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TNS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion of the financial condition and results of operations of TNS, Inc. in conjunction with the consolidated financial statements and the related notes included in our annual report on Form 10-K filed with the SEC on March 14, 2012 and available directly from the SEC at www.sec.gov and the consolidated financial statements and the related condensed notes of TNS, Inc., included elsewhere in this quarterly report. There are statements made herein which may not address historical facts and, therefore, could be interpreted to be forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, forecasts and assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those set forth in, or implied by, the forward-looking statements. The Company has attempted, whenever possible, to identify these forward-looking statements using words such as "may," "will," "should," "projects," "estimates," "expects," "plans," "intends," "anticipates," "believes," and variations of these words and similar expressions. Similarly, statements herein that describe the Company's business strategy, prospects, opportunities, outlook, objectives, plans, intentions or goals are also forward-looking statements. Actual results may differ materially from those indicated by such forward-looking statements as a result of various important factors, including: the Company's reliance upon a small number of customers for a significant portion of its revenue; competitive factors such as pricing pressures; increases in the prices charged by telecommunication providers for services used by the Company; the Company's ability to grow its business domestically and internationally by generating greater transaction volumes, longer than expected sales cycles, customer delays in migration, acquiring new customers or developing new service offerings; fluctuations in the Company's quarterly results because of the seasonal nature of the business and other factors outside of the Company's control, including fluctuations in foreign exchange rates and the continuing impact of the current economic conditions; the Company's ability to identify, execute or effectively integrate acquisitions; uncertainties related to the updated international tax planning strategy implemented by the Company; the Company's ability to adapt to changing technology; the Company's ability to refinance its senior secured credit facility and its ability to borrow funds in amounts sufficient to enable it to service its debt or meet its working capital and capital expenditure requirements; additional costs related to compliance with any regulatory changes such as Securities and Exchange Commission (SEC) rule changes or other corporate governance issues; and other risk factors described in the Company's annual report on Form 10-K filed with the SEC on March 14, 2012. In addition, the statements in this quarterly report are made as of the date of this filing. The Company expects that subsequent events or developments will cause its views to change. The Company undertakes no obligation to update any of the forward-looking statements made herein, whether as a result of new information, future events, changes in expectations or otherwise. These forward-looking statements should not be relied upon as representing the Company's views as of any date subsequent to the date of this filing. The forward-looking statements in this document are intended to be subject to the safe harbor protection provided by Sections 27A of the Securities Act and 21E of the Securities Exchange Act. 16 -------------------------------------------------------------------------------- Table of Contents Business Overview TNS is an international data communications company which provides networking, managed connectivity, data communications and value added services to many of the world's leading telecommunication firms, retailers, banks, payment processors and financial institutions. Our services enable secure and reliable transmission of time-sensitive data critical to our customers' operations. Our customers outsource their data communications requirements to us because of our substantial expertise, comprehensive customer support and cost-effective services. We provide services to customers in the United States and increasingly to international customers in more than 60 countries including Canada and Mexico and countries in Europe, Latin America and the Asia-Pacific region. We provide services through our data network, which is designed specifically for data-oriented applications and incorporates multi-protocol label switching, or MPLS, based topology. Our network supports a variety of widely accepted communications' protocols and is designed to be scalable, interoperable and accessible by multiple methods, including broadband, dedicated, dial-up, wireless and internet connections. We generate revenues through three business divisions: † Telecommunication services. Our telecommunication services division provides innovative communications infrastructure services to fixed, mobile, broadband and VoIP operators around the world. We collaborate with customers, sharing our expertise, resources and infrastructure to leverage rapidly evolving technologies. Our suite of services includes a reliable, nationwide SS7 network, intelligent database and registry services, identity and verification services, hosted roaming and clearing solutions, and mobile applications that simplify our customers' operations, expand their reach and provide a foundation that helps them increase their profitability. † Payment services. We deliver a broad portfolio of secure and resilient transaction delivery services as well as innovative value added solutions to many of the world's top banks, retailers, ISOs, transaction processors, ATM deployers, card schemes, and alternative payment providers. Our PCI DSS certified global backbone network and range of payment gateways securely deliver billions of card-present and card-not-present transactions each year from the Point-of-Sale (POS) to their destination. Protocol/message conversion, ATM and POS processing, payment encryption and file settlement form part of the comprehensive payment solutions that we provide around the world. † Financial services. As one of the industry's leading electronic connectivity solutions, our Secure Trading Extranet brings together an extensive global financial community of interest and delivers mission-critical low latency connectivity solutions to some of the largest and most prominent financial organizations in the world. Our private Secure Trading Extranet provides low latency to support Direct Market Access, algorithmic trading and market data distribution. Organizations utilizing our network can benefit from a range of value added services, including co-location and hosting services, interoffice WAN solutions and connectivity to our large community of interest. Our most significant expense is cost of network services, which is comprised primarily of the following: telecommunications charges, including data transmission and database access, leased digital capacity charges, circuit installation charges and activation charges; salaries and other costs related to supporting our data platforms and systems; and compensation paid to providers of calling name and line information database records. The cost of data transmission is based on a contract, or in the United States potentially a tariff rate per minute of usage in addition to a prescribed rate per transaction for some vendors. The costs of database access, circuits, installation charges and activation charges are based on fixed fee contracts with local exchange carriers and interexchange carriers. The cost of accessing database records from external providers is based on a per query fee for the use of that data. The compensation charges paid to providers of calling name and line information database records are based on a percentage of query revenue generated from our customers accessing those records. Depreciation expense on our network equipment, amortization of capitalized software and amortization of developed technology is excluded from our cost of network services and is included in depreciation and amortization of property and equipment and amortization of intangible assets in our consolidated statements of comprehensive income. 