.6% increase in the Average load transaction value. The increase in Number of load transactions reflects our acquisitions of InteliSpend and Retailo in the fourth quarter of 2013, improved store productivity in certain parts of our distribution network, the addition of new distribution partners including our expansion into South Africa and increases in products sold through our online and digital distribution channels. Increases in open loop, financial services and incentive products sold as a proportion of total Load Value increased Average load transaction value and decreased Commissions and fees as a percentage of load value as these products generally have higher load values with lower Commissions and fees revenue but generate higher amounts of revenues included in Program, interchange, marketing and other fees. Program, Interchange, Marketing and Other Fees Program, interchange, marketing and other fees increased primarily due to a 34.7%, or $3.3 million, increase in marketing revenues, and increases in our program-managed Visa gift and PayPower GPR cards sold as well as our acquisition of InteliSpend, which collectively resulted in a 68.9%, or $6.6 million increase in post-activation program management fees and a 21.2%, or $1.5 million, increase in net interchange fees, card expiration fees and account service fees. Product Sales Product sales increased primarily due to a 39.2%, or $4.7 million, increase in sales from Cardpool, a 32.6%, or $1.8 million, increase in card production sales and a 19.6%, or $0.5 million, increase in telecom handset and other product sales. 27-------------------------------------------------------------------------------- Table of Contents Operating Expenses The following table sets forth our consolidated operating expenses for the 12 weeks ended June 14, 2014 and June 15, 2013. 12 Weeks Ended June 14, 2014 June 15, 2013 Change (in thousands, except percentages) OPERATING EXPENSES: Distribution partner commissions $ 144,023 $ 118,153 $ 25,870 21.9 % Processing and services 45,314 34,258 11,056 32.3 % Sales and marketing 45,779 39,932 5,847 14.6 % Costs of products sold 25,495 18,509 6,986 37.7 % General and administrative 10,934 11,015 (81 ) (0.7 )% Business acquisition expense (benefit) and amortization of acquisition intangibles 3,458 (1,384 ) 4,842 (349.9 )% Total operating expenses $ 275,003 $ 220,483 $ 54,520 24.7 % Distribution Partner Commissions Distribution partner commissions expense increased 21.9% primarily due to a 22.4% increase in Commissions and fees revenue. Distribution partner commissions expense as a percentage of commissions and fees revenue decreased from 66.8% in the 12 weeks ended June 15, 2013 to 66.6% for the 12 weeks ended June 14, 2014 primarily due to favorable changes in our U.S. distribution partner mix and our acquisition of Retailo, which has lower commission sharing agreements, partially offset by an increased portion of our prepaid products sold in certain international areas which have higher commission sharing agreements. Processing and Services Processing and services expenses increased 32.3% primarily due to a 23.4% increase in Number of load transactions. The $11.1 million increase includes increases of $3.1 million for our card program management services, including card production, redemption transaction processing and customer care primarily for our Visa gift, PayPower GPR and incentive cards; $2.4 million for personnel costs, including employee and contractor compensation, benefits and travel related costs; $2.4 million for our technology infrastructure, including depreciation of capitalized software and related hardware, data center lease, data connectivity, activation transaction processing and other equipment costs; $1.6 million for maintaining our distribution partner network, including in-store fixture amortization and merchandising and supply chain costs; and $1.6 million net increase in other costs. Processing and services expenses increased as a percentage of Total operating revenues to 16.0% in the 12 weeks ended June 14, 2014 from 15.2% in the 12 weeks ended June 15, 2013 primarily due to our acquisition of InteliSpend, which has higher Processing and services expenses but substantially lower Distribution partner commissions expense, as well as investments in our distribution partner network. Sales and Marketing Sales and marketing expenses increased due to an $8.4 million increase in program marketing and development expenses, which partially resulted from the $3.3 million increase in marketing revenue in Program, interchange, marketing and other fees as well as expansion of our distribution network. Sales and marketing expenses also increased due to a $4.0 million increase in employee compensation, benefits and travel related costs, primarily from our acquisition of InteliSpend, and a $0.7 million net increase in other costs. These