UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended March 31, 2004
OR
For the transition period from to
Commission file number 0-27512
CSG SYSTEMS INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)
7887 East Belleview, Suite 1000
Englewood, Colorado 80111
(Address of principal executive offices, including zip code)
(303) 796-2850
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES x NO ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Shares of common stock outstanding at May 5, 2004: 53,933,005.
FORM 10-Q For the Quarter Ended March 31, 2004
INDEX
Part I -FINANCIAL INFORMATION
Item 1.
Condensed Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003 (Unaudited)
Notes to Condensed Consolidated Financial Statements (Unaudited)
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Item 4.
Controls and Procedures
Part II - OTHER INFORMATION
Legal Proceedings
Item 2
Changes in Securities and Use of Proceeds
Item 6.
Exhibits and Reports on Form 8-K
Signatures
Index to Exhibits
2
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
Current assets:
Cash and cash equivalents
Short-term investments
Total cash, cash equivalents and short-term investments
Trade accounts receivable-
Billed, net of allowance of $11,397 and $11,145
Unbilled and other
Deferred income taxes
Income taxes receivable
Other current assets
Total current assets
Property and equipment, net of depreciation of $91,712 and $89,529
Software, net of amortization of $66,487 and $62,957
Goodwill
Client contracts, net of amortization of $53,205 and $50,973
Other assets
Total assets
Current liabilities:
Current maturities of long-term debt
Client deposits
Trade accounts payable
Accrued employee compensation
Deferred revenue
Income taxes payable
Arbitration charge payable
Other current liabilities
Total current liabilities
Non-current liabilities:
Long-term debt, net of current maturities
Other non-current liabilities
Total non-current liabilities
Stockholders' equity:
Preferred stock, par value $.01 per share; 10,000,000 shares authorized; zero shares issued and outstanding
Common stock, par value $.01 per share; 100,000,000 shares authorized; 53,779,261 shares and 53,788,062 shares outstanding
Additional paid-in capital
Deferred employee compensation
Accumulated other comprehensive income:
Unrealized gain on short-term investments, net of tax
Cumulative translation adjustments
Treasury stock, at cost, 5,499,796 shares
Accumulated earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
The accompanying notes are an integral part of these condensed consolidated financial statements.
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CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
Revenues:
Processing and related services
Software
Maintenance
Professional services
Total revenues
Cost of revenues:
Cost of processing and related services
Cost of software and maintenance
Cost of professional services
Total cost of revenues
Gross margin (exclusive of depreciation)
Operating expenses:
Research and development
Selling, general and administrative
Depreciation
Restructuring charges
Total operating expenses
Operating income
Other income (expense):
Interest expense
Interest and investment income, net
Other
Total other
Income before income taxes
Income tax provision
Net income
Basic net income per common share:
Net income available to common stockholders
Weighted average common shares
Diluted net income per common share:
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities-
Amortization
Restructuring charge for abandonment of facilities
Tax benefit of stock options exercised
Stock-based employee compensation
Changes in operating assets and liabilities:
Trade accounts and other receivables, net
Other current and noncurrent assets
Income taxes payable/receivable
Accounts payable and accrued liabilities
Net cash provided by operating activities
Cash flows from investing activities:
Purchases of property and equipment
Purchases of short-term investments
Acquisition of businesses and assets, net of cash acquired
Acquisition of and investments in client contracts
Net cash used in investing activities
Cash flows from financing activities:
Proceeds from issuance of common stock
Repurchase and cancellation of common stock
Payments on long-term debt.
Payments of deferred financing costs
Net cash used in financing activities
Effect of exchange rate fluctuations on cash
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
Supplemental disclosures of cash flow information:
Cash paid (received) during the period for-
Interest
Income taxes
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The accompanying unaudited condensed consolidated financial statements at March 31, 2004 and December 31, 2003, and for the three months ended March 31, 2004 and 2003, have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information, and pursuant to the instructions to Form 10-Q and the rules and regulations of the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the financial position and operating results have been included. The condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations, contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, filed with the SEC (the “Company’s 2003 10-K”). The results of operations for the three months ended March 31, 2004, are not necessarily indicative of the expected results for the entire year ending December 31, 2004.
Postage. The Company passes through to its clients the cost of postage that is incurred on behalf of those clients, and typically requires an advance payment on expected postage costs. These advance payments are included in “client deposits” in the accompanying Condensed Consolidated Balance Sheets and are classified as current liabilities regardless of the contract period. The Company nets the cost of postage against the postage reimbursements, and includes the net amount in processing and related services revenues. The total cost of postage incurred on behalf of clients that has been netted against processing and related services revenues for the three months ended March 31, 2004 and 2003 was $44.3 million and $37.9 million, respectively.
Stock-Based Compensation Expense. During the fourth quarter of 2003, the Company adopted the fair value method of accounting for stock-based awards in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), using the prospective method of transition as outlined in SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure — An Amendment of FASB Statement No. 123” (“SFAS 148”). The adoption of SFAS 123 was effective as of January 1, 2003. Under the prospective method of transition, all stock-based awards granted, modified, or settled on or after January 1, 2003, are accounted for in accordance with SFAS 123. Stock-based awards granted prior to January 1, 2003, continue to be accounted for in accordance with Accounting Principles Board No. 25, “Accounting for Stock Issued to Employees”, and related Interpretations (“APB 25”), and follow the disclosure provisions of SFAS 123 and SFAS 148. As a result, the Company has restated its condensed consolidated financial statements for the three months ended March 31, 2003 to reflect the inclusion of additional stock-based compensation expense of $0.1 million.
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At March 31, 2004, the Company had five stock-based compensation plans. The Company recorded stock-based compensation expense of $4.1 million and $1.3 million, respectively, for the three months ended March 31, 2004 and 2003. Stock-based compensation expense is included in the following income statement captions in the accompanying Condensed Consolidated Statements of Income (in thousands):
Total stock-based compensation expense
Awards under the Company’s stock-based compensation plans generally vest over periods ranging from three to four years. Because the Company follows APB 25 for all stock-based awards granted prior to January 1, 2003, and the prospective method of transition under SFAS 148 for stock-based awards granted, modified, or settled on or after January 1, 2003, compensation expense recorded in the Company’s accompanying Consolidated Statements of Income is less than what would have been recognized if the fair value based method under SFAS 123 had been applied to all awards for all periods. Had compensation expense for the Company’s five stock-based compensation plans been based on the fair value at the grant dates for awards under those plans for all periods, consistent with the methodology of SFAS 123, the Company’s net income and net income per share available to common stockholders for the three months ended March 31, 2004 and 2003, would approximate the pro forma amounts as follows (in thousands, except per share amounts):
Net income, as reported
Add: Stock-based compensation expense included in reported net income, net of related tax effects
Deduct: Total stock-based compensation expense determined under the fair value-based method for all awards, net of related tax effects
Net income, pro forma
Net income per share:
Basic – as reported
Basic – pro forma
Diluted – as reported
Diluted – pro forma
The Company did not grant any stock-based awards during the first quarter of 2004. The fair value of stock options granted during the first quarter of 2003 was estimated on the date of grant using the Black-Scholes option-pricing model, with the following weighted average assumptions: risk-free interest rate of 2.7%; dividend yield of zero; expected life of 5.2 years; and volatility of 60.0%.
Reclassification. Certain March 31, 2003 amounts have been reclassified to conform to the March 31, 2004 presentation.
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Modifications to Stock-Based Compensation Awards. During the first quarter of 2004, the Company modified the terms of approximately 406,000 shares of unvested restricted stock, and 116,000 unvested stock options held by key members of management (members other than executive management) to include a provision which allows for full vesting of the stock-based awards upon a change in control of the Company. Unless such an event occurs, the stock-based awards will continue to vest as set forth in the original terms of the agreements. This modification did not have a significant impact on total stock-based compensation expense in the first quarter of 2004.
Earnings per common share (“EPS”) has been computed in accordance with SFAS No. 128, “Earnings Per Share”. Basic EPS is computed by dividing income available to common stockholders (the numerator) by the weighted average number of common shares outstanding during the period (the denominator). Basic and diluted EPS are presented on the face of the Company’s Condensed Consolidated Statements of Income. Diluted EPS is consistent with the calculation of basic EPS while considering the effect of potentially dilutive common shares outstanding during the period. Unvested shares of restricted stock are not included in the basic EPS calculation.