17 -------------------------------------------------------------------------------- Table of Contents Our engineering and development expenses include salaries and other costs related to product development, engineering, hardware maintenance and materials. The majority of these costs are expensed as incurred, including costs related to the development of internal use software in the preliminary project, the post-implementation and operation stages. Development costs we incur during the software application development stage are capitalized and amortized over the estimated useful life of the developed software. Our selling, general and administrative expenses include costs related to sales, marketing, administrative and management personnel, as well as external legal, accounting and consulting services. Our contingent consideration fair value adjustment includes the change in fair value of contingent consideration relating to the acquisition of Cequint (See Note 2). Acquisitions On October 1, 2010, we completed the acquisition of Cequint, Inc. (Cequint) in accordance with the terms and conditions of the Agreement and Plan of Merger dated September 8, 2010 (see Note 2). The purchase price, following working capital adjustments, included an initial payment of $50.0 million, consisting of $46.9 million in cash and $3.1 million (178,823 shares) in TNS common stock issued to certain Cequint shareholders, and may be adjusted in the future for a potential additional $52.5 million in cash based upon the achievement of four specified profit milestones not to extend past May 31, 2014, for a potential total purchase price of $102.5 million. In addition to the contingent consideration of up to $52.5 million, there are additional performance payments which may be payable to key personnel, based on the achievement of the same four profit-related milestones of up to $10.0 million. To the extent the additional $10.0 million is probable to be earned, it will be amortized over the expected service period and included in operating expenses in our consolidated statements of comprehensive income. During the three and nine months ended September 30, 2012, $0.1 million of income and $0.5 million of compensation expense has been included in selling, general and administrative expense in the Company's consolidated statements of comprehensive income, respectively. During the three and nine months ended September 30, 2011, $0.5 million and $0.7 million, respectively, of compensation expense has been included in selling, general, and administrative expense in the Company's consolidated statements of comprehensive income. We funded the transaction through a new $50.0 million term loan facility using a portion of the accordion feature of our November 2009 Credit Facility (see Note 5). Cequint provides carrier grade caller identification products and enhanced services to top U.S.-based mobile operators. We have integrated Cequint into our telecommunication services division. This acquisition has been accounted for as a business combination under the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 805, Business Combinations. On August 24, 2012, the Company acquired certain assets from Transydian, LLC for a purchase price of approximately $4.0 million. The initial purchase price is subject to a post-closing working capital adjustment. The assets acquired primarily include an assembled workforce of software development personnel from Transydian, as well as intangible assets. The Company purchased these assets to assist with the development and maintenance of software platforms that will help lower our technology costs while maintaining or improving our service levels. Divestiture On August 31, 2011, we divested our ATM processing assets in Canada for a sale price of $1. Upon closing of the transaction, we recorded a loss on the sale of this business of $27,000. Management made the decision to divest this business in order to focus our resources more on our network services offerings in Canada and investments in our payment gateway initiatives. In accordance with FASB ASC 205, Presentation of Financial Statements, we have reported the results of our ATM processing business in Canada as discontinued operations in the accompanying consolidated statements of comprehensive income for all periods presented (see Note 3). Restructuring Costs In August 2012, we implemented a plan to reduce our cost structure and improve operating efficiencies by reducing our workforce and implementing productivity improvement initiatives and expense reduction measures (2012 Restructuring Plan). In connection with the 2012 Restructuring Plan, we incurred approximately $2.8 million associated with our workforce reduction, of which $2.0 million is included in selling, general and administrative expense and $0.8 million is included in engineering and development expense in the accompanying consolidated statement of comprehensive income for the three and nine months ended September 30, 2012. In addition, we anticipate recording additional charges related to workforce reductions during the fourth quarter. 18 -------------------------------------------------------------------------------- Table of Contents Share Repurchase Plan In July 2012, the Company's Board of Directors authorized a share repurchase program for up to $30 million of the Company's common stock over the period ending July 31, 2015, subject to compliance with financial and other covenants of the Company's February 2012 Credit Facility. The Company commenced repurchasing shares during the three month period ended September 30, 2012, repurchasing 161,082 shares for a total cost of $2.4 million. Results of Operations The following table sets forth, for the periods indicated selected statements of comprehensive income data (in thousands): Three months ended Nine months ended September 30, September 30, 2011 2012 2011 2012 Revenues $ 142,731 $ 137,205 $ 417,406 $ 412,893 Operating expenses: Cost of network services, exclusive of the items shown separately below 70,714 69,758 209,547 213,286 Engineering and development 11,657 12,265 33,997 34,188 Selling, general, and administrative 26,241 25,699 75,495 75,526 Contingent consideration fair value adjustment 918 (49 ) 1,668 802 Depreciation and amortization of property and equipment 10,912 13,168 33,838 38,961 Amortization of intangible assets 9,888 9,705 30,070 28,516 Total operating expenses 130,330 130,546 384,615 391,279 Operating income 12,401 6,659 32,791 21,614 Interest expense (6,266 ) (3,191 ) (19,394 ) (16,673 ) Interest income 52 57 193 163 Other (expense) income, net (150 ) 50 (1,471 ) (15 ) Income from continuing operations before income tax provision 6,037 3,575 12,119 5,089 Income tax provision (3,901 ) (597 ) (7,278 ) (3,646 ) Income from continuing operations 2,136 2,978 4,841 1,443 Loss from discontinued operations (538 ) - (1,391 ) - Net income $ 1,598 $ 2,978 $ 3,450 $ 1,443 19 -------------------------------------------------------------------------------- Table of Contents Three months ended September 30, 2012 compared to the three months ended September 30, 