increases were partially offset by a $7.3 million decrease in mark-to-market and amortization expense for equity instruments held by distribution partners, primarily as a result of the accelerated mark-to-market expense that we recorded at the time of our our initial public offering in April 2013. Costs of Products Sold Costs of products sold increased due to $4.5 million increase in Cardpool costs, a $1.7 million increase in card production costs and a $0.8 million increase in telecom handsets and other product costs. Costs of products sold increased to 93.8% of product sales in the 12 weeks ended June 14, 2014 compared to 91.9% in the 12 weeks ended June 15, 2013 primarily due to decreases in the gross margin percentage for card production sales and telecom handsets and other product costs, partially offset by an increase in the gross margin percentage for Cardpool. 28-------------------------------------------------------------------------------- Table of Contents General and Administrative General and administrative expenses decreased primarily due to a $3.9 million benefit resulting from the reversal of our previously recorded reserve (including interest) for patent infringement litigation with e2interactive and Interactive Communications International, Inc. (see Note 8 - Commitments and Contingencies in the notes to our condensed consolidated financial statements), substantially offset by a $3.0 million increase in employee compensation, benefits and travel related costs, primarily as a result of our acquisitions of InteliSpend, and a $0.8 million increase in other net costs, primarily related to professional services related to the Spin-Off. Business acquisition expense (benefit) and amortization of acquisition intangibles Business acquisition expense (benefit) and amortization of acquisition intangibles for the 12 weeks ended June 14, 2014 and June 15, 2013 consisted of the following (in thousands): 12 Weeks Ended June 14, 2014 June 15, 2013 Change in fair value of Cardpool contingent consideration liability (See Note 3-Fair Value Measurements in the notes to our condensed consolidated financial statements) $ - $ (1,481 ) Amortization of intangible assets acquired in business combination 3,425 97 Acquisition related expenses 33 - Total business acquisition expense (benefit) and amortization of acquisition intangibles $ 3,458 $ (1,384 ) Business acquisition expense (benefit) and amortization of acquisition intangibles increased $3.3 million for the amortization of intangible assets resulting from our acquisitions of InteliSpend and Retailo in the fourth quarter of 2013, partially offset by a $1.5 million benefit for the non-cash adjustment in the 12 weeks ended June 15, 2013 related to the change in the estimated fair value of the Cardpool contingent consideration liability. Other Income (Expense) and Income Tax Expense The following table sets forth our consolidated other income (expense), and income tax expense and effective tax rates for the 12 weeks ended June 14, 2014 and June 15, 2013. 12 Weeks Ended June 14, 2014 June 15, 2013 Change (in thousands, except percentages) OTHER INCOME (EXPENSE): Interest income and other income (expense), net $ 353 $ 96 $ 257 267.7 % Interest expense (956 ) - (956 ) - % Total other income (expense) $ (603 ) $ 96 $ (699 ) (728.1 )% INCOME TAX EXPENSE $ 3,275 $ 3,470 $ (195 ) (5.6 )% EFFECTIVE TAX RATE 39.3 % 63.4 % (24.1 )% Other Income (Expense) Other income (expense) consists of Interest income and other income (expense), net and Interest expense. Interest income and other income (expense), net includes interest income earned primarily on short-term cash investments and Overnight cash advances to Safeway balances, as well as foreign currency transaction gains and losses and other non-operating gains and losses. During the 12 weeks ended June 14, 2014, interest income consisted solely of short-term cash investments since Safeway did not borrow any of our cash balances. Interest income has fluctuated with the amount and duration of the short-term cash investments and Overnight cash advances to Safeway balances and changes in interest and commercial paper rates. Interest expense includes interest charged under our Note payable and the amortization of deferred financing costs and the discount on the Note payable (see Note 4 - Financing in the accompanying notes to our condensed consolidated financial statements). In late March 2014, we terminated our Cash Management and Treasury Services Agreement with Safeway (the CMATSA). Under the CMATSA, pursuant to unsecured promissory notes, Safeway borrowed available excess cash from us, and we borrowed from Safeway to meet our working capital and capital expenditure requirements (See Note 9 - Related Party Transactions in the accompanying notes to our condensed consolidated financial statements). In conjunction with such 