No reconciliation of the basic and diluted EPS numerators is necessary for the three months ended March 31, 2004 and 2003, as net income is used as the numerator for each period. The reconciliation of the EPS denominators is included in the following table (in thousands).
Three Months Ended
March 31,
Basic common shares outstanding
Dilutive effect of stock options
Dilutive effect of unvested restricted stock
Diluted common shares outstanding
For the three months ended March 31, 2004 and 2003, common stock options of 1.1 million shares and 6.1 million shares, respectively, were excluded from the computation of diluted EPS as their effect was antidilutive. In addition, for the three months ended March 31, 2004 and 2003, 0.9 million shares and 0.5 million shares, respectively, of unvested restricted stock were excluded from the computation of diluted EPS as their effect was antidilutive.
The Company’s components of comprehensive income were as follows (in thousands):
Other comprehensive income (loss), net of tax, if any:
Foreign currency translation adjustments
Unrealized gain on short-term investments
Comprehensive income
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Comcast Corporation
Arbitration Resolution. During 2002 and 2003, the Company was involved in various legal proceedings with its largest client, Comcast Corporation (“Comcast”), consisting principally of arbitration proceedings related to the Comcast Master Subscriber Agreement. In October 2003, the Company received the final ruling in the arbitration proceedings. The Comcast arbitration ruling included an award of $119.6 million to be paid by the Company to Comcast. The award was based on the arbitrator’s determination that the Company had violated the most favored nations (“MFN”) clause of the Comcast Master Subscriber Agreement. The Company recorded the impact from the arbitration ruling in the third quarter of 2003 as a charge against its revenues. In the fourth quarter of 2003, the Company paid approximately $95 million of the arbitration award to Comcast, and in January 2004, the Company paid the remaining portion of the arbitration award of approximately $25 million. In addition to the arbitration award, the Company paid to Comcast interest of $1.1 million, $0.1 million of which was reflected as interest expense in the first quarter of 2004.
Signing of New Comcast Contract. In March 2004, the Company signed a new contract with Comcast (the “Comcast Contract”). The Comcast Contract supersedes the former Comcast Master Subscriber Agreement that was set to expire at the end of 2012. The term of the new agreement runs through December 31, 2008. A summary of the significant provisions of the Comcast Contract and related documents is as follows:
See Note 8 for discussion of the client contracts intangible asset related to the Comcast Contract.
Echostar Communications
Signing of New Contract Amendment. Echostar Communications (“Echostar”) is the Company’s second largest client. In February 2004, the Company signed the Thirtieth Amendment to the Echostar Master Subscriber Agreement, extending the term of the Echostar Master Subscriber Agreement until March 1, 2006. The Echostar Master Processing Agreement was previously set to expire at the end of 2004. The significant provisions of the Thirtieth Amendment to the Echostar Master Subscriber Agreement included: (i) the elimination of the MFN language in the contract; and (ii) the redefinition of the underlying customer billing units.
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The Company serves its clients through its two operating segments: the Broadband Services Division (the “Broadband Division”) and the Global Software Services Division (the “GSS Division”). The Company’s operating segment information and corporate overhead costs are presented below (in thousands).
GSS
Division
Processing revenues
Software revenues
Maintenance revenues
Professional services revenues
Segment operating expenses (1)
Contribution margin (loss) (1)
Contribution margin (loss) percentage
Certain non-cash expenses:
Amortization of investment in client contracts (3)
Other intangible assets amortization
Stock-based compensation
Total
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Reconciling information between reportable segments contribution margin and the Company’s consolidated totals is as follows (in thousands):
Segment contribution margin
Of the $2.2 million restructuring charges recorded in the three months ended March 31, 2004, $0.3 million relates to the Broadband Division, $1.2 million relates to the GSS Division, and $0.7 million relates to Corporate. Of the $3.2 million restructuring charges recorded in the three months ended March 31, 2003, $0.1 million relates to the Broadband Division and $3.1 million relates to the GSS Division.
Goodwill. The Company does not have any intangible assets with indefinite lives other than goodwill. The changes in the carrying amount of goodwill by operating segment for the three months ended March 31, 2004 was as follows (in thousands):
Balance as of December 31, 2003
Impairment losses
Effects of changes in foreign currency exchange rates and other
Balance as of March 31, 2004
Other Intangible Assets. The Company’s intangible assets subject to amortization consist of client contracts and software. As of March 31, 2004 and December 31, 2003 the carrying values of these assets were as follows (in thousands):
Client contracts
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The aggregate amortization related to intangible assets for the three months ended March 31, 2004 and 2003 was $5.6 million and $6.1 million, respectively. Based on the March 31, 2004 net carrying value of these intangible assets, the estimated aggregate amortization for each of the five succeeding fiscal years ending December 31 are: 2004 – $25.3 million; 2005 – $25.0 million; 2006 – $21.5 million; 2007 – $13.7 million; and 2008 – $11.9 million. These amounts have been revised from the amounts disclosed as of December 31, 2003 as a result of the change in amortization related to the Comcast client contracts intangible asset, as discussed below.
Carrying Value of the GSS Division’s Intangible Assets. As of March 31, 2004, there was approximately $35 million in net intangible assets and approximately $219 million of goodwill that was attributable to the GSS Division, which included the assets from the Kenan Business, ICMS, Davinci, and plaNet acquisitions. The Company performed its annual goodwill impairment test in the third quarter of 2003, and concluded that no impairment of the GSS Division’s goodwill had occurred at that time. As of March 31, 2004, the Company has concluded that no events or changes in circumstances have occurred since that time to warrant an impairment assessment of the GSS Division’s goodwill and/or other long-lived intangible assets. The Company will continue to monitor the carrying value of these assets during the period of economic recovery for the telecommunications industry. If the current economic conditions take longer to recover than anticipated, it is reasonably possible that a review for impairment of the goodwill and/or related long-lived intangible assets in the future may indicate that these assets are impaired, and the amount of impairment could be substantial.
Carrying Value of Broadband Division’s Intangible Assets. As of March 31, 2004, the Broadband Division had client contracts intangible assets with a net carrying value of approximately $55 million. Of this amount, approximately $53 million related to the Comcast Contract. As discussed in Note 6 above, during the first quarter of 2004, the Company signed a new contract with Comcast. The Company has evaluated the carrying value of this intangible asset in light of the net cash flows expected to be generated from the Comcast Contract, and has concluded that there was no impairment to this asset as a result of the new Comcast Contract. However, as a result of the shortened term of the Comcast Contract, effective in March 2004, the Company was required to accelerate the amortization of this intangible asset. The Company’s revised estimated amortization of all client contracts intangible assets, reflecting the accelerated amortization resulting from the Comcast Contract, for each of the succeeding fiscal years ending December 31 will be: 2004 - $11.1 million; 2005 - $12.2 million; 2006 - $12.1 million; 2007 - $12.0 million; and 2008 - $11.9 million.
New Amendments. During the first quarter of 2004, the Company entered into two amendments to its 2002 Credit Facility. The Second Amendment was made to clarify the Company’s ability to repurchase its common stock in certain situations pursuant to the Company’s stock-based compensation plans. The Third Amendment was made in conjunction with the Company signing the Comcast Contract (see Note 6).
Mandatory Prepayment. In March 2004, the Company made a $30 million mandatory prepayment on its 2002 Credit Facility using the proceeds from income tax refunds received in the first quarter of 2004. This $30 million mandatory prepayment, required under the First Amendment to the 2002 Credit Facility, was to be paid on or before July 30, 2004.
Cost Reduction Initiatives. Due to the economic decline in the global telecommunications industry and the uncertainty in the timing and the extent of any economic turnaround within the industry, beginning in the third quarter of 2002 and continuing through the third quarter of 2003, the Company implemented several cost reduction initiatives resulting in restructuring charges. In addition, in response to the expected reduction in revenues resulting from the Comcast arbitration ruling received in October 2003, the Company implemented a cost reduction initiative in the fourth quarter of 2003. A summary of the Company’s cost reduction initiatives through March 31, 2004 is as follows:
During the third quarter of 2002, the cost reduction initiative consisted of: (i) involuntary employee terminations from all areas of the Company of approximately 300 people (approximately 10% of the Company’s then current workforce); (ii) limited hiring of new employees; (iii) a reduction of the Company’s
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facilities and infrastructure support costs, including facility consolidations and abandonments; and (iv) reductions in costs in several discretionary spending areas, such as travel and entertainment. Substantially all of the involuntary employee terminations were completed during the third quarter of 2002, with the remainder completed during the fourth quarter of 2002.