2011 Revenues. Total revenues decreased $5.5 million, or 3.9%, to $137.2 million for the three months ended September 30, 2012, from $142.7 million for the three months ended September 30, 2011. The negative effect of foreign exchange translation on a year-over-year basis was $2.3 million. Excluding the effect of foreign exchange rates, total revenues decreased $3.2 million, or 2.3%, to $139.5 million for the three months ended September 30, 2012. Telecommunication services division. Revenues from the telecommunication services division decreased $3.9 million, or 5.2%, to $70.6 million for the three months ended September 30, 2012, from $74.5 million for the three months ended September 30, 2011 as follows: Identity and verification services revenue decreased $2.2 million, or 6.9%, to $29.7 million due to a $1.7 million reduction resulting from fewer queries to wireless carrier data by peering partners in connection with the launch of wireless caller name products, a $1.5 million contract price concession given to a peering partner in connection with the anticipated launch of wireless caller name services with a second tier-one mobile operator, $0.7 million due to the renewal of certain customer contracts, and $0.3 million from lower volumes in legacy payphone fraud and validation services. These decreases were partially offset by $2.0 million of volume growth in our caller name access business. Network services revenue decreased $3.3 million, or 11.5%, to $25.4 million due to $1.9 million related primarily to price concessions and to a lesser extent from volume reductions which principally resulted from industry consolidation, $0.9 million due to pass-through regulatory charges, and a reduction of $0.5 million of project related work. Registry services revenue decreased $0.3 million, or 5.2%, to $5.5 million due to $0.5 million related primarily to price concessions and to a lesser extent from volume reductions which principally resulted from industry consolidation. These decreases were partially offset by increased usage of IP registry services. Roaming and clearing revenue increased $0.9 million, or 16.7%, to $6.1 million due primarily to increased demand for data roaming services. This was partially offset by a reduction in traffic of approximately $0.8 million from certain customers entering into direct peering relationships. We have recently seen an increase in the competive environment for roaming and clearing solutions and as a result in 2013 it is likely our revenue per message will decrease and depending upon the volume we transport our roaming and clearing revenues may decrease. Mobile applications (Cequint) revenue increased $1.0 million, or 33.3%, to $3.9 million due to an increase of $1.5 million in the wireless caller name product that was introduced in partnership with a tier-one mobile operator in the third quarter of 2011. This was partially offset by a $0.5 million reduction in CityID revenues primarily from another tier-one mobile operator that is transitioning to the wireless caller name product. Future revenue growth in the telecommunication services division depends on a number of factors including the number of database access queries we transport, the number of call signaling routes our customers purchase, and the success of our new product offerings, which potentially may be offset by customers seeking pricing discounts due to industry consolidation or other reasons, as well as the successful integration of the products acquired through our purchase of Cequint (see Note 2). We have also experienced a reduction in query volumes from certain of our wireline caller name peering partners. We currently estimate that this may reduce 2012 revenues by approximately $5 million. Payment services division. Revenues from the payment services division decreased $1.0 million, or 2.0%, to $50.3 million for the three months ended September 30, 2012 from $51.3 million for the three months ended September 30, 2011. The negative effect of foreign currency translation on a year-over-year basis was $2.0 million. Excluding the effect of foreign exchange rates, revenues increased $1.0 million to $52.3 million as follows: Network services increased $0.2 million, or 0.4%, to $41.1 million, as follows: † North America: revenue decreased $0.6 million, or 5.0%, to $12.2 million due to reductions in dial transaction volumes. † Europe: revenue increased $0.8 million, or 3.2%, to $24.8 million due primarily to $1.3 in market share gains for dial services and IP-based network services primarily in UK, France and Romania, partially offset by $0.5 million decrease in dial-based network services from existing customers primarily in the UK, France and Spain. 20 -------------------------------------------------------------------------------- Table of Contents † Asia Pacific: revenue was flat due to $0.3 million from volume increases in new markets in Asia, primarily in Taiwan, and $0.2 million of market share gains for IP-based network services offset by $0.5 million in lower dial transaction volumes in Australia. Payment gateway services increased $1.1 million, or 13.6%, to $9.5 million. Certain 2011 amounts have been reclassified to the North American region from the Asia Pacific region to conform to current-period presentation of revenue. The increase is due to the following: † North America: revenue increased $0.5 million, or 31.7%, to $2.3 million due primarily to market share gains in cardholder-not-present services. † Europe: revenue increased $1.2 million, or 50.4%, to $3.5 million due primarily to $1.0 million in market share gains and to a lesser extent from increases in transaction volumes of cardholder present services from existing customers in the UK. † Asia Pacific: revenue decreased $0.5 million, or 12.5%, to $3.7 million, due to $0.6 million decrease in development revenue, partially offset by an increase of $0.1 million related to increased volumes. Payment processing and other services decreased $0.4 million, or 18.3%, to $1.6 million, due primarily to a decrease in transaction volumes and to a lesser extent from lower average transaction pricing. Future revenue growth in the payment services division depends on a number of factors including the success of our IP-related network services and payment gateway services, the success of our payment products in countries we have recently entered, the total number of transactions we transport, and the effect of global economic conditions on merchant transaction volumes. Smaller merchants, which represent a large portion of the user base for our dial-up services, in our opinion have been more adversely impacted by recent global economic conditions than the larger merchants and may take longer to recover if and when the economy improves. We have continued to see a reduction in the growth rates of our dial-up transaction volumes in many of the markets in which we operate, which we primarily attribute to the overall weakness of the global economy. Financial services division. Revenues from the financial services division decreased $0.6 million, or 3.6%, to $16.4 million for the three months ended September 30, 2012, from $17.0 million for the three months ended September 30, 2011. The negative effect of foreign exchange translation on a year-over-year basis was $0.3 million. Excluding the impact of foreign exchange rates, financial services revenue decreased 2.5% or $0.4 million to $16.7 million on a constant currency basis as follows: Network services revenues decreased due to the following: † North America: revenue decreased $0.9 million, or 7.9%, to $10.0 million due to a reduction of $1.0 million primarily from the loss of customer trading connections and market data access services believed to be attributable to