ITEM 1. BUSINESS
General
John H. Harland Company (the "Company") is a Georgia corporation incorporated in 1923. The Company is a leading provider of printed products and software sold to financial institutions, including banks, credit unions, brokerage houses and financial software companies. The Company's subsidiary, Scantron Corporation ("Scantron"), is a leading provider of data collection, testing and assessment products and maintenance services sold primarily to the educational, financial institution and commercial markets.
The Company serves its major markets through three primary business segments: Printed Products, Software and Services and Scantron. Each of these three segments is described below. Reference is made to Note 14 of the Notes to Consolidated Financial Statements in this Annual Report on Form 10-K with respect to information concerning the Company's business segments, including segment sales for each of the last three fiscal years.
Recent Developments
In 2003, the Company completed the acquisition of Premier Systems Inc. ("PSI"), a provider of core processing solutions for credit unions. PSI provided these solutions through a service bureau model, which the Company believes strengthens its position in the credit union market.
In the third quarter of 2003, the Company announced a reorganization of its Printed Products division. The reorganization will include plant consolidation and reduction of selling, general and administrative expenses. The Company expects the reorganization to be completed in 2004.
The Company's three business segments introduced a number of new products and services in 2003. The Company believes these new products and services will help strengthen its relationships with customers and its position in the marketplace. These new products are described below.
Printed Products
The Printed Products segment ("Printed Products") includes the Company's checks operations, as well as its direct marketing and analytical services businesses and computer checks and forms business. Segment sales of $498.3 million accounted for 63% of the Company's consolidated sales in 2003.
Printed Products' traditional products are checks and forms, including personal and business checks and computer checks, as well as internal bank forms. Printed Products also produces a variety of financial documents in conjunction with personal or small business financial software packages. The analytical services business sells behavioral model services to financial institutions, enabling them to, among other things, identify their customers most at risk of switching financial institutions, as well as a consumer's propensity to purchase a financial product and the financial product a consumer is most likely to purchase next.
Printed Products has two primary competitors in the sale of checks to financial institutions. They are national financial printers that specialize in check printing, one of which has substantially greater sales and financial resources than the Company. The Company believes that the competitive factors influencing buying decisions within the Printed Products segment include pricing (which in certain circumstances may include significant upfront contract
incentive payments), service, quality, and the ability to increase customer operational efficiencies and profitability. The Company lost business with some of its larger customers in 2002 and 2003, due primarily to competitive pricing, resulting in lower volumes and profitability. There is no assurance that the Company will not lose other significant customers or that any such losses could be offset by the addition of new customers. Other competitive pressures on the Printed Products segment include the continuing expansion of alternative payment systems such as credit cards, debit cards and other forms of electronic commerce or on-line payment systems.
Printed Products markets its products and services primarily in the United States. Printed Products has five distinct sales forces. One focuses on large national financial institutions, another sells primarily to community banks and credit unions, a third to brokerage houses, the fourth sells direct marketing and analytical services, while the fifth concentrates on financial software companies and office supply superstores.
At the end of the third quarter of 2003, Printed Products announced a reorganization that is expected to be completed in 2004. As part of the reorganization, Printed Products will reduce the number of its domestic production facilities from 14 to 9. Printed Products also has an imprint facility in Puerto Rico. The Company has a 51% ownership in a check-printing company in Mexico, which has one production facility.
In 2000, Printed Products began converting its imprint facilities from offset printing to digital printing technology. The conversion of all domestic imprint facilities, which cost approximately $45 million, was completed by the end of 2002. As part of the reorganization discussed above, Printed Products plans to convert its Puerto Rico and business check facilities to digital technology.
The Company is investing in new systems and infrastructure for Printed Products' customer service operations, which it believes will help Printed Products improve service and functionality for its customers and increase revenue per unit for Printed Products. As of December 31, 2003, approximately $45 million has been expended on these initiatives, of which approximately $32 million was capitalized. The new systems are expected to cost approximately $60 to $65 million over the four-year period ending in 2004. Although development of these systems will continue throughout 2004, the Company expects to delay implementation of certain system functionality in the second half of 2004 in order to evaluate controls and processes as required by Section 404 of the Sarbanes-Oxley Act, thereby deferring certain expenditures into 2005.
Principal raw materials used by Printed Products include safety paper, form paper and MICR bond paper. Printed Products purchases other material, such as vinyl, inks, checkboards, packaging material and miscellaneous supplies from a number of suppliers. The Company believes that adequate raw materials will be available to support Printed Products' operations.
The Company believes that the loss of any one customer in the Printed Products segment would not have a materially adverse effect on the Company's consolidated operations.