Restructuring Charges. As a result of the cost reduction initiatives described above, during the three months ended March 31, 2004 and 2003, the Company recorded restructuring charges of $2.2 million and $3.2 million, respectively. The restructuring costs have been reflected as a separate line item on the accompanying Condensed Consolidated Statements of Income. The components of the restructuring charges are as follows (in thousands):
Involuntary employee terminations
Facility abandonments
All other
Total restructuring charges
The involuntary employee terminations component of the restructuring charges relates primarily to severance payments and job placement assistance for those terminated employees. The facility abandonments component of the restructuring charges relates to office facilities that are under long-term lease agreements that the Company has abandoned. The facility abandonments charge is equal to the present value of the future costs associated with those abandoned facilities, net of the estimated proceeds from any future sublease agreements. The Company has used estimates to arrive at both the future costs of the abandoned facilities and the proceeds from any future sublease agreements. The Company will continue to evaluate its estimates used in recording the facility abandonments charge. As a result, there may be additional charges or reversals in the future related to the facilities that had been abandoned as of March 31, 2004.
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Restructuring Reserves. The activity in the business restructuring reserves during the first quarter of 2004 is as follows (in thousands):
December 31, 2003, balance
Charged to expense during period
Cash payments
Amortization of liability for facility abandonments
March 31, 2004, balance
Of the $13.6 million business restructuring reserve as of March 31, 2004, $8.3 million was included in current liabilities and $5.3 million was included in non-current liabilities.
The Company was in a domestic net operating loss (“NOL”) position for 2003 as a result of the Comcast $119.6 million arbitration charge (see Note 6). The Company’s income tax receivable as of December 31, 2003 was $35.1 million, which resulted from the Company’s ability to claim a refund for 2003 income taxes already paid, and from its ability to carry back the Company’s NOL to prior years. During the first quarter of 2004, the Company received approximately $34 million of this income tax receivable, and identified additional income tax receivable amounts during its final preparation of the 2003 U.S. Federal income tax return, which was filed in March 2004. As a result, the Company’s March 31, 2004, income taxes receivable is $4.4 million, which is expected to be collected within the next 12 months.
Product Warranties. The Company generally warrants that its products and services will conform to published specifications, or to specifications provided in an individual client arrangement, as applicable. The typical warranty period is 90 days from delivery of the product or service. The typical remedy for breach of warranty is to correct or replace any defective deliverable, and if not possible or practical, the Company will accept the return of the defective deliverable and refund the amount paid to the Company under the client arrangement that is allocable to the defective deliverable. Historically, the Company has incurred minimal warranty costs, and as a result, does not maintain a warranty reserve.
Product Indemnifications. The Company’s software arrangements generally include a product indemnification provision that will indemnify and defend a client in actions brought against the client that claim the Company’s products infringe upon a copyright, trade secret, or valid patent. Historically, the Company has not incurred any significant costs related to product indemnification claims, and as a result, does not maintain a reserve for such exposure.
Contingent Consideration. Contingent consideration represents an arrangement to provide additional consideration to the seller in a business combination if contractually specified conditions related to the acquired entity are achieved. In the Davinci Business Acquisition, which closed in December 2002, the stock purchase agreement included contingent consideration related to the amount of the Company revenues in 2004, 2005 and 2006 associated with CSG Total Care (formerly Davinci’s m-Care solution). The maximum contingent consideration that could be paid out over the three years is $2.3 million. As of March 31, 2004, the Company had not accrued any amount for the 2004 portion of the contingent consideration as the outcome of the contingency is not determinable beyond a reasonable doubt.
Claims for Company Non-performance. The Company’s arrangements with its clients typically cap the Company’s liability for breach to a specified amount of the direct damages incurred by the client resulting from the breach. From time-to-time, the Company’s arrangements may also include provisions for possible liquidated damages or
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other financial remedies for non-performance by the Company, or in the case of certain of the Company’s out-sourced customer care and billing solutions, provisions for damages related to service level performance requirements. The service level performance requirements typically relate to system availability and timeliness of service delivery. As of March 31, 2004, the Company believes it had adequate reserves to cover any reasonably anticipated exposure as a result of the Company’s nonperformance for any past or current arrangements with its clients.
Legal Proceedings. From time-to-time, the Company is involved in litigation relating to claims arising out of its operations in the normal course of business. In the opinion of the Company’s management, the Company is not presently a party to any material pending or threatened legal proceedings.
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Software.
Maintenance.
Professional services.
Cost of software and maintenance.
Cost of professional services.
Gross margin (exclusive of depreciation).
Research and development.
Depreciation.
Restructuring charges.
Total operating expenses.
Interest expense.
Interest and investment income, net.
Other.
Total other.
Net income available to common stockholders.
Weighted average common shares.
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The information contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto (the “Financial Statements”) included in this Form 10-Q and the audited consolidated financial statements and notes thereto in our Annual Report on Form 10-K for the year ended December 31, 2003 (our “2003 10-K”).
Forward-Looking Statements
This report contains a number of forward-looking statements relative to our future plans and our expectations concerning the global customer care and billing industry, as well as the converging telecommunications industry it serves, and similar matters. These forward-looking statements are based on assumptions about a number of important factors, and involve risks and uncertainties that could cause actual results to differ materially from estimates contained in the forward-looking statements. Some of the risks that are foreseen by management are contained in Exhibit 99.01 “Safe Harbor for Forward-Looking Statements Under the Private Securities Litigation Reform Act of 1995—Certain Cautionary Statements and Risk Factors”. Exhibit 99.01 constitutes an integral part of this report, and readers are strongly encouraged to review this exhibit closely in conjunction with MD&A.
Management Overview
The Company. We are a global leader in next-generation billing and customer care solutions for the cable television, direct broadcast satellite, advanced IP services, next-generation mobile, and fixed wireline markets. Our combination of proven and future-ready solutions, delivered in both outsourced and licensed formats, enables our clients to deliver high quality customer service, improve operational efficiencies and rapidly bring new revenue-generating products to market. We are a S&P Midcap 400 company. We serve our clients through two operating segments: the Broadband Services Division (the “Broadband Division”) and the Global Software Services Division (the “GSS Division”).
General Market Conditions. Beginning in early 2001, the economic state of the global telecommunications industry deteriorated, resulting from (among other reasons) a general global economic downturn, network and plant overcapacity, and limited availability of capital. This trend continued into 2003. During this time frame, many companies operating within this industry publicly reported decreased revenues and earnings, and several companies filed for bankruptcy protection. Most telecommunications companies reduced their operating costs and capital expenditures to cope with the market condition during these times. Since our clients operate within this industry sector, the economic state of this industry directly impacts our business, limiting the amount of money spent on customer care and billing products and services, as well as increasing the likelihood of uncollectible accounts receivable and lengthening the cash collection cycle.
Recent public reports are providing signs of economic improvement within this industry sector. The turnaround in the market conditions will likely be slow, and a full, sustained recovery may take several years. As our client base and prospects continue to see improved financial strength in their own businesses, this allows them to invest in future opportunities for new revenue growth and increased customer satisfaction. We have started to see signs of this type of slow, measured recovery over the past two quarters, with the most recent quarter actually providing quantifiable examples such as increased product sales and the first increase in our software and services backlog in the past two years. In addition, we are seeing increased activity in our sales pipeline, including an increase in actual Requests-For-Proposals (“RFP’s”) among new prospects. As a result, we believe our software and professional services revenues will begin to slowly trend up when compared to our most recent quarters. However, our ability to increase our revenues and operating performance is highly dependent upon the pace at which the market recovers and our success in selling new products and services. There can be no assurance that the market will recover, and even if so, that we will be successful in increasing our revenues and operating performance.
Broadband Division. The Broadband Division generates its revenues by providing customer care and billing services on a service bureau basis with its core product, CSG CCS/BP (“CCS”), to North American (primarily the U.S.) broadband service providers, primarily for cable television, Internet, and satellite television product offerings.
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The market for the Broadband Division’s products and services is highly competitive, resulting in significant pricing pressures for contract renewals.
A summary of the key business matters for the Broadband Division in the first quarter of 2004 is as follows:
GSS Division. The GSS Division was established as a result of our acquisition of the Kenan Business from Lucent Technologies (“Lucent”) in February 2002. The GSS Division is a global provider of convergent billing and customer care software and services that enables telecommunications service providers to bill their customers for existing and next-generation services, including mobile and wireline telephony, Internet, cable television, and satellite.