negative economic factors impacting the financial services industry and a reduction of $0.8 million due to the restructuring of an agreement with a customer on October 1, 2011 which resulted in a reduction of both revenue and commission payable (which was included in sales, general, and administrative expenses). These decreases were partially offset by $0.9 million in sales of bandwidth-based services marketed primarily to participants in the foreign exchange community. † Asia Pacific: revenue increased $0.2 million, or 7.4%, to $2.9 million due to $0.5 million related to the continued expansion of the number of customer endpoints connected to the network, partially offset by $0.3 million related to disconnects of customer trading connections as the financial services industry consolidates in certain markets in this region. † Europe: revenue increased $0.2 million, or 6.6%, to $3.7 million due to market share gains of $0.3 million which were partially offset by $0.1 million related to the loss of endpoints. Future revenue growth in the financial services division depends on a number of factors including the number of connections to and through our network as well as the success of our new product offerings. During 2011 and 2012, a number of our equity trading customers, primarily in North America and Europe, and to a lesser extent Asia, consolidated the number of connections to other customers on our network resulting in lower average revenue per endpoint. 21 -------------------------------------------------------------------------------- Table of Contents Cost of network services. Cost of network services decreased $1.0 million, or 1.4%, to $69.8 million for the three months ended September 30, 2012, from $70.7 million for the three months ended September 30, 2011. On a constant dollar basis, cost of network services would have decreased $0.3 million to $70.4 million. The decrease was due to the following: a reduction of telecommunications services division costs of $0.9 million due primarily to lower volumes and to a lesser extent from cost savings initiatives partially offset by increased compensation paid to providers of calling name and line information database records; a reduction of payments division costs of $0.2 million primarily from lower dial-up transaction volumes partially offset by increased costs related to growth in IP-based network services; an increase of $0.3 million in our financial services division due primarily to increased connectivity costs in North America and to a lesser extent increases to support revenue growth in Europe and Asia Pacific; and an increase of $0.5 million in shared network, payroll and overhead expense primarily to support our IP network services, roaming and clearing and payment gateway platforms. Future cost of network services depends on a number of factors including total transaction and query volumes, the relative growth and contribution to total transaction volume of each of our customers, changes in revenue share within our identity and verification services, the success of our new service offerings, the timing and extent of our network expansion and the timing and extent of any network cost increases or reductions. Engineering and development expense. Engineering and development expense increased $0.6 million, or 5.2%, to $12.3 million for the three months ended September 30, 2012, from $11.7 million for the three months ended September 30, 2011. On a constant dollar basis, engineering and development expense increased $0.7 million, or 5.6%, to $12.3 million, and represented 8.8% and 8.2% of revenues for the three months ended September 30, 2012 and 2011, respectively. The increase in engineering and development costs was primarily due to headcount related costs of approximately $0.8 million, and restructuring costs of approximately $0.7 million. These increases were partially offset by an increase in capitalized software development costs, which are offset against engineering and development costs, of $0.8 million due to increased utilization of employees and to focus on our investment in our growth initiatives. Selling, general and administrative expense. Selling, general and administrative expenses decreased $0.5 million, or 2.1%, to $25.7 million for the three months ended September 30, 2012, from $26.2 million for the three months ended September 30, 2011. On a constant dollar basis selling, general and administrative expenses would have decreased $0.1 million, or 0.8%, to $26.1 million and represented 18.7% and 18.4% of revenues for the three months ended September 30, 2012 and 2011, respectively. The decrease is primarily due to a decrease of $1.7 million in variable compensation and $0.8 million reduction in third party commission expense to a financial services division customer in connection with the restructuring of their agreement on October 1, 2011. These decreases were partially offset by an increase of $1.8 million of severance expense related to restructuring, $0.4 million in stock compensation due primarily to the timing of the grant of stock based awards, and $0.2 million increase in payroll and overhead expense due to increased headcount and other costs to align our resources with our growth initiatives. Contingent consideration fair value adjustment. Contingent consideration fair value adjustment of $0.1 million of income for the three months ended September 30, 2012, represents the change in the fair value of the liability recorded for the additional consideration which may be payable in relation to the acquisition of Cequint, Inc. See Note 2 to the financial statements for further details regarding the Cequint contingent consideration. This liability will be re-measured each reporting period and changes in the fair value will be recorded through this line item in our consolidated statement of comprehensive income. Depreciation and amortization of property and equipment. Depreciation and amortization of property and equipment increased $2.3 million, or 20.7%, to $13.2 million for the three months ended September 30, 2012, from $10.9 million for the three months ended September 30, 2011. There was no significant currency impact on depreciation and amortization expense for the period. Depreciation and amortization represented 9.5% and 7.6% of revenue for the three months ended September 30, 2012 and 2011, respectively. This increase is primarily due to capital expenditures to support each of our growth initiatives. Amortization of intangible assets. Amortization of intangible assets decreased $0.2 million, or 1.8%, to $9.7 million for the three months ended September 30, 2012, from $9.9 million for the three months ended September 30, 2011. During the three months ended September 30, 2012, impairment charges of $0.3 million were recorded related to certain customer relationships. Excluding these impairment charges, amortization of intangible assets decreased $0.5 million due to certain intangible assets reaching the end of their economic useful lives. Interest expense. Interest expense decreased $3.1 million, or 49.1%, to $3.2 million for the three months ended September 30, 2012, from $6.3 million for the three months ended September 30, 2011. Amortization of deferred financing fees and original issue discount for the three months ended September 30, 2012 and 2011 was $0.4 million and $0.5 million, respectively. Excluding these charges, cash interest expense decreased $3.0 million to $2.8 million for the three months ended September 30, 2012 from $5.8 million for the three months ended September 30, 2011, primarily due to the lower average interest rates as a result of the refinancing the November 2009 Credit Facility in February 2012. Other (expense) income, net. Other (expense) income was income of $0.1 million for the three months ended September 30, 2012 compared to a loss of $0.2 million for the three months ended September 30, 2011. Included in other income (expense) was income of approximately $0.1 million and a loss of $0.2 million for the three months ended September 30, 2012 and 2011, respectively, related to foreign currency revaluation. These revaluation amounts were due to fluctuations in the value of the U.S. dollar, principally against the Euro, Japanese Yen and Australian dollar. 