29-------------------------------------------------------------------------------- Table of Contents termination, we entered into a credit agreement with a group of banks. We expect interest expense related to the credit agreement to total approximately $4.5 million for fiscal 2014. See Note 4 - Financing in the notes to our condensed consolidated financial statements and "-Liquidity and Capital Resources-Sources of Liquidity" for additional information. Income Tax Expense Our effective tax rates were 39.3% and 63.4% for the 12 weeks ended June 14, 2014 and June 15, 2013, respectively. The effective rate for the 12 weeks ended June 14, 2014 was lower primarily due to lesser amounts of nondeductible equity-based compensation for certain executives, which, as a result of our initial public offering, became subject to IRS limitations. In April 2014, we and Safeway executed the second Amended and Restated Tax Sharing Agreement (the SARTSA). See Note 7 - Income Taxes in the notes to our condensed consolidated financial statements for information regarding this agreement. Adjusted Effective Income Tax Rate Our Adjusted net income adjusts Net income for certain noncash items, including certain amounts that are nontaxable or nondeductible for income tax purposes, including i) the change in the fair value of contingent consideration, ii) certain amounts of distribution partner mark-to-market expense and iii) certain amounts of stock-based compensation for certain executives that are subject to IRS limitations as a result of our initial public offering. As such, we have presented in the table below reconciliations from our effective income tax rate to our Adjusted effective income tax rate used in the determination of our Adjusted net income for the 12 weeks ended June 14, 2014 and June 15, 2013, which we believe provides a clearer understanding of our operational performance by removing the impact of such nontaxable or nondeductible items that we do not consider indicative of our core operating performance within the period presented. 12 Weeks Ended June 14, 2014 June 15, 2013 (in thousands, except percentages) Income before income tax expense $ 8,338 $ 5,475 Income tax expense $ 3,275 $ 3,470 Effective income tax rate 39.3 % 63.4 % Adjusted income before income tax expense $ 14,308 $ 13,597 Adjusted income tax expense $ 5,421 $ 4,986 Adjusted effective income tax rate 37.9 % 36.7 % Our Adjusted effective income tax rates were 37.9% and 36.7% for the 12 weeks ended June 14, 2014 and June 15, 2013, respectively. This increase reflects benefits related to return-to-provision adjustments that we recorded in the 12 weeks ended June 15, 2013. 30-------------------------------------------------------------------------------- Table of Contents Comparison of the 24 Weeks Ended June 14, 2014 and June 15, 2013 The fiscal periods presented in the accompanying tables below and throughout this Results of Operations section consist of the 24-week periods ended June 14, 2014 and June 15, 2013. The following table sets forth the revenue and expense amounts as a percentage of total operating revenues by the line items in our condensed consolidated statements of income for the 24 weeks ended June 14, 2014 and June 15, 2013. 24 Weeks 24 Weeks Ended % of Total Ended % of Total June 14, Operating June 15, Operating 2014 Revenues 2013 Revenues (in thousands, except percentages) OPERATING REVENUES: Commissions and fees $ 394,436 76.3 % $ 321,294 78.2 % Program, interchange, marketing and other fees 76,086 14.7 % 53,265 13.0 % Product sales 46,537 9.0 % 36,353 8.8 % Total operating revenues 517,059 100.0 % 410,912 100.0 % OPERATING EXPENSES: Distribution partner commissions 262,617 50.8 % 214,135 52.1 % Processing and services 86,939 16.8 % 66,394 16.2 % Sales and marketing 84,570 16.4 % 68,257 16.6 % Costs of products sold 44,799 8.7 % 34,359 8.4 % General and administrative 25,537 4.9 % 22,795 5.5 % Business acquisition expense (benefit) and amortization of acquisition intangibles 7,869 1.5 % (707 ) (0.2 )% Total operating expenses 512,331 99.1 % 405,233 98.6 % OPERATING INCOME 4,728 0.9 % 5,679 1.4 % OTHER INCOME (EXPENSE): Interest income and other income (expense), net (56 ) - % 373 0.1 % Interest expense (1,001 ) (0.2 )% - - % INCOME BEFORE INCOME TAX EXPENSE 3,671 0.7 % 6,052 1.5 % INCOME TAX EXPENSE 1,492 0.3 % 3,788 0.9 % NET INCOME BEFORE ALLOCATION TO NON-CONTROLLING INTEREST 2,179 0.4 % 2,264 0.6 % Add: Net loss attributable to non-controlling interests (net of tax) 96 - % 213 - % NET INCOME ATTRIBUTABLE TO BLACKHAWK $ 2,275 0.4 % $ 2,477 0.6 % 31-------------------------------------------------------------------------------- Table of Contents 24 Weeks Ended June 14, 2014 and June 15, 2013: Operating Revenues The following table sets forth our consolidated operating revenues for the 24 weeks ended June 14, 2014 and June 15, 2013. 