The GSS Division’s revenues consist of software license and maintenance fees, and various professional and consulting services related to its software products (principally, implementation services). The market for the GSS Division’s products and services is highly competitive, resulting in significant pricing pressures for both new and existing client purchases. For 2003, approximately 78% of the GSS Division’s revenues were generated outside the U.S., as compared to approximately 79% for 2002. We expect that a similar percentage of the GSS Division’s 2004 revenues will be generated outside the U.S.
A summary of the key business matters for the GSS Division in the first quarter of 2004 is as follows:
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Other Key Events.
Significant Client Relationships
Comcast
Background. Comcast is our largest client. During the first quarters of 2004 and 2003, revenues from Comcast represented approximately 18% and 26%, respectively, of our total consolidated revenues. The decrease in the percentage between the first quarters of 2004 and 2003 relates primarily to the impact of the new pricing as required by the October 2003 arbitration ruling, which is discussed below. Total revenues generated from Comcast in the fourth quarter of 2003, which were also impacted by the Comcast arbitration ruling, were approximately 17% of our total consolidated revenues. We expect that the percentage of our total consolidated revenues in 2004 related to Comcast will represent a percentage comparable to that of the fourth quarter of 2003 and the first quarter of 2004 (i.e., approximately 16—17%).
Arbitration Resolution. During 2002 and 2003, we were involved in various legal proceedings with Comcast, consisting principally of arbitration proceedings related to the Comcast Master Subscriber Agreement. In October 2003, we received the final ruling in the arbitration proceedings. The Comcast arbitration ruling included an award of $119.6 million to be paid by us to Comcast. The award was based on the arbitrator’s determination that we had violated the most favored nations (“MFN”) clause of the Comcast Master Subscriber Agreement. We recorded the
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impact from the arbitration ruling in the third quarter of 2003 as a charge to the Broadband Division’s revenues. In the fourth quarter of 2003, we paid approximately $95 million of the arbitration award to Comcast, and in January 2004, we paid the remaining portion of the arbitration award of approximately $25 million. In addition to the arbitration award, we paid to Comcast interest of $1.1 million, $0.1 million of which was reflected as interest expense in the first quarter of 2004. See the “Comcast and AT&T Broadband Business Relationship” section of the MD&A section of our 2003 10-K for additional discussion of the results of the Comcast arbitration ruling.
Signing of New Comcast Contract. In March 2004, we signed a new contract with Comcast (the “Comcast Contract”). The Comcast Contract supersedes the former Comcast Master Subscriber Agreement that was set to expire at the end of 2012. Under the new agreement, we expect to continue to support at least a portion of Comcast’s video and high-speed Internet customers at least through December 31, 2008. The pricing inherent in the Comcast Contract does not materially change our revenue expectations for 2004, except for the impact of the accelerated amortization of the client contracts intangible asset related to the Comcast Contract, as discussed below. The Comcast Contract was approved by our Bank Group in March 2004 via the Third Amendment to our 2002 Credit Facility.
A summary of the significant provisions of the Comcast Contract and related documents is as follows:
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The Comcast Contract is included in the exhibits to our periodic filings with the Securities and Exchange Commission (“SEC”). The document is available on the Internet and we encourage readers to review this document for further details.
Impact of Comcast Contract on Client Contracts Intangible Asset. We have a long-lived client contracts intangible asset related to our Comcast Contract that has a net carrying value as of March 31, 2004 of approximately $53 million. We have evaluated the carrying value of this intangible asset in light of the net cash flows expected to be generated from the Comcast Contract, and have concluded that there was no impairment to this asset as a result of the new Comcast Contract. However, as a result of the shortened term of the Comcast Contract, effective in March 2004, we were required to accelerate the amortization of this intangible asset. The increase in amortization recorded in the first quarter of 2004 was approximately $450,000 when compared to the fourth quarter of 2003. The annual impact of this accelerated amortization for the Comcast Contract is illustrated as follows (in thousands):
Amortization under previous contract
Amortization under new contract
Increase (decrease)
The entire amount of the amortization of the client contracts intangible asset is recorded as a reduction in revenues, as opposed to amortization expense.
Significant Client Concentration Risk. We expect to continue to generate a significant percentage of our future revenues under the Comcast Contract. There are inherent risks whenever a large percentage of total revenues are concentrated with one client. One such risk is that, should Comcast terminate its contract in whole or in part for any of the reasons stated above, or significantly reduce the number of customers processed on our system, it could have a material adverse effect on our financial condition and results of operations (including possible impairment, or significant acceleration of the amortization of the Comcast client contracts intangible asset).
Echostar
Background. Echostar has been a significant client of ours since we signed the original Echostar Master Subscriber Agreement in April 1999, and is currently our second largest client. During the first quarters of 2004 and 2003, revenues from Echostar represented approximately 13% and 11%, respectively, of our total consolidated revenues. We expect that the percentage of our total consolidated revenues in 2004 related to Echostar will represent a percentage comparable to that of the first quarter of 2004 (i.e., approximately 13%).
Signing of New Echostar Contract Amendment. In February 2004, we signed the Thirtieth Amendment to the Echostar Master Subscriber Agreement, extending the term of the Echostar Master Subscriber Agreement until March 1, 2006. The Echostar Master Processing Agreement was set to expire at the end of 2004. The pricing inherent in the amended Echostar contract does not materially change our revenue expectations going forward.
The significant provisions of the Thirtieth Amendment to the Echostar Master Subscriber Agreement included: (i) the elimination of the MFN language in the contract; and (ii) the redefinition of the underlying customer billing units. Although this change in the measurement of billing units had the effect of reducing the number of customer accounts processed, it did not materially impact the total amount invoiced for our processing services.
The Echostar Master Subscriber Agreement, to include all amendments, is included in the exhibits to our periodic filings with the SEC. The document is available on the Internet and we encourage readers to review this document for further details.
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Significant Client Concentration Risk. We expect to continue to generate a significant percentage of our future revenues under the Echostar contract. As stated above, the Echostar contract runs through March 1, 2006. The failure of Echostar to further renew its contract, representing a significant part of its business with us, could have a material adverse effect on our financial condition and results of operations.
Critical Accounting Policies
The preparation of our financial statements in conformity with accounting principles generally accepted in the U.S. requires us to select appropriate accounting policies, and to make judgments and estimates affecting the application of those accounting policies. In applying our accounting policies, different business conditions or the use of different assumptions may result in materially different amounts reported in our Financial Statements.
We have identified the most critical accounting policies upon which our financial status depends. The critical accounting policies were determined by considering accounting policies that involve the most complex or subjective decisions or assessments. The most critical accounting policies identified relate to: (i) revenue recognition; (ii) allowance for doubtful accounts receivable; (iii) impairment of long-lived assets; (iv) business restructuring; (v) loss contingencies; (vi) income taxes; (vii) business combinations and asset purchases; (vii) stock-based compensation expense; and (viii) capitalization of internal software development costs. These critical accounting policies and our other significant accounting policies are discussed in our 2003 10-K.
Three Months Ended March 31, 2004 Compared to Three Months Ended March 31, 2003
Results of Operations – Consolidated Basis
Total Revenues. Total revenues for the three months ended March 31, 2004 decreased 8.2% to $130.4 million, from $141.9 million for the three months ended March 31, 2003. The decrease between periods is primarily due to lower processing revenues from Comcast as a result of the arbitration ruling discussed above.
We use the location of the client as the basis of attributing revenues to individual countries. Revenues by geographic region for the first quarters of 2004 and 2003 were as follows (in thousands):
Three Months
Ended March 31,
North America (principally the United States)
Europe, Middle East and Africa (principally Europe)
Asia Pacific
Central and South America
For revenues generated outside North America, no single country accounts for more than 5% of our total revenues.
See the “Results of Operations – Operating Segments” section below for a detailed discussion of revenues and related changes between periods on a segment basis.
Cost of Revenues. See our 2003 10-K for a description of the types of costs that are included in the individual line items for cost of revenues.
Cost of Processing and Related Services. The cost of processing and related services for the three months ended March 31, 2004 decreased 0.9% to $33.8 million, from $34.1 million for the three months ended March 31, 2003. The decrease between periods is primarily due to a reduction in certain personnel costs, to include the impact of the cost reduction initiatives discussed below, and is also reflective of our continued focus on cost controls in this area. Processing costs as a percentage of related processing revenues were 41.7% (gross margin of 58.3%) for the three months ended March 31, 2004 compared to 37.4% (gross margin of 62.6%) for the three months ended March 31, 2003.
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The increase in processing costs as a percentage of related revenues is primarily due to the lower Comcast revenues in the first quarter of 2004 as a result of the arbitration ruling. We expect our quarterly 2004 gross margin percentage for processing services to be in a range comparable to that of the first quarter of 2004.
Cost of Software and Maintenance. The combined cost of software and maintenance for the three months ended March 31, 2004 decreased 11.1% to $16.3 million, from $18.3 million for the three months ended March 31, 2003. The decrease is primarily due to: (i) the first quarter of 2003 having approximately $1 million of amortization related to the acquired Kenan Business client contracts, which became fully amortized in February 2003; and (ii) a reduction in various costs between periods, to include the impact of the cost reduction initiatives discussed below. The cost of software and maintenance as a percentage of related revenues was 49.8% (gross margin of 50.2%) for the three months ended March 31, 2004 as compared to 56.2% (gross margin of 43.8%) for the three months ended March 31, 2003. As discussed below, fluctuations in the quarterly gross margin for software and maintenance revenues are an inherent characteristic of software companies, which can be impacted by, among others things, the timing of executed contracts in any one quarter.
Cost of Professional Services. The cost of professional services for the three months ended March 31, 2004 decreased 23.7% to $14.2 million, from $18.6 million for the three months ended March 31, 2003. The decrease relates primarily to a reduction in personnel costs, to include the impact of the cost reduction initiatives discussed below, and to a much lesser degree, approximately $1 million of expense recorded in 2003 related to the loss contract for the Proximus implementation project, with no comparable amount in the current quarter. The cost of professional services as a percentage of related revenues was 85.5% (gross margin of 14.5%) for the three months ended March 31, 2004, as compared to 102.0% (negative gross margin of 2.0%) for the three months ended March 31, 2003. The negative gross margin in the first quarter of 2003 is reflective of the difficulties we experienced on the Proximus implementation project. The gross margin percentage for the fourth quarter of 2003 for professional services revenues was approximately 12%. Although fluctuations in the gross margin for professional services revenues are an inherent characteristic of professional services companies, we expect the 2004 gross margin for this revenue source to remain comparable to that of the last two quarters.
Gross Margin. As a result of the Kenan Business acquisition, our revenues from software licenses, maintenance services and professional services have increased and become a larger percentage of total revenues. Variability in quarterly revenues and operating results are inherent characteristics of companies that sell software licenses, maintenance services, and perform professional services. Our quarterly revenues for software licenses, maintenance services and professional services revenues may fluctuate, depending on various factors, including the timing of executed contracts and the delivery of contracted services or products. See Exhibit 99.01, “Variability of Quarterly Results”, for additional discussion of factors that may cause fluctuations in quarterly revenues and operating results. However, the costs associated with software and maintenance revenues, and professional services revenues are not subject to the same degree of variability (i.e., these costs are generally fixed in nature within a relatively short period of time), and thus, fluctuations in our software and maintenance, professional services, and overall gross margins, will likely occur between periods.
The overall gross margin for the three months ended March 31, 2004 decreased 6.8% to $66.1 million from $70.9 million for the three months ended March 31, 2003. The overall gross margin percentage increased to 50.7% for the three months ended March 31, 2004, compared to 50.0% for the three months ended March 31, 2003. The changes in the gross margin and gross margin percentage were due to the factors discussed above.
Research and Development Expense. R&D expense remained relatively consistent between periods, increasing to $15.8 million for the three months ended March 31, 2004, from $15.5 million for the three months ended March 31, 2003. As a percentage of total revenues, R&D expense increased to 12.2% for the three months ended March 31, 2004, from 10.9% for the three months ended March 31, 2003. The reason for the overall increase in R&D as a percentage of total revenues is due to the lower revenues resulting from the Comcast arbitration ruling, as discussed above. We did not capitalize any internal software development costs during the three months ended March 31, 2004 and 2003.
During the first quarter of 2004, we focused our development and enhancement efforts on:
various R&D projects for the GSS Division, including the Kenan FX business framework (see the “Business” section of the 2003 10-K for additional discussion of Kenan FX), which was introduced in late
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2003, and includes enhancements to the existing versions of the Kenan Business product suite, as well as new modules; and
At this time, we expect our investment in R&D over time will approximate our historical investment rate of 10-12% of total revenues. We expect this investment will be focused on the CCS and the Kenan Business product suite, as well as additional stand-alone products as they are identified.
Selling, General and Administrative Expense. SG&A expense for the three months ended March 31, 2004, decreased 22.2% to $23.2 million, from $29.8 million for the three months ended March 31, 2003. As a percentage of total revenues, SG&A expense decreased to 17.8% for the three months ended March 31, 2004, from 21.1% for the three months ended March 31, 2003. The decrease in SG&A expense relates primarily to: (i) a decrease in legal fees due to the Comcast arbitration concluding in October 2003; and to a much lesser degree (ii) a reduction in certain personnel costs, to include the impact of the cost reduction initiatives discussed below. We incurred approximately $5 million of legal expenses in defense of the Comcast litigation during the three months ended March 31, 2003 with no comparable amount for 2004. These decreases were offset by an increase in stock-based compensation expense primarily due to the voluntary exchange of stock options for restricted stock (also referred to as our “tender offer”) that took place in December 2003 and the adoption of SFAS No. 123 (see our 2003 10-K for discussion of both events) which was effective January 1, 2003. We recorded $2.6 million of stock-based compensation expense attributed to SG&A in the first quarter of 2004, compared to $1.3 million in the first quarter of 2003.
Depreciation Expense. Depreciation expense for the three months ended March 31, 2004 decreased 20.9% to $3.6 million, from $4.6 million for the three months ended March 31, 2003. The decrease in depreciation expense related to the decrease in capital expenditures made during the last twelve months as a result of our focus on cost controls. The capital expenditures during the first three months of 2004 consisted principally of computer hardware and related equipment and statement production equipment. Depreciation expense for all property and equipment is reflected separately in the aggregate and is not included in the cost of revenues or the other components of operating expenses.
Restructuring Charges. Our restructuring charges relate to various cost reduction initiatives implemented primarily as a result of market conditions, and the Comcast arbitration ruling. See Note 10 to our Condensed Consolidated Financial Statements for a more detailed discussion of our cost reduction initiatives and related restructuring charges, including the current activity in the accrued liabilities related to the restructuring charges. We believe that the operational impact from these initiatives will not negatively impact our ability to service our current or future clients.
Cost Reduction Initiatives Related to Market Conditions
In response to poor economic conditions within the global telecommunications industry, during 2003 and 2002, we implemented several cost reduction initiatives, consisting primarily of involuntary employee terminations and facility abandonments, with the greatest percentage of the involuntary terminations occurring within the GSS Division. These cost reduction initiatives resulted in restructuring charges in both 2003 and 2002. In the aggregate, these various initiatives were targeted at reducing operating expenses by approximately $60 million annually, based on various measurement points. These programs were substantially completed by the end of the second quarter of 2003.
Cost Reduction Initiatives Related to the Comcast Arbitration Ruling.
In response to the expected reduction in revenues resulting from the Comcast arbitration ruling, during the fourth quarter of 2003, we implemented a cost reduction initiative, consisting primarily of involuntary employee terminations and a reduction of costs related to certain of our employee compensation and fringe benefit programs, to include a freeze in wages for 2004, with the greatest percentage of the involuntary employee terminations occurring within the Broadband Division. This cost reduction initiative resulted in restructuring charges in the fourth quarter of 2003 and the first quarter of 2004.
The 2004 cost savings from this initiative are targeted to be approximately $30 million, when compared to the third quarter 2003 annualized operating expense run rate, with the savings expected to be realized somewhat
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ratably across 2004. The cost savings that were realized in the first quarter of 2004 were in line with our expectations. The overall expected cost savings from this initiative are reflected in our 2004 financial guidance. At this time, we do not to expect to record any material restructuring charges related to this cost reduction initiative beyond the first quarter of 2004.
Summary of Restructuring Charges.