22 -------------------------------------------------------------------------------- Table of Contents Income tax provision. For the three months ended September 30, 2012, our income tax provision was approximately $0.6 million compared to $3.9 million for the three months ended September 30, 2011. Our effective tax rate was 16.7% and 64.6% for the three months ended September 30, 2012 and 2011, respectively. Our effective tax rate differs from the U.S. federal statutory rate primarily due to the application of a valuation allowance against certain U.S. tax attributes and profits of our international subsidiaries being taxed at rates different than the U.S. federal statutory rate. Nine months ended September 30, 2012 compared to the nine months ended September 30, 2011 Revenues. Total revenues decreased $4.5 million, or 1.1%, to $412.9 million for the nine months ended September 30, 2012, from $417.4 million for the nine months ended September 30, 2011. The negative effect of foreign exchange translation on a year-over-year basis was $5.4 million. On a constant currency basis, total revenues increased $0.9 million for the nine months ended September 30, 2012. Telecommunication services division. Revenues from the telecommunication services division decreased $1.3 million, or 0.6%, to $213.1 million for the nine months ended September 30, 2012, from $214.4 million for the nine months ended September 30, 2011 as follows: † Identity and verification services revenue increased $2.4 million, or 2.7%, to $91.9 million due to $7.2 million primarily due to market share gains and volume growth in our caller name access business and $3.7 million from caller name storage contract wins. These were partially offset by decreases of $3.2 million due to an anticipated contract price concession given to a peering partner in connection with the anticipated launch of our wireless caller name service with our second tier one mobile operator, $2.6 million due to the renewal of certain customer contracts, $1.9 million due to lower queries to wireless data and $0.8 million from lower volumes in our legacy payphone fraud and validation services. † Network services revenue decreased $5.8 million, or 7.0%, to $77.9 due to a $5.5 million decrease related primarily to price concessions on call signaling routes as a result of industry consolidation and a reduction of $2.0 million of pass-through revenues from regulatory message signaling unit charges. These decreases were partially offset by increased revenue of $1.7 million due to higher demand for connectivity and signaling services from existing customers. † Roaming and clearing revenue increased $2.4 million, or 16.9%, to $16.7 million due to market share gains and increased demand for data roaming services from existing customers partially offset by reduced volumes from certain customers who have entered into direct peering relationships for the exchange of traffic. † Registry services revenue decreased $2.8 million, or 15.4%, to $15.8 million due to $0.9 million related to the expiry in May 2011 of a transition services agreement acquired through the CSG acquisition, $1.3 million due to price concessions on the renewal of certain customer contracts due primarily to industry consolidation and $0.9 million from reduced volumes. These decreases were partially offset by $0.3 million from increased usage of our IP registry services. † Mobile applications (Cequint) revenue increased $2.4 million, or 29.0%, to $10.7 million due to an increase of $2.8 million in the wireless caller name product that was introduced in partnership with a tier one mobile operator in the third quarter of 2011. This was partially offset by a $0.4 million reduction in CityID revenues primarily from another tier one mobile operator that is transitioning to the wireless caller name product. Payment services division. Revenues from the payment services division decreased $1.8 million, or 1.2%, to $150.6 million for the nine months ended September 30, 2012 from $152.4 million for the nine months ended September 30, 2011. The negative effect of foreign currency translation on a year-over-year basis was $4.9 million. Excluding the effect of foreign exchange rates, revenues increased $3.1 million to $155.5 million as follows: Network services decreased $1.9 million, or 1.5%, to $120.4 million, as follows: † North America: revenue decreased $2.8 million, or 6.9%, to $37.8 million due to the following: $1.3 million in lower average transaction pricing from the renewal of certain customer contracts at the end of the second quarter of 2011 and $1.5 million of reductions in dial transaction volumes. † Europe: revenue increased $1.0 million, or 1.5%, to $70.5 million due to $3.7 million in market share gains for IP-based network services from existing customers, mainly in the UK, Spain, and Romania. These increases were partially offset by a $2.7 million decrease in dial-based network services in the UK, France and other markets. † Asia Pacific: revenue decreased $0.1 million, or 0.9%, to $11.7 million due to $1.5 million in lower transaction volumes from the loss by our Australian telecommunications partner of a portion of its wholesale business, offset by an increase of $1.4 million in transaction volumes in other markets in Asia, primarily Taiwan. Payment gateway services increased $6.2 million, or 26.1%, to $29.9 million. Certain 2011 amounts have been reclassified to the North American region from the Asia Pacific region to conform to current-period presentation of revenue. The increase is due to the following: 23 -------------------------------------------------------------------------------- Table of Contents † North America: revenue increased $4.2 million, or 78.2%, to $9.7 million primarily due to $2.0 million related to a new contract arrangement with an existing customer, $1.0 million of increased demand for cardholder-not-present services, and $1.2 million related to the expansion of an existing customer's contract in the second quarter of 2011. † Europe: increased $2.9 million, or 43.3%, to $9.4 million due primarily to $2.3 million market share gains and to a lesser extent from increases in transaction volumes of cardholder present services in the UK and an increase in development revenue of $0.6 million in France. † Asia Pacific: revenue decreased $0.9 million, or 7.8%, to $10.6 million due primarily to a decrease of $1.7 million in development revenue, partially offset by an increase of $0.8 million related to increased volumes from new and existing customers. Payment processing and other services decreased $1.3 million, or 20.3%, to $5.2 million, due primarily to the decrease in transaction volumes and to a lesser extent lower average transaction pricing. Financial services division. Revenues from the financial services division decreased $1.4 million, or 2.7%, to $49.2 million for the nine months ended September 30, 2012, from $50.6 million for the nine months ended September 30, 2011. The negative effect of foreign exchange translation on a year-over-year basis was $0.5 million. Excluding the impact of foreign exchange rates, financial services revenue decreased $0.9 million, or 1.8%, to $49.7 million as follows: Network services: † North America: revenue decreased $2.8 million, or 8.4%, to $30.3 million due to $2.6 million from the loss of endpoints and market data access services believed to be attributable to negative economic factors impacting the financial services industry and a reduction of $2.3 million due to the restructuring of an agreement with a customer on October 1, 2011 which resulted in a reduction of both revenue and commission payable (which was included in sales, general, and administrative expenses). These decreases were partially offset by an increase of $2.1 million in sales of bandwidth based services marketed primarily to participants in the foreign exchange community. † Asia Pacific: revenue increased $1.1 million, or 14.5%, to $8.5 million due to $2.1 million related to the continued expansion of the number of customer endpoints connected to our network, partially offset by $1.0 million related to disconnects of customer trading connections as the financial services industry consolidates in certain markets in this region. † Europe: revenue increased $0.8 million, or 7.6%, to $10.9 million due to market share gains of $1.3 million which were partially offset by $0.5 million related to the loss of endpoints. Cost of network services. Cost of network services increased $3.7 million, or 1.8%, to $213.3 million for the nine months ended September 30, 2012, from $209.6 million for the nine months ended September 30, 2011. On a constant dollar basis, cost of network services would have increased $5.7 million to $215.3 million. This was due to the following increases: $3.8 million due to higher volumes in our telecommunication services division primarily related to increased demand for our identity and verification services and to a lesser extent from increased compensation paid to providers of calling name and line information database records; $2.5 million in shared network, payroll and overhead expense primarily to support our IP network services, roaming and clearing and payment gateway platforms; and $1.2 million in our financial services division due primarily to increased connectivity costs in North America and to a lesser extent increases to support revenue growth in Europe and Asia Pacific. These increases were partially offset by a decrease of $0.9 million due to cost savings initiatives to reduce network services costs and $0.9 million of regulatory charges which are passed through to our customers. Engineering and development expense. Engineering and development expense increased $0.2 million, or 0.6%, to $34.2 million for the nine months ended September 30, 2012, from $34.0 million for the nine months ended September 30, 2011. On a constant dollar basis, engineering and development expense increased $0.3 million, or 0.9%, to $34.3 million, and represented 8.2% of revenues for the nine months ended September 30, 2012 and 2011. The increase in engineering and development costs was primarily due to additional headcount related cost of $4.1 million partially offset by an increase in capitalized software development costs, which are offset against engineering and development costs, of $3.8 million due to increased utilization of current employees and new resources to focus on our investment in our growth initiatives. 24 -------------------------------------------------------------------------------- Table of Contents Selling, general and administrative expense. Selling, general and administrative expenses remained flat at $75.5 million for the nine months ended September 30, 2012 and for the nine months ended September 30, 2011. On a constant dollar basis, selling, general and administrative expenses would have increased $0.9 million, or 1.2%, to $76.4 million and represented 18.3% and 18.1% of revenues for the nine months ended September 30, 2012 and 2011, respectively. The increase is primarily due to $2.2 million increase of stock compensation expense due primarily to the timing of issuance of performance awards in the third quarter of 2011, $1.9 million in payroll and overhead expense due to increased headcount and other costs to align our resources with our growth initiatives, and $1.6 million in restructuring costs. These increases were partially offset by a $2.3 million reduction in commission expense to a financial services division customer in connection with the restructuring of their agreement on October 1, 2011, $1.5 million decrease in variable compensation and $1.0 million decrease in professional fees and other costs. Contingent consideration fair value adjustment. Contingent consideration fair value adjustment of $0.8 million for the nine months ended September 30, 2012, represents the change in the fair value of the liability recorded for the additional consideration which may be payable in relation to the acquisition of Cequint, Inc. See Note 2 to the financial statements for further details regarding the Cequint contingent consideration. This liability will be re-measured each reporting period and changes in the fair value will be recorded through this line item in our consolidated statement of comprehensive income. Depreciation and amortization of property and equipment. Depreciation and amortization of property and equipment increased $5.2 million, or 15.1%, to $39.0 million for the nine months ended September 30, 2012, from $33.8 million for the nine months ended September 30, 2011. On a constant dollar basis, depreciation and amortization of property and equipment increased $5.3 million to $39.2 million and represented 9.4% and 8.1% of revenue for the nine months ended September 30, 2012 and 2011, respectively. Included in depreciation and amortization of property and equipment for the nine months ended September 30, 2011 was an accelerated depreciation charge of $0.7 million related to the phasing out of $6.2 million of surplus network assets and software as a result of the integration of the CSG and TNS networks. Excluding the accelerated charges, depreciation and amortization of property and equipment for the nine months ended September 30, 2012 increased $6.0 million due to capital expenditures to support our growth initiatives. Amortization of intangible assets. Amortization of intangible assets decreased $1.6 million, or 5.2%, to $28.5 million for the nine months ended September 30, 2012, from $30.1 million for the nine months ended September 30, 2011. During the nine months ended September 30, 2012, impairment charges of $0.3 million were recorded related to certain customer relationships. Excluding these impairment charges, amortization of intangible assets decreased $1.9 million due to certain intangible assets reaching the end of their economic useful lives. Interest expense. Interest expense decreased $2.7 million, or 14.0%, to $16.7 million for the nine months ended September 30, 2012, from $19.4 million for the nine months ended September 30, 2011. Included in this decrease were charges of $5.5 million related to the write-off of debt discount and deferred financing fees following the refinancing of the November 2009 Credit Facility in February 2012. Amortization of deferred financing fees and original issue discount, excluding the write-offs as a result of refinancing, was $1.3 million and $1.5 million for the nine months ended September 30, 2012 and 2011, respectively. Excluding these write-offs and charges, cash interest expense decreased $8.0 million to $9.9 million for the nine months ended September 30, 2012 from $17.9 million for the nine months ended September 30, 2011, primarily due to the lower average interest rates as a result of the refinancing the November 2009 Credit Facility in February 2012. Other (expense) income, net. Other (expense) income was a loss of $0.1 million and $1.5 million for the nine months ended September 30, 2012 and 2011, respectively. Included