Software and Services
Software and Services' operations are conducted through Harland Financial Solutions, Inc. ("HFS"), a wholly owned subsidiary of the Company, and are composed of two primary business groups: Retail and Lending Solutions and Core Systems. HFS sells a variety of products and services that are designed to help its customers strengthen profitable relationships with their customers. These products and services include lending and mortgage origination and servicing applications, business intelligence solutions, customer relationship management ("CRM") software, branch automation solutions and core processing systems. Segment sales in 2003 were $176.8 million, which accounted for 23% of the Company's consolidated sales.
Retail and Lending Solutions includes the Company's Delivery Systems, Mortgage Solutions and Retail Solutions businesses. Delivery Systems sells loan and deposit origination and compliance software to the financial institution market. The Company believes Delivery Systems sells the most complete product suite in the industry, including solutions for lending, account opening, sales management and loan underwriting. Competition within this market varies by financial institution size, but the Company believes Delivery Systems is a market leader.
Mortgage Solutions provides mortgage loan origination, production and servicing solutions. Like Delivery Systems, Mortgage Solutions is largely a compliance business. The Company believes HFS has a leadership position in this market segment. A new product, E3, which is a web-based platform solution for loan production, is expected to be launched at the end of the first quarter of 2004.
Retail Solutions helps financial institutions increase the profitability of customer relationships through CRM software and branch automation software.
Retail Solutions' CRM software, Touche(R), is a complete enterprise-wide solution that allows financial institutions to manage all aspects of the customer relationship. The Company believes it is one of the most complete CRM solutions designed specifically for financial institutions. The Touche Analyzer(TM) module provides tools to create marketing campaigns, segment customers by demographic criteria, determine customer and product profitability, and provide research, reporting and campaign management. Touche Sales & Service(TM) handles all customer contacts, sales and referral activities, as well as problem resolution and service requests. Touche Messenger(TM) is the interaction management component responsible for fully automated, multi-channel, one-to-one campaign management to customers at every point of contact.
Retail Solutions' branch automation offerings include ENCORE!(R) and EZTeller(R). These systems enhance the customer experience through tightly integrated teller, platform and call center tools designed for banks of all sizes.
Core Systems sells host processing application software to both credit unions and banks. Its products centralize customer information and facilitate high speed and reliable processing of transactions from every delivery channel. HFS has integrated its core processing solution for credit unions, the ULTRADATA(R) System, and its core processing solution for banks, the SPARAK(R) System, with 12 other Harland products and services and believes that this is an example of how HFS can differentiate itself in the market. The acquisition of PSI expanded HFS' core processing solutions for credit unions to include the delivery of the ULTRADATA System as a service bureau delivery option.
HFS backlog, which consists primarily of contracted products and services prior to delivery, was $101.6 million and $43.9 million for the years ended December 31, 2003 and 2002 respectively. The Company expects to deliver
approximately 49% of the 2003 backlog within the next twelve months. Due to the long-term nature of certain service contracts, primarily in the Core Systems service bureau business, the balance of the 2003 backlog will be delivered beyond the next twelve months. Substantially all of the 2002 backlog was filled in 2003.
The market for providing technological solutions to financial institutions is highly competitive and fragmented. The Company believes there is one other company that competes with all HFS business units, and there are two other competitors whose product offerings compete with product offerings of several, but not all, of HFS' business units. There are also other competitors that offer one or more specialized products or services that compete with the Software and Services segment. The Company believes that competitive factors influencing buying decisions for HFS product offerings include product features and functionality, customer support, price and vendor financial stability.
The Company believes that the loss of any one customer in the Software and Services segment would not have a materially adverse effect on the Company's consolidated operations.
Scantron
Scantron was founded in 1972 and acquired by the Company in 1988. Scantron is a leading provider of data collection, testing and assessment and field maintenance services. Its products and services include scannable forms, scanning equipment, imaging software, survey services and curriculum development, testing and assessment tools. Field maintenance services include installation, maintenance and repairs for computers and related equipment, as well as Scantron optical mark recognition equipment. Segment sales for 2003 were $113.2 million, which accounted for 14% of the Company's consolidated sales.
Scantron has a solid leadership position in the in-classroom testing and assessment market, where more than 90% of all high schools and 80% of all colleges and universities use at least one Scantron product. In addition to the traditional Scantron system, which consists of a scanner, forms and software, Scantron has introduced new products for the education market including Classroom Wizard(TM) in 2002, which the Company believes is the first real-time testing solution for the in-classroom education market. It allows students to take tests using handheld devices that provide instantaneous feedback to both the student and teacher. Other new products are Performance Series(TM), which enables educators to assess a student's grade-level proficiency in a number of subjects and Curriculum Designer(TM), which allows educators to develop comprehensive education plans aligned to state and national education standards. These two products were obtained through acquisition in 2002.
Scantron also provides a total solution for customers' forms-based transactions, including printing, distributing, processing and electronic archiving.