The components of the restructuring charges included in total operating expenses, and the impact (net of related estimated income tax expense) these restructuring charges had on net income and diluted earnings per share, for the three months ended March 31, 2004 and 2003 are as follows (in thousands, except diluted earnings per share):
Impact of restructuring charges on results of operations (i.e., have reduced operating results):
Diluted earnings per share
As shown above, we recorded restructuring charges related to involuntary employee terminations and various facility abandonments during the three months ended March 31, 2004 and 2003. The accounting for facility abandonments require significant judgments in determining the restructuring charges, primarily related to the assumptions regarding the timing and the amount of any potential sublease arrangements for the abandoned facilities, and the discount rates used to determine the present value of the liabilities. We continually evaluate these assumptions, and adjust the related facility abandonment reserves based on the revised assumptions at that time. In addition, we continually evaluate ways to cut our operating expenses through restructuring opportunities, to include the utilization of our workforce and current operating facilities. As a result, there is a reasonable possibility that we may incur additional material restructuring charges in the future.
Operating Income. Operating income for the three months ended March 31, 2004, was $21.3 million or 16.3% of total revenues, compared to $17.9 million or 12.6% of total revenues for the three months ended March 31, 2003. The increase in these measures between years relates to the factors discussed above.
We expect our 2004 full year operating margin to range between 17% and 18%.
Interest Expense. Interest expense for the three months ended March 31, 2004, decreased 8.3% to $3.6 million, from $3.9 million for the three months ended March 31, 2003. The weighted-average balance of our long-term debt for the three months ended March 31, 2004 was $228.4 million, compared to $270.0 million for the three months ended March 31, 2003. The weighted-average interest rate on our debt borrowings for the three months ended March 31, 2004, including the amortization of deferred financing costs and commitment fees on our revolving credit facility, was 5.8%, compared to 5.5% for the three months ended March 31, 2003. The increase in rates is due primarily to the First Amendment (entered into on December 5, 2003) to the 2002 Credit Facility (the “First Amendment”) resulting in an increase in the applicable LIBOR margins by 75 basis points. In March 2004, we made the $30 million mandatory principal payment on our long-term debt required by the First Amendment no later than July 2004.
Income Tax Provision. For the three months ended March 31, 2004, we recorded an income tax provision of $6.7 million, or an effective income tax rate of approximately 38%, compared to an effective income tax rate of approximately 40% for the three months ended March 31, 2003.
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The effective income tax rate for the first quarter of 2004 represents our estimate of the effective income tax rate for 2004. The estimate of 38% for 2004 is based on various assumptions, with the primary assumptions related to our estimate of total pretax income, the status of certain income tax contingencies, foreign tax credit utilization, and the amounts and sources of foreign pretax income. The actual effective income tax rate for 2004 could deviate from the 38% estimate based on our actual experiences with these items, as well as others.
As of March 31, 2004, our net deferred income tax assets of $58.3 million were related primarily to our domestic operations, and represented approximately 9% of total assets. We continue to believe that sufficient taxable income will be generated to realize the benefit of these deferred income tax assets. Our assumptions of future profitable domestic operations are supported by the strong operating performance of the Broadband Division over the last several years, and our expectations of future profitability.
Results of Operations - Operating Segments
We serve our clients through our two operating segments: the Broadband Division and the GSS Division. See our 2003 10-K for further discussion of the operations of each operating segment and the related product and service offerings, and the components of segment operating results.
Operating segment information and corporate overhead costs for the three months ended March 31, 2004 and 2003, are presented in Note 7 to our Condensed Consolidated Financial Statements.
Broadband Division
Total Revenues. Total Broadband Division revenues for the three months ended March 31, 2004 decreased 11.2% to $86.6 million, from $97.5 million for the three months ended March 31, 2003 primarily due to a decrease in processing revenues as discussed in more detail below.
Processing revenues. Processing revenues for the three months ended March 31, 2004 decreased 11.1% to $80.4 million, compared to $90.4 million for the three months ended March 31, 2003. The decrease in processing revenues was due primarily to lower processing revenues from Comcast for the three months ended March 31, 2004 of approximately $13 million, as a result of the arbitration ruling received in October 2003. Processing revenues for the fourth quarter of 2003 were $79.3 million. We expect the Broadband Division’s 2004 quarterly processing revenues to be comparable to that of the last two quarters.
Total domestic customer accounts processed on our system as of March 31, 2004 were 43.5 million compared to 44.1 million as of December 31, 2003, a one percent decrease. During the current quarter, a client contract was renewed in which the definition of customer billing units was modified, having the effect of lowering the customer volume counts processed. The annualized revenue per unit (“ARPU”) for the first quarter of 2004 was $7.38 compared to $7.33 for the fourth quarter of 2003. These ARPU measures include $0.14 and $0.10, respectively, related to non-recurring processing revenues. For 2004, we expect our ARPU to range from $7.10 to $7.25; though for the second quarter of 2004, we expect to be towards the higher end of this range. We expect this to result in approximately $79 million to $80 million of total consolidated processing revenues for the second quarter of 2004.
Segment Operating Expenses and Contribution Margin. Broadband Division operating expenses for the three months ended March 31, 2004 decreased by 4.6% to $49.3 million, from $51.6 million for the three months ended March 31, 2003. The decrease in the Broadband Division’s operating expenses is due primarily to the fourth quarter 2003 cost reduction initiative (principally a reduction in personnel costs), and our continued focus on cost controls for this division.
Broadband Division contribution margin decreased by 18.6% to $37.3 million (contribution margin percentage of 43.1%) for the three months ended March 31, 2004, from $45.9 million (contribution margin percentage of 47.1%) for the three months ended March 31, 2003. The Broadband Division contribution margin and contribution margin percentage decreased between periods primarily due to the impact of the Comcast arbitration ruling on processing revenues for the three months ended March 31, 2004. Total non-cash charges related to depreciation, amortization
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(shown as a reduction of processing revenues), and stock-based compensation expense included in the determination of the Broadband Division’s contribution margin for the three months ended March 31, 2004 and 2003 were $5.0 million and $4.2 million, respectively.
GSS Division
Total Revenues. Total GSS Division revenues for the three months ended March 31, 2004 decreased 1.5% to $43.8 million, as compared to $44.4 million for the three months ended March 31, 2003, with the decrease due primarily to a decrease in software revenues and professional services revenues as discussed in more detail below.
Software Revenues. Software revenues for the three months ended March 31, 2004 decreased by 20.6% to $6.7 million, from $8.5 million for the three months ended March 31, 2003. The decrease in software revenues was primarily due to the timing of certain software contracts and related revenue recognition. We expect software revenues for the remainder of 2004 to trend up depending upon the pace at which the market recovers.
Maintenance Revenues.Maintenance revenues for the three months ended March 31, 2004 increased by 14.7% to $19.9 million, from $17.4 million for the three months ended March 31, 2003. This increase in maintenance revenues was due primarily to the renewal of certain maintenance contracts subsequent to the first quarter of 2003, and an increase in the installed software license base as a result of new sales since the end of the first quarter of 2003. We expect the GSS Divisions’ quarterly maintenance revenues for the remainder of 2004 to be comparable to the first quarter of 2004.
Professional Services Revenues. Professional services revenues for the three months ended March 31, 2004 decreased by 8.0% to $16.4 million, from $17.8 million for the three months ended March 31, 2003. The decrease in revenues was due primarily to several large projects in progress during the first quarter of 2003 which were substantially completed in 2003, without replacement of comparable projects upon completion. We typically sell professional services in conjunction with software sales. One impact of reduced demand for software sales over the last several quarters is that we have fewer revenue generating opportunities for our professional services organization at this time. We expect professional services revenues for the remainder of 2004 to trend up, depending upon the pace at which the market begins to recover, and our success in selling additional software licenses and Kenan FX upgrade projects.
Segment Operating Expenses and Contribution Loss. GSS Division operating expenses for the three months ended March 31, 2004 decreased by 17.1% to $42.6 million, from $51.3 million for the three months ended March 31, 2003. The decrease in GSS Division operating expenses is due primarily to a reduction in various personnel costs, to include the impact of the cost reduction initiatives discussed above.
The GSS Division’s contribution margin for the three months ended March 31, 2004 was $1.2 million (contribution margin percentage of 2.7%) as compared to a contribution loss for the three months ended March 31, 2003 of $6.9 million (negative contribution margin of 15.6%). The increase in contribution margin between quarters is due primarily to the reduction in GSS Division operating expenses between periods, as discussed above. Total non-cash charges related to depreciation, amortization, and stock-based compensation expense included in the determination of the GSS Division’s contribution margin for the three months ended March 31, 2004 and 2003 were $5.4 million and $5.6 million, respectively.
We expect the GSS Division to have a positive contribution margin for the remainder of 2004.
Corporate
Corporate Operating Expenses. Corporate overhead expenses for the three months ended March 31, 2004, decreased 15.9% to $15.1 million, from $18.0 million for the three months ended March 31, 2003. The decrease in operating expenses related primarily to a decrease in legal fees as a result of completion of the Comcast arbitration proceedings. We incurred approximately $5 million of legal fees in the three months ended March 31, 2003 in defense of the Comcast litigation, with no comparable amount for 2004. This decrease is offset by an increase in stock-based compensation expense of $1 million between periods, due primarily to the voluntary exchange of stock options for restricted stock that took place in December 2003 and the adoption of SFAS No. 123 which was effective January 1, 2003.
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Liquidity
Cash and Liquidity. As of March 31, 2004, our principal sources of liquidity included cash, cash equivalents, and short-term investments of $105.7 million, compared to $105.4 million as of December 31, 2003. We generally invest our excess cash balances in low-risk, short-term investments to limit our exposure to market risks. We also have a $40 million revolving credit facility, under which there were no borrowings outstanding as of March 31, 2004. Our ability to borrow under the revolver is subject to a limitation of total indebtedness based upon the results of a leverage ratio calculation, and based upon the amount of CSG System, Inc.’s (one of our primary subsidiaries) current cash balance. As of March 31, 2004, approximately $27 million of the revolver was available to us. The revolving credit facility expires in February 2007.
Our cash balances as of March 31, 2004 and December 31, 2003 were located in the following geographical regions (in thousands):
North America (principally the U.S.)
Total cash, equivalents and short-term investments
We generally have ready access to substantially all of our cash and short-term investment balances, but do face limitations on moving cash out of certain foreign jurisdictions. As of March 31, 2004, the cash and short-term investments subject to such limitations were not significant. In addition, our credit facility places certain restrictions on the amount of cash that can be freely transferred between certain operating subsidiaries. These restrictions are not expected to cause any liquidity issues at the individual subsidiary level in the foreseeable future.
Cash Flows From Operating Activities. We calculate our cash flows from operating activities in accordance with generally accepted accounting principles, beginning with net income, adding back the impact of non-cash items (e.g., depreciation, amortization, stock-based compensation expense, etc.), and then factoring in the impact of changes in working capital items. See our 2003 10-K for a description of the primary uses and sources of our cash flows from operating activities.
Our net cash flows provided by (used in) operating activities for the quarterly and year-to-date totals for the indicated periods were as follows (in thousands). These amounts are reflected in our Consolidated Statements of Cash Flows.
2003 (1):
March 31
June 30
September 30
December 31
2004:
March 31(2)
The negative cash flows from operating activities of $(38.5) million in the fourth quarter of 2003 relates primarily to the approximately $95 million paid to Comcast during the fourth quarter of 2003 as a result of the arbitration ruling. Absent this amount, we generated strong quarterly cash flows from operating
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activities for 2003, primarily as a result of our improved cash collections of our international accounts receivable during the last two quarters of 2003. This improved collections performance allowed us to pay amounts to Comcast with available corporate funds, without having to draw on our revolving credit agreement.
We believe this table illustrates our ability to consistently generate strong quarterly and annual cash flows, and the importance of managing our working capital items, in particular, timely collections of our accounts receivable. Absent any unusual fluctuations in working capital items, we expect our 2004 annual cash flows from operating activities to range from $90 million to $110 million, and expect the quarterly amounts to be somewhat consistent between quarters.
The key balance sheet items impacting our cash flows from operating activities are as follows.
Billed Accounts Receivable
Our billed accounts receivable balance by geographic region (based on the location of the client) as of the end of the indicated periods are as follows (in thousands):
Europe, Middle East and Africa (principally Europe )
Total billed accounts receivable
Less allowance for doubtful accounts
Total billed accounts receivable, net of allowance
Management of our billed accounts receivable is one of the primary factors in maintaining strong quarterly cash flows from operating activities. Our billed trade accounts receivable balance includes billings for several non-revenue items (primarily postage, sales tax, and deferred revenue items). As a result, we evaluate our performance in collecting our accounts receivable through our calculation of days billings outstanding (“DBO”) rather than a typical days sales outstanding (“DSO”) calculation. DBO is calculated based on the billing for the period (including non-revenue items) divided by the average monthly net trade accounts receivable balance for the period. Our target range for our DBO is 65-75 days.
Our gross and net billed trade accounts receivable and related allowance for doubtful accounts receivable (“Allowance”), as of the end of the indicated periods, and our DBOs for the quarters then ended, are as follows (in thousands, except DBOs):
Quarter Ended
2003:
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The increase in the net billed accounts receivable balance between December 31, 2003 and March 31, 2004 relates primarily to the timing of new invoices and cash collections. The increase in billed accounts receivable and DBOs during the first and second quarter of 2003 is primarily the result of the increased aging of certain receivables within the GSS Division. During this time frame, we experienced collection problems with certain clients due to various administrative and client-specific matters. In particular, there were two large implementation projects in progress in India where we were executing on the implementation projects generally as expected, but we had built up a billed accounts receivable balance of approximately $23 million as of March 31, 2003. We resolved many of the issues that had caused the delays in collecting these amounts, and as a result, we significantly reduced the outstanding balances of these two clients as of December 31, 2003 to approximately $7 million. During the first quarter of 2004, we collected $3.6 million of the December 31, 2003 amounts, and expect to collect a substantial percentage of the remaining December 31, 2003 accounts receivable balances from these clients by the end of the second quarter of 2004. In addition, we sent new invoices of $3.9 million during the first quarter of 2004 related to additional products and services purchased by these clients, leaving the overall March 31, 2004 billed accounts receivable balance for these two clients relatively unchanged from December 31, 2003.
Unbilled Accounts Receivable and Other Receivables
Revenue earned and recognized prior to the scheduled billing date of an item is reflected as unbilled accounts receivable. Unbilled accounts receivable are an inherent characteristic of certain software and professional services transactions and may fluctuate between quarters, as these types of transactions typically have scheduled invoicing terms over several quarters, as well as certain milestone billing events. Our unbilled accounts receivable and other receivables as of the end of the indicated periods are as follows (in thousands):
We have consciously managed the unbilled receivables down, and going forward, we are targeting a range comparable to that of the last two quarters. The March 31, 2004 unbilled accounts receivable balance consists primarily of several projects with various milestone and contractual billing dates which have not yet been reached, and unbilled accounts receivable related to billing cutoffs for certain processing services. A substantial percentage of the March 31, 2004 unbilled accounts receivable are scheduled to be billed and collected by the end of the third quarter of 2004. However, there can be no assurances that the fees will be billed and collected within the expected time frames.
Income Taxes Receivable
We were in a domestic net operating loss (“NOL”) position for 2003 as a result of the Comcast $119.6 million arbitration charge discussed above. Our income tax receivable as of December 31, 2003 was $35.1 million, which resulted from our ability to claim a refund for 2003 income taxes already paid, and from our ability to carry back our NOL to prior years. During the first quarter of 2004, we received approximately $34 million of this income tax receivable, and identified additional income tax receivable amounts during our final preparation of our 2003 U.S. Federal income tax return, which was filed in March 2004. As a result, our March 31, 2004, income taxes receivable is $4.4 million, which is expected to be collected within the next 12 months.
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Deferred Revenue
Client payments and billed amounts due from clients in excess of revenue recognized are recorded as deferred revenue. Deferred revenue broken out by source of revenue as of the end of the indicated periods was as follows (in thousands):
June 30,
2003
Processing
The changes in total deferred revenues between December 31, 2003 and March 31, 2004 relates primarily to the timing of invoices for such products and services, and the related revenue recognition for such items. The majority of our maintenance agreements provide for invoicing of annual maintenance fees in the first and fourth fiscal quarters of the year.
Arbitration Charge Payable
The arbitration charge payable reflected in our Consolidated Financial Statements relates to the $119.6 million Comcast arbitration award. We paid approximately $95 million of this amount in the fourth quarter of 2003. During the first quarter of 2004, we paid the remaining approximately $25 million.
Investing Activities. Our investing activities typically consist of purchases of property and equipment and investments in client contracts intangible assets, and business acquisitions.
Purchases of Short-term Investments
We generally invest our excess cash balances in low-risk, short-term investments to limit our exposure to market risks. These short-term investments are readily convertible back into cash. During the first quarter of 2004, we purchased $1.2 million in short-term investments. The Company is currently evaluating the possible uses of its excess cash balances and may purchase additional short-term investments in the future.