24 Weeks Ended June 14, 2014 June 15, 2013 Change (in thousands, except percentages) OPERATING REVENUES: Commissions and fees $ 394,436 $ 321,294 $ 73,142 22.8 % Program, interchange, marketing and other fees 76,086 53,265 22,821 42.8 % Product sales 46,537 36,353 10,184 28.0 % Total operating revenues $ 517,059 $ 410,912 $ 106,147 25.8 % Commissions and Fees Commissions and fees revenue increased primarily due to a 36.2%, or $1.3 billion, increase in Load value, partially offset by a decrease in Commissions and fees as a percentage of load value of 90 basis points, to 8.2% for the 24 weeks ended June 14, 2014 from 9.1% for the 24 weeks ended June 15, 2013. The increase in Load value was primarily due to a 22.4% increase in the Number of load transactions and an 11.3% increase in the Average load transaction value. The increase in Number of load transactions reflects our acquisitions of InteliSpend and Retailo in the fourth quarter of 2013, improved store productivity in certain parts of our distribution network, the addition of new distribution partners including our expansion into South Africa and increases in products sold through our online and digital distribution channels. Increases in open loop, financial services and incentive products sold as a proportion of total Load Value increased Average load transaction value and decreased Commissions and fees as a percentage of load value as these products generally have higher load values with lower Commissions and fees revenue but generate higher amounts of revenues included in Program, interchange, marketing and other fees. Program, Interchange, Marketing and Other Fees Program, interchange, marketing and other fees increased primarily due to a 37.1%, or $5.7 million, increase in marketing revenues, and increases in our program-managed Visa gift PayPower GPR cards sold as well as our acquisition of InteliSpend, which collectively resulted in 44.4%, or $9.0 million, increase in post-activation program management fees and a 61%, or $7.7 million, increase in net interchange fees, card expiration fees and account service fees. Product Sales Product sales increased primarily due to a 27.7%, or $6.8 million, increase in sales from Cardpool, a 38.0%, or $3.0 million, increase in card production sales and a 9.1%, or $0.4 million, increase in telecom handset and other product sales. 32-------------------------------------------------------------------------------- Table of Contents Operating Expenses The following table sets forth our consolidated operating expenses for the 24 weeks ended June 14, 2014 and June 15, 2013. 24 Weeks Ended June 14, 2014 June 15, 2013 Change (in thousands, except percentages) OPERATING EXPENSES: Distribution partner commissions $ 262,617 $ 214,135 $ 48,482 22.6 % Processing and services 86,939 66,394 20,545 30.9 % Sales and marketing 84,570 68,257 16,313 23.9 % Costs of products sold 44,799 34,359 10,440 30.4 % General and administrative 25,537 22,795 2,742 12.0 % Business acquisition expense (benefit) and amortization of acquisition intangibles 7,869 (707 ) 8,576 (1,213.0 )% Total operating expenses $ 512,331 $ 405,233 $ 107,098 26.4 % Distribution Partner Commissions Distribution partner commissions expense increased 22.6% primarily due to a 22.8% increase in Commissions and fees revenue. Distribution partner commissions expense as a percentage of commissions and fees revenue remained constant 66.6% in the 24 weeks ended June 15, 2013 and June 14, 2014 as an increased portion of our prepaid products sold in certain international areas which have higher commission sharing agreements was offset by favorable changes in our U.S. distribution partner mix and our acquisition of Retailo, which has lower commission sharing agreements. Processing and Services Processing and services expenses increased 30.9% primarily due to a 22.4% increase in Number of load transactions. The $20.5 million increase includes increases of $6.0 million for our card program management services, including card production, redemption transaction processing and customer care primarily for our Visa gift, PayPower GPR and incentive cards; $4.3 million for our technology infrastructure, including depreciation of capitalized software and related hardware, data center lease, data connectivity, activation transaction processing and other equipment costs; $3.9 million for maintaining our distribution partner network, including in-store fixture amortization and merchandising and supply chain costs; $3.8 million for personnel costs, including employee and contractor compensation, benefits and travel related costs; and $2.5 million net increase in other costs. Processing and services expenses increased as a percentage of Total operating revenues to 16.8% in the 24 weeks ended June 14, 2014 from 16.2% in the 24 weeks ended June 15, 2013 primarily due to our acquisition of InteliSpend, which has higher Processing and services expenses but substantially lower Distribution partner commissions expense, as well as investments in our distribution partner network. Sales and Marketing Sales and marketing expenses increased due to a $12.9 million increase in program marketing and development expenses, which partly resulted from the $5.7 million increase in marketing revenue in Program, interchange, marketing and other fees as well as expansion of our distribution network. Sales and marketing expenses also increased due to a $7.9 million increase in employee compensation, benefits and travel related costs, primarily from our acquisition of InteliSpend, and a $1.3 million net increase in other costs. These increases were partially offset by a $5.8 million decrease in mark-to-market and amortization expense for equity instruments held by distribution partners, primarily as a result of the accelerated mark-to-market expense that we recorded due to our initial public offering in April 2013. Costs of Products Sold Costs of products sold increased due to $6.9 million increase in Cardpool costs, a $2.8 million increase in card production costs and a $0.7 million increase in telecom handset and other product costs. Costs of products sold increased to 96.3% of product sales in the 24 weeks ended June 14, 2014 compared to 94.5% in the 24 weeks ended June 15, 2013 primarily due to decreases in the gross margin percentage among all product sales. 33-------------------------------------------------------------------------------- Table of Contents General and Administrative General and administrative expenses increased primarily due to a $5.1 million increase in employee compensation, benefits and travel related costs, primarily as a result of our acquisitions of InteliSpend, and $1.5 million increase in other net costs, primarily related to professional services related to our Spin-Off, partially offset by a $3.9 million benefit for the reversal of our previously recorded reserve (including interest) for patent infringement litigation with e2interactive and Interactive Communications International, Inc. (see Note 8 - Commitments and Contingencies in the notes to our condensed consolidated financial statements). Business acquisition expense (benefit) and amortization of acquisition intangibles Business acquisition expense and amortization of acquisition intangibles for the 24 weeks ended June 14, 2014 and June 15, 2013 consisted of the following (in thousands): 24 Weeks Ended June 14, June 15, 2014 2013Change in fair value of Cardpool contingent consideration liability (See Note 3 - Fair Value Measurements in the notes to our condensed consolidated financial statements) $ - $ (903 ) Amortization of intangible assets acquired in business combination 7,835 196 Acquisition related expenses 34 - Total business acquisition expense (benefit) and amortization of acquisition intangibles $ 7,869 $ (707 ) Business acquisition expense (benefit) and amortization of acquisition intangibles increased $7.6 million for the amortization of intangible assets resulting from our acquisitions of InteliSpend and Retailo in the fourth quarter of 2013, partially offset by a $0.9 million benefit for the non-cash adjustment in the 24 weeks ended June 15, 2013 related to the change in the estimated fair value of the Cardpool contingent consideration liability. Other Income (Expense) and Income Tax Expense The following table sets forth our consolidated other income (expense), and income tax expense and effective tax rates for the 24 weeks ended June 14, 2014 and June 15, 2013. 24 Weeks Ended June 14, 2014 June 15, 2013 Change (in thousands, except percentages) OTHER INCOME (EXPENSE): Interest income and other income (expense), net $ (56 ) $ 373 $ (429 ) (115.0 )% Interest expense (1,001 ) - (1,001 ) - % Total other income (expense) $ (1,057 ) $ 373 $ (1,430 ) (383.4 )% INCOME TAX EXPENSE $ 1,492 $ 3,788 $ (2,296 ) (60.6 )% EFFECTIVE TAX RATE 40.6 % 62.6 % (22.0 )% Other Income (Expense) Other income (expense) consists of Interest income and other income (expense), net and Interest expense. Interest income and other income (expense), net includes interest income earned primarily on short-term cash investments and Overnight cash advances to Safeway balances, as well as foreign currency transaction gains and losses and other non-operating gains and losses. During the 24 weeks ended June 14, 2014, interest income consisted solely of short-term cash investments since Safeway did not borrow any of our cash balances. Interest income has fluctuated with the amount and duration of the short-term cash investments and Overnight cash advances to Safeway balances and changes in interest and commercial paper rates. Such investments were significantly lower during the 24 weeks ended June 14, 2014 due to our acquisitions of InteliSpend and Retailo in the fourth quarter of 2013. Additionally, in the 24 weeks ended June 14, 2014, we recognized $0.4 million in losses on intercompany foreign currency transactions, and we had no such expense in the 24 weeks ended June 15, 2013. Interest expense includes interest charged under our Note payable and the amortization of deferred financing costs and the discount on the Note payable (see Note 4 - Financing in the accompanying notes to our condensed consolidated financial statements). 34-------------------------------------------------------------------------------- Table of Contents In late March 2014, we terminated our Cash Management and Treasury Services Agreement with Safeway (the CMATSA). Under the CMATSA, pursuant to unsecured promissory notes, Safeway borrowed available excess cash from us, and we borrowed from Safeway to meet our working capital and capital expenditure requirements (See Note 9 - Related Party Transactions in the accompanying notes to our condensed consolidated financial statements). In conjunction with such termination, we entered into a credit agreement with a group of banks. We expect interest expense related to the credit agreement to total approximately $4.5 million for fiscal 2014. See "-Liquidity and Capital Resources-Sources of Liquidity" for additional information. Income Tax Expense Our effective tax rates were 40.6% and 62.6% for the 24 weeks ended June 14, 2014 and June 15, 2013, respectively. The effective rate for the 24 weeks ended June 14, 2014 was lower primarily due to lower amounts of nondeductible equity based compensation expense for certain executives, which, as a result of our initial public offering, became subject to IRS limitations. In April 2014, we and Safeway executed the second Amended and Restated Tax Sharing Agreement (the SARTSA). See Note 7 - Income Taxes in the notes to our condensed consolidated financial statements for information regarding this agreement. Adjusted Effective Income Tax Rate Our Adjusted net income adjusts Net income for certain noncash items, including certain amounts that are nontaxable or nondeductible for income tax purposes, including i) the change in the fair value of contingent consideration, ii) certain amounts of distribution partner mark-to-market expense and iii) certain amounts of stock-based compensation for certain executives that are subject to IRS limitations as a result of our initial public offering. As such, we have presented in the table below reconciliations from our effective income tax rate to our Adjusted effective income tax rate used in the determination of our Adjusted net income for the 24 weeks ended June 14, 2014 and June 15, 2013, which we believe provides a clearer understanding of our operational performance by removing the impact of such nontaxable or nondeductible items that we do not consider indicative of our core operating performance within the period presented. 24 Weeks Ended June 14, 2014 June 15, 2013 (in thousands, except percentages) Income before income tax expense $ 3,671 $ 6,052 Income tax expense $ 1,492 $ 3,788 Effective income tax rate 40.6 % 62.6 % Adjusted income before income tax expense $ 19,790 $ 16,684 Adjusted income tax expense $ 7,552 $ 6,199 Adjusted effective income tax rate 38.2 % 37.2 % Our Adjusted effective income tax rates were 38.2% and 37.2% for the 24 weeks ended June 14, 2014 and June 15, 2013, respectively. This increase reflects benefits related to return-to-provision adjustments that we recorded in the 24 weeks ended June 15, 2013. 35-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital ResourcesThe following table sets forth the major sources and uses of cash for the 24 weeks ended June 14, 2014 and June 15, 2013. 24 Weeks Ended June 14, 2014 June 15, 2013 (in thousands) Net cash used in operating activities $ (411,377 ) $ (488,669 ) Net cash provided by (used in) investing activities (15,690 ) 423,608 Net cash provided by (used in) financing activities 176,498 (886 ) Effect of exchange rates on cash (84 ) (2,335 ) Net decrease in cash and cash equivalents $ (250,653 ) $ (68,282 ) Adjusted for Change in overnight cash advances to Safeway - (430,000 ) Net decrease in cash and cash equivalents and overnight cash advances to Safeway $ (250,653 ) $ (498,282 ) In March 2014, Safeway announced that it had entered into a definitive agreement to merge with Albertsons. If the merger is completed, it is expected that the distribution of our shares in the Spin-Off will be taxable to Safeway and its shareholders. If the merger is completed, it is also anticipated that there will be a step-up in the tax basis of our assets that would be amortized as a tax deduction that could result in an estimated $30 million in cash tax savings per year for us, assuming a 15-year recovery period. We are currently analyzing the allocation of the basis step-up between our U.S. and international entities which will determine the final benefit that we will realize. Our ability to realize these benefits will be dependent upon, among other things, our ability to generate adequate taxable income to fully utilize the deductions and the value of our common stock at the time of the distribution. See Note 7 - Income Taxes in the notes to our condensed consolidated financial statements for additional information. Adjusted Net Cash Provided by (Used in) Operating Activities and Free Cash Flow Adjusted net cash provided by (used in) operating activities is calculated as the net cash used in operating activities adjusted to exclude the impact from changes in Settlement receivables and Settlement payables. Free cash flow is calculated as Adjusted net cash provided by (used in) operating activities, less Expenditures for property, equipment and technology. Cash from the sale of prepaid products is held for a short period of time and then remitted, less our commissions, to our content providers, and is significantly impacted by the portion of gift card sales that occur in late December. Because this cash flow is temporary and highly seasonal, it is not available for other uses is therefore excluded from our calculation of free cash flow. Free cash flow provides information regarding the cash that our business generates without the fluctuations resulting from the timing of cash inflows and outflows from gift card sales in late December, which we believe is useful to understanding our business. Please see "-Cash Flows from Operating Activities" for additional information. The following table sets forth our Adjusted net cash flow provided by (used in) operating activities and Free cash flow for the 24 weeks ended June 14, 2014 and June 15, 2013. 24 Weeks Ended June 14, 2014 June 15, 2013 (in thousands) Net cash used in operating activities $ (411,377 ) $ (488,669 ) Decrease in settlement payables, net of settlement receivables 408,257 491,639 Adjusted net cash provided by (used in) operating activities (1) (3,120 ) 2,970 Expenditures for property, equipment and technology (18,241 ) (15,110 ) Free cash flow (1) $ (21,361 ) $ (12,140 ) (1) Our Adjusted net cash flow provided by (used in) operating activities and Free cash flow are non-GAAP financial measures. Generally, a non-GAAP financial measure is a numerical measure of a company's performance, financial position or cash flow that either excludes or includes amounts that are not normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP. This measure, however, should be considered in addition to, and not as a substitute for or superior to cash flows or other measures of the financial performance prepared in accordance with GAAP. 36-------------------------------------------------------------------------------- Table of Contents Cash Flows from Operating Activities Our Adjusted net cash provided by (used in) operating activities, which removes the impact on operating cash flow from the timing of cash settlement of Settlement receivables and Settlement payables, decreased primarily due to a $12.5 million decrease in cash flows from changes in operating assets and liabilities (excluding Settlement receivables and Settlement payables). The decrease in cash flows from the changes in operating assets and liabilities was partially offset by a 19.8%, or $6.4 million, increase in net income adjusted for noncash reconciling items to $38.9 million in the 24 weeks ended June 14, 2014 from $32.5 million in the 24 weeks ended June 15, 2013. This increase primarily reflects a 25.8% increase in our operating revenues, partially offset by certain investments in our retail distribution partner network. Cash Flows from Investing Activities The net cash used in investing activities for the 24 weeks ended June 14, 2014 totaled $15.7 million, which included $18.2 million for expenditures for property, equipment and technology, partially offset by a net cash receipt of $2.6 million for the subsequent assumption of cardholder liabilities and purchase price adjustments related to our acquisitions of Retailo and InteliSpend (see Note 2 - Business Acquisitions and Note 5 - Condensed Consolidated Financial Statement Details in the notes to our condensed consolidated financial statements). During the 24 weeks ended June 15, 2013, we advanced a portion of our U.S. cash balances at the end of every day to Safeway, which invested these amounts in overnight investments. The net cash provided by investing activities for the 24 weeks ended June 15, 2013 totaled $423.6 million, which included $430.0 million for the change in overnight cash advances to Safeway and $9.0 million for the release of restricted cash upon our initial public offering in April 2013, partially offset by $15.1 million for expenditures for property, equipment and technology. Cash Flows from Financing Activities The net cash provided by financing activities for the 24 weeks ended June 14, 2014 totaled $176.5 million, which included $172.5 million in proceeds from our Note payable under our credit agreement with a group of banks, net of deferred financing costs (see below under Credit Agreements), and $3.6 million from the proceeds from the issuance of common stock from the exercise of employee stock options and our employee stock purchase. The net cash used in financing activities for the 24 weeks ended June 15, 2013 totaled $0.9 million, primarily consisting of a payment of $1.9 million for our Cardpool acquisition liability and $0.8 million for reimbursement, net of payments, for costs related to our initial public offering. Credit Agreements In conjunction with our entry into a new credit agreement (see below), we and Safeway terminated the Cash Management and Treasury Services Agreement (the CMATSA). Under the CMATSA, we borrowed from Safeway to meet our working capital and capital expenditure requirements. In conjunction with such termination, on March 28, 2014, we repaid $103.1 million of amounts outstanding under the Note payable to Safeway. Additionally, as a result of the Spin-Off, Safeway no longer provides guarantees to certain content providers. On March 28, 2014, in conjunction with the termination of the CMATSA, we entered into a credit agreement with a group of banks (the Credit Agreement). The Credit Agreement includes a $175 million 4-year term loan (which we present as Note payable in our condensed consolidated financial statements), with an option, expiring in September 2014, to increase such loan to $225 million, and a revolving credit facility of up to $200 million with up to an additional $100 million during the year-end holiday period for specific settlement related requirements. The revolving credit facility includes a $100 million subfacility for the issuance of letters of credit. Loans borrowed under the Credit Agreement bear interest, in the case of LIBOR rate loans, at a per annum rate equal to the LIBOR rate plus the Applicable Margin (as defined in the Credit Agreement), which may range from 1.25% to 2.00%, based on our Consolidated Total Leverage Ratio (as defined in the Credit Agreement). Loans that are borrowed under the Credit Agreement that are not LIBOR rate loans bear interest at a per annum rate equal to (i) the highest of (A) the rate of interest announced, from time to time, by Wells Fargo Bank, National Association as its "prime rate," (B) the Federal Funds Rate plus 0.50% and (C) one-month LIBOR plus 1.00%, plus (ii) the Applicable Margin, which may range from 0.25% to 1.00%, based on our Consolidated Total Leverage Ratio. A letter of credit commission on the daily amount available to be drawn under letters of credit issued under the Credit Agreement is payable by us at the rate per annum equal to the Applicable Margin with respect to LIBOR rate loans, which Applicable Margin may range from 1.25% to 2.00% per annum, based on our Consolidated Total Leverage Ratio; provided, however, that the commission on letters of credit secured by cash is payable at the rate of 0.75% per annum. 37-------------------------------------------------------------------------------- Table of Contents A commitment fee on the average daily unused portion of the Revolving Credit Facility is payable by us at the rate per annum equal to the Applicable Margin for that fee, which may range from 0.20% to 0.35%, based on the Company's Consolidated Total Leverage Ratio. Other fees are also payable by us, as referenced in the Credit Agreement. As of June 14, 2014, we had $175 million outstanding under our Note payable, no amounts outstanding under our revolving credit facility, $41.9 million in outstanding letters of credit and and $158.1 million available under our revolving credit facility. We believe that our Cash and cash equivalents, projected cash flow from operations and our Credit Agreement provides sufficient liquidity to meet our expected needs, including working capital and capital expenditure requirements, for the next 12 months. For the maturity dates of our Note payable, see Note 4 - Financing in the notes to our condensed consolidated financial statements. The Credit Agreement contains various loan covenants that restrict our ability to take certain actions and contains financial covenants that require us periodically to meet certain financial tests. Please see "Part II, Item 1A-Risk Factors-Risk Factors Related to Our Business or Industry-Our credit and collateral agreements with Wells Fargo Bank, National Association, and other financial institutions contain certain restrictions that limit our flexibility in operating our business and, in the event of a default, could have a material adverse impact on our business and results of operations." 38-------------------------------------------------------------------------------- Table of Contents |