in other income (expense) was a loss of approximately $0.1 million compared to a loss of $1.7 million for the nine months ended September 30, 2012 and 2011, respectively, related to foreign currency revaluation. These revaluation amounts were due to fluctuations in the value of the U.S. dollar, principally against the Euro, Japanese Yen, and Australian dollar. Income tax provision. For the nine months ended September 30, 2012, our income tax provision was approximately $3.6 million compared to $7.3 million for the nine months ended September 30, 2011. Our effective tax rate was 71.7% and 60.1% for the nine months ended September 30, 2012 and 2011, respectively. Our effective tax rate differs from the U.S. federal statutory rate primarily due to the application of a valuation allowance against certain U.S. tax attributes and profits of our international subsidiaries being taxed at rates different than the U.S. federal statutory rate. Additional Information Non-GAAP Measures To supplement our consolidated financial statements presented on a GAAP basis, we disclose certain non-GAAP measures, including adjusted earnings before interest, taxes, depreciation and amortization (adjusted EBITDA), adjusted net income and adjusted net income per share. These non-GAAP measures are not in accordance with, or an alternative for, generally accepted accounting principles in the United States. Reconciliations of each of these non-GAAP measures to the corresponding GAAP measure are included elsewhere in this 10-Q. 25 -------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA is determined by adding the following items to Net Income, the closest GAAP financial measure: loss from discontinued operations, income tax provision, other income (expense), interest expense, depreciation and amortization of property and equipment, amortization of intangibles, change in fair value of contingent consideration, milestone compensation expense, restructuring costs other one-time items and stock compensation expense. Adjusted net income is determined by adding the following items to Net Income, the closest GAAP financial measure: provision for income taxes, loss from discontinued operations, certain non-cash items, including amortization of intangible assets, stock compensation expense, the change in fair value of contingent consideration, milestone compensation expense, restructuring costs, other one-time items, and the amortization of debt issuance costs, and the result is tax effected at an assumed long-term tax rate of 20%, which excludes the effect of our net operating losses. The assumed long-term tax rate of 20% takes into consideration the following primary factors: the income generated outside of the U.S. which is taxed at substantially lower rates than U.S. statutory rates; the cash benefit of our tax-deductible amortization of intangible assets and tax-deductible goodwill; and the cash benefit of tax-deductible stock compensation expense. We believe that the disclosure of adjusted EBITDA and adjusted net income and related per-share amounts are useful to investors as these non-GAAP measures form the basis of how our management team reviews and considers our operating results. We also rely on adjusted net income as the primary measure of our earnings exclusive of certain non-cash charges and other one-time items. By disclosing these non-GAAP measures, we believe that we create for investors a greater understanding of, and an enhanced level of transparency into, the means by which our management team operates our company. We also believe these measures can assist investors in comparing our performance to that of other companies on a consistent basis exclusive of selected significant non-cash items. Adjusted EBITDA, adjusted net income and adjusted net income per share have limitations as analytical tools, and you should not rely upon them or consider them in isolation or as a substitute for GAAP measures, such as net income and other consolidated income or other cash flows statement data prepared in accordance with GAAP. In addition, these non-GAAP measures may not be comparable to other similarly titled measures of other companies. Because of these limitations, adjusted EBITDA, should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. Adjusted net income and adjusted net income per share also should not be considered as a replacement for, or a measure that should be used or analyzed in lieu of, net income or net income per share. We attempt to compensate for these limitations by relying primarily upon our GAAP results and using adjusted EBITDA, adjusted net income and adjusted net income per share as supplemental information only. All references to the effect of foreign currency exchange rates on a constant dollar basis were determined by applying the prior year foreign currency rates to the current year results. This information is presented to provide a basis for evaluating operating results excluding the effect of foreign currency fluctuations. 26 -------------------------------------------------------------------------------- Table of Contents Adjusted net income and related per share amounts, adjusted EBITDA and revenue comparisons at constant exchange rates are not measures prepared in accordance with U.S. GAAP. See Additional Information above for an explanation of management's use of these non-GAAP measures. The following is a reconciliation of our results of operations prepared in accordance with U.S. GAAP to those adjusted results considered by management (in thousands): Three months ended Nine months ended September 30, September 30, 2011 2012 2011 2012 Adjusted EBITDA: Net income (GAAP) $ 1,598 $ 2,978 $ 3,450 $ 1,443Add back the following items: Loss on discontinued operations 538 - 1,391 - Provision for income taxes 3,901 597 7,278 3,646 Other (expense) income, net 150 (50 ) 1,471 15 Interest income (52 ) (56 ) (192 ) (163 ) Interest expense 6,266 3,191 19,394 16,673 Depreciation and amortization of property and equipment 10,912 13,168 33,838 38,961 Amortization of intangible assets 9,888 9,705 30,070 28,516 Contingent consideration fair value adjustment (1) 918 (49 ) 1,668 802 Restructuring costs - 2,763 276 2,763 Earnout milestone compensation (2) 526 (40 ) 667 498 Stock compensation expense 1,720 2,286 4,170 6,628 Adjusted EBITDA $ 36,365 $ 34,493 $ 103,481 $ 99,782 Adjusted Net Income: Net income (GAAP) $ 1,598 $ 2,978 $ 3,450 $ 1,443 Add back the following items: Loss on discontinued operations 538 - 1,391 - Provision for income taxes 3,901 597 7,278 3,646 Amortization of intangible assets 9,888 9,705 30,070 28,516 Contingent consideration fair value adjustment 918 (49 ) 1,668 802 Restructuring costs - 2,763 276 2,763 Earnout milestone compensation 526 (40 ) 667 498 Other debt related costs (3) 457 383 1,535 6,806 Stock compensation expense 1,720 2,286 4,170 6,628 Adjusted Net Income before income taxes 19,546 18,623 50,505 51,102 Income tax provision at 20% (3,909 ) (3,725 ) (10,101 ) (10,220 ) Adjusted Net Income $ 15,637 $ 14,898 $ 40,404 $ 40,882 Diluted weighted average common shares outstanding 25,488,294 24,573,469 25,663,721 24,668,489 Adjusted Net Income per common share $ 0.61 $ 0.61 $ 1.58 $ 1.66 -------------------------------------------------------------------------------- (1) The contingent consideration change in fair value represents the change in the fair value of the liability recorded for the additional consideration which may be payable in relation to the acquisition of Cequint, Inc. This liability is re-measured each reporting period and changes in the fair value are recorded through this line item in our consolidated statements of comprehensive income. See Note 2. (2) Earnout milestone compensation represents performance payments which may be payable to certain key personnel in addition to the contingent consideration, based on the achievement of four profit-related milestones of up to $10.0 million. To the extent the additional $10.0 million is payable, it will be recorded as compensation expense. See Note 2. (3) Other debt related costs for the nine months ended September 30, 2012 represents the amortization of deferred financing costs of $0.4 million and the loss on debt extinguishment of $5.5 million related to the February 2012 Credit Facility refinancing. See Note 5. 27 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates We base the discussion and analysis of our financial condition and results of operations upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We discuss the most critical estimates in our Annual Report on Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission on March 14, 2012. Liquidity and Capital Resources Our primary liquidity and capital resource needs are to finance the costs of our operations, to make capital expenditures and to service our debt. Based upon our current level of operations, we expect that our cash flow from operations, together with the amounts we are able to borrow under the February 2012 Credit Facility, will be adequate to meet our anticipated needs for the foreseeable future. The covenants in our February 2012 Credit Facility do not, and are not reasonably likely to, limit our ability to pursue strategic acquisitions as part of our growth strategy to a material extent. To the extent that we are not able to fund a strategic acquisition through cash flow from operations or additional amounts that we are able to borrow under our February 2012 Credit Facility, we would need to undertake additional debt or equity financing. Our operations provided us cash of $79.4 million for the nine months ended September 30, 2012, which was attributable to a net income of $1.4 million, depreciation, amortization and other non-cash charges of $82.0 million and an increase in working capital of $4.0 million due primarily to timing differences. Our operations provided us cash of $60.4 million for the nine months ended September 30, 2011, which was attributable to net income of $3.5 million, depreciation, amortization and other non-cash charges of $72.8 million and an increase in working capital of $15.9 million. The increase in working capital relates primarily to the reversal of the $10.5 million working capital decrease from the fourth quarter of 2010, during the nine months ended September 30, 2011, and to a lesser extent from delays in collections in the third quarter of 2011 which reversed early in the fourth quarter of 2011. We used cash of $35.9 million and $34.9 million in investing activities for the nine months ended September 30, 2012, and 2011, respectively, for capital expenditures. Our capital expenditures in 2011 and 2012 are focused on our growth initiatives, including mobile applications, our payment gateway, verification services, IP registry and roaming and clearing services. In addition to capital expenditures during the nine months ended September 30, 2012, the Company also invested in a business combination of $4.0 million. We used cash of $33.4 million for financing activities for the nine months ended September 30, 2012. During the nine months ended September 30, 2012, we refinanced our amended November 2009 Credit Facility to take advantage of current interest rates. As a result of the refinancing, we repaid $373.1 million related to the November 2009 Credit Facility and received $368.8 million in proceeds of issuance from the February 2012 Credit Facility. The proceeds include $375.0 million of term debt, reduced by $6.3 million of fees paid to issue the debt. In addition, in May 2012 we voluntarily prepaid $20 million and in August 2012 we prepaid $5 million on the February 2012 Credit Facility. We also used $2.4 million to repurchase stock as part of the Company's authorized share repurchase program (see Note 1) as well as $1.7 million to repurchase stock to satisfy employee tax withholding requirements on the vesting of restricted stock units, and we received $0.1 million from the exercise of employee stock options. We used cash of $55.9 million for financing activities for the nine months ended September 30, 2011. This consisted primarily of $34.4 million voluntary payments on the November 2009 Credit Facility. In addition, $20.3 million was used to repurchase stock as part of the Company's authorized share repurchase program during the prior year as well as $1.5 million to repurchase stock to satisfy employee tax withholding requirements on the vesting of restricted stock units, and we received $0.3 million from the exercise of employee stock options. A portion of the undistributed earnings of our UK and Irish subsidiaries are not considered indefinitely reinvested, as we do not have specific plans for reinvestment plans of the current and future earnings of these subsidiaries in the foreseeable future. Undistributed earnings of our other international subsidiaries are considered indefinitely reinvested. As of September 30, 2012, approximately $3.4 million of our cash balances were held at international locations for which earnings were considered indefinitely reinvested. We believe that our current plans with respect to the current and future earnings of our UK and Irish subsidiaries, along with our other liquidity sources discussed above, provide sufficient sources of liquidity to finance our domestic operations and support our assertions that the undistributed earnings held by foreign subsidiaries may be considered indefinitely reinvested. Seasonality Credit card and debit card transactions account for a major percentage of the transaction volume processed by the customers of our payment services division. The volume of these transactions on our networks generally is greater in the third and fourth quarter vacation and holiday seasons than during the rest of the year. Consequently, revenues and earnings from credit card and debit card transactions in the first and second quarter generally are lower than revenues and earnings from credit card and debit card transactions in the third and fourth quarters of the immediately preceding year. We expect that our operating results in the foreseeable future will be significantly affected by seasonal trends in the credit card and debit card transaction market. 28 -------------------------------------------------------------------------------- Table of Contents Call volumes from business users account for a major percentage of the database access volume of our identity and verification and registry services in our telecommunication services division. As a result, we generally see higher database access volumes on business days as opposed to weekends and holidays. The volume of these database access volumes is generally greater in the second and third quarters than during the rest of the year. In addition, the levels of roaming and clearing traffic processed by our mobile operator customers and mobile switch and transport volumes are generally greater in the second and third quarter vacation and travel seasons than during the rest of the year. We expect that our operating results in the foreseeable future will be significantly affected by seasonal trends in the telecommunications industry. Effects of Inflation Our monetary assets, consisting primarily of cash and receivables, and our non-monetary assets, consisting primarily of intangible assets and goodwill, are not affected significantly by inflation. However, the rate of inflation affects our expenses, such as those for employee compensation and costs of network services, which may not be recoverable in the price of services offered by us. |