Property and Equipment/Client Contracts
Our capital expenditures for the quarters ended March 31, 2004 and 2003 for property and equipment, and investments in client contracts were as follows (in thousands):
Property and equipment
As of March 31, 2004, we did not have any material commitments for capital expenditures or for investments in client contracts intangible assets. Our budgeted capital expenditures for 2004 are approximately $15 million, which also represents the maximum amount that we can spend for this purpose in 2004 under our current credit agreement.
Business and Asset Acquisitions
Historically, our business model has not included a significant amount of business acquisition activity. However, in order to expand our international business, in 2002 we acquired several different businesses and related assets for $270.6 million. This consisted principally of the Kenan Business acquisition in February 2002. See our 2003 10-K for a more detailed discussion of our most recent acquisitions. During the three months ended March 31, 2004, our business acquisition activity was not significant at $0.3 million for the quarter. Our current credit agreement places certain restrictions upon acquisitions. As a result, we do not expect any significant acquisitions during 2004.
Financing Activities. We have had limited financing activities over the last several years, and historically, we have not been active in the capital markets.
Long-Term Debt
During the first quarter of 2004, we made the mandatory $30 million prepayment which was due no later than July 2004. This payment was made with the proceeds from our $34 million of income tax refunds received in March 2004.
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As of March 31, 2004, we were in compliance with both the financial and non-financial covenants of our amended credit agreement and expect to remain in compliance going forward. The total scheduled principal payments for the next twelve months is $19.6 million, with the first payment of $1.9 million due in June 2004. Our estimated interest expense for 2004 is approximately $13 million. See Note 9 to our Condensed Consolidated Financial Statements for a discussion of subsequent amendments made to the credit agreement during the first quarter of 2004.
Common Stock
Proceeds from the issuance of common stock relates to our various stock-based compensation plans. We do not expect any significant amount of cash from our stock-based compensation plans in 2004.
Repurchase of Common Stock
During the first quarter of 2004, we repurchased and then cancelled 16,589 shares of common stock pursuant to our stock-based compensation plans.
In 1999, our Board of Directors authorized us, at our discretion, to purchase up to a total of ten million shares of our common stock from time-to-time as market and business conditions warrant. We did not purchase any of our shares under the stock repurchase program during the three months ended March 31, 2004 or 2003. A summary of the activity to date for this repurchase program is as follows (in thousands, except per share amounts):
Shares repurchased
Total amount paid
Weighted-average price per share
At March 31, 2004, the total remaining number of shares available for repurchase under the program totaled 3.7 million shares. Our amended credit facility restricts the amount of common stock we can repurchase under our stock repurchase program to $50 million, and at this time, also restricts our ability to purchase any additional shares until we achieve a certain leverage ratio. We do not expect to achieve this leverage ratio in 2004 and as a result, we do not expect to purchase any shares under this program during 2004.
Capital Resources
We continue to make investments in client contracts, capital equipment, facilities, research and development, and at our discretion, may continue to make voluntary principal payments on our long-term debt. The scheduled principal payments on our long-term debt within the next 12 months are $19.6 million, with the first payment due on June 30, 2004 in the amount of $1.9 million. Although it is part of our growth strategy, we are not likely to enter into any significant business or asset acquisitions during 2004 as a result of the limitations placed on such activities by our credit agreement.
We believe that our current cash and short-term investments, together with cash expected to be generated from future operating activities, will be sufficient to meet our anticipated cash requirements through at least the next 12 months.
As discussed in greater detail above, our current debt agreement includes various restrictions on the use of our cash, and the free movement of cash between our subsidiaries. We believe we can modify our capital structure, either through an amendment to our current debt agreement or through alternative sources of capital resources, which may eliminate or significantly reduce these restrictions at costs similar to our current debt agreement. Our belief that we can modify our current capital structure, if necessary, is based primarily on our current expectations of future
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operating profitability and future cash flows to be generated from operations. We are currently evaluating the various opportunities we believe exist for our capital structure.
As discussed in our 2003 10-K, we are exposed to various market risks, including changes in interest rates and foreign currency exchange rates. Market risk is the potential loss arising from adverse changes in market rates and prices. We do not enter into derivatives or other financial instruments for trading or speculative purposes.
Interest Rate Risk. As of March 31, 2004, we had long-term debt of $198.9 million, consisting of a Tranche A Term Loan (“Tranche A”) with an outstanding balance of $59.8 million, a Tranche B Term Loan (“Tranche B”) with an outstanding balance of $139.1 million, and a revolving credit facility (the “Revolver”), with an outstanding balance of zero.
In March 2004, we made a $30 million mandatory prepayment on our credit facility using the proceeds from income tax refunds received in the first quarter of 2004. This $30 million mandatory prepayment, required under the First Amendment to the 2002 Credit Facility, was to be paid on or before July 30, 2004.
As a result of the mandatory prepayment, the combined scheduled maturities of Tranche A and Tranche B for the remainder of 2004 and for the remaining term of the 2002 Credit Facility are as follows (in thousands):
Tranche A
Tranche B
Total payments
The interest rate features on our long-term debt are discussed in detail in our 2003 10-K. As of March 31, 2004, we have six-month LIBOR contracts that lock in the interest rates on $3.7 million of long-term debt until June 30, 2004, and have six-month LIBOR contracts that lock in the interest rates on $195.2 million of long-term debt until September 30, 2004. The interest rates on the LIBOR contracts that mature on June 30, 2004, are based upon a contracted LIBOR rate of 1.2125% (for a combined interest rate of 4.4625% for the Tranche A Loan and 4.7125% for the Tranche B Loan). The interest rates on the LIBOR contracts that mature on September 30, 2004, are based upon a contracted LIBOR rate of 1.16% (for a combined interest rate of 4.41% for the Tranche A Loan and 4.66% for the Tranche B Loan).
We continually evaluate whether we should enter into derivative financial instruments as an additional means to manage our interest rate risk, but as of the date of this filing, have not entered into such instruments. We believe the carrying amount of our long-term debt approximates its fair value due to the long-term debt’s variable interest rate features.
Foreign Exchange Rate Risk. Our approximate percentage of total revenues generated outside the U.S. for the years ended December 31, 2003 and 2002 was 32% and 25%, respectively. Our approximate percentage of total revenues generated outside the U.S. for the three months ended March 31, 2004 and 2003 was 26% and 25%, respectively. Refer to our 2003 10-K for further discussion of our foreign exchange rate risk.
We continue to evaluate whether we should enter into derivative financial instruments for the purposes of managing our foreign currency exchange rate risk, but, as of the date of this filing, we have not entered into such instruments. A hypothetical adverse change of 10% in the March 31, 2004 foreign currency exchange rates would not have a material impact upon our results of operations.
Market Risk Related to Short-term Investments. There have been no material changes to our market risks related to short-term investments during the three months ended March 31, 2004.
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(a) Disclosure Controls and Procedures
As required by Rule 13a-15(b), our management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), conducted an evaluation as of the end of the period covered by this report of the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15(e). Based on that evaluation, the CEO and CFO concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
(b) Internal Control Over Financial Reporting
As required by Rule 13a-15(d), our management, including the CEO and CFO, also conducted an evaluation of our internal control over financial reporting, as defined by Rule 13a-15(f), to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on that evaluation, the CEO and CFO concluded that there has been no such change during the quarter covered by this report.
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PART II. OTHER INFORMATION
From time-to-time, we are involved in litigation relating to claims arising out of its operations in the normal course of business. In the opinion of our management, we are not presently a party to any material pending or threatened legal proceedings.
The following table presents information with respect to purchases of common stock of the Company made during the three months ended March 31, 2004 by CSG Systems International, Inc. or any “affiliated purchaser” of CSG Systems International, Inc., as defined in Rule 10b-18(a)(3) under the Exchange Act.
Period
January 1 - January 31
February 1 - February 29
March 1 - March 31
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: May 10, 2004
/s/ Neal C. Hansen
Neal C. Hansen
Chairman and Chief Executive Officer
(Principal Executive Officer)
/s/ Peter E. Kalan
Peter E. Kalan
Executive Vice President and Chief Financial Officer
(Principal Financial Officer)
/s/ Randy R. Wiese
Randy R. Wiese
Senior Vice President and Chief Accounting Officer
(Principal Accounting Officer)
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INDEX TO EXHIBITS
Exhibit
Number
Description
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