Scantron's markets are diverse and competitive. In addition to the education market, Scantron markets its products to the commercial and financial institution markets. The Company believes Scantron is the second-largest provider of data collection systems to commercial and educational markets in the United States. The Company believes that factors influencing the buying decisions within the Scantron segment include pricing, service, quality, product offerings and the ability to customize programs.
There is a seasonal nature to Scantron's business in the educational market, but it does not significantly affect the Company's consolidated results.
The Company believes that the loss of any one Scantron customer would not have a materially adverse effect on the Company's consolidated operations.
Patents and Trademarks
The Company has patents on several products and processes and trademarks on several of its products and services. While the Company believes these patents and trademarks to be of value, it does not consider any of them to be critical to its operations.
Foreign Sales
The Company conducts business in Mexico and Canada. Sales outside the United States totaled $9.2 million, $10.0 million and $12.2 million for the years ended December 31, 2003, 2002 and 2001, respectively.
Research and Development
The Company's research and development costs are primarily costs incurred related to the development of software and the enhancement of existing software products. Software development costs incurred prior to the establishment of technological feasibility are expensed as incurred. Software development costs incurred after the technological feasibility of the subject software product has been established are capitalized. The Company incurred expenses totaling $22.6 million, $14.5 million and $15.0 million in 2003, 2002 and 2001, respectively, for research and development activities.
Government Regulation
The Company is subject to the Gramm-Leach-Bliley Act and certain of its implementing regulations (the "GLB Act"). Under the GLB Act, financial institutions and their service providers are responsible for developing, implementing and maintaining reasonable administrative, technical and physical safeguards to protect the security, confidentiality and integrity of non-public personal information regarding financial institution customers. The Company believes it is in compliance with the GLB Act.
Employees
As of December 31, 2003, the Company and its subsidiaries employed approximately 4,900 people.
Availability of Reports
The Company makes available free of charge through its website, www.harland.com, its annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports filed pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after the Company files such material with, or furnishes it to, the SEC.
The Company's Corporate Governance Principles and Practices, Audit Committee Charter, Governance Committee Charter and its Code of Business Conduct and Ethics are also available on its website and are available in print to any shareholder upon request. Requests for copies of any of these documents should be directed in writing to Investor Relations, John H. Harland Company, P.O. Box 105250, Atlanta, Georgia 30348, or by telephone to (770) 593-5128.
ITEM 2.
ITEM 2. PROPERTIES
As of December 31, 2003, the Company and its subsidiaries owned and leased facilities throughout the United States and in Canada, Puerto Rico and Mexico. The following table provides a description of the Company's principal facilities:
The Company's leases on the properties it does not own have expiration dates ranging from 2005 to 2013.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In the ordinary course of business, the Company is subject to various legal proceedings and claims. The Company believes that the ultimate outcome of these matters will not have a material effect on its financial statements.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth information with respect to all executive officers of the Company.
Name Age Office Held Timothy C. Tuff 56 Chairman, President and Chief Executive Officer Arlene S. Bates 52 Senior Vice President - Human Resources Charles B. Carden 59 Senior Vice President and Chief Financial Officer John T. Heald, Jr. 58 President, Harland Printed Products John C. Walters 63 Senior Vice President, Secretary and General Counsel
Mr. Tuff joined the Company as President and Chief Executive Officer in 1998 and was named Chairman in 2000. For the prior five years, he served as President and Chief Executive Officer of Boral Industries, Inc., managing the North American and European operations of Australian-based Boral, Ltd., a world leader in building and construction materials.
Ms. Bates has been employed by the Company since 1980 and has served as Vice President of Human Resources since 1993 and was named Senior Vice President in 2003.
Mr. Carden joined the Company in 1999 as Vice President and Chief Financial Officer. Mr. Carden was named Senior Vice President and Chief Financial Officer in 2003. He previously served as Executive Vice President and Chief Financial Officer of Mariner Post-Acute Network, a health care provider, since 1996.
Mr. Heald joined the Company in December 2002 from Baldwin Technology Company where he served as Chief Executive Officer for the manufacturer of controls and accessories for the printing industry since 2001. Previously, he served as Executive Vice President - Operations of Sappi Fine Paper NA, a leading producer of coated fine paper for two years. He was previously employed by Union Camp Corporation, a worldwide producer of paper and packaging products, for 22 years, last serving as Executive Vice President - Packaging Operations.
Mr. Walters joined the Company in 1996 as Senior Vice President and General Counsel and was named Secretary in 1999.
Mr. Tuff also serves on the Board of Directors. Officers are elected annually and serve at the pleasure of the Board.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock is listed on the New York Stock Exchange under the symbol "JH." As of March 3, 2004, the Company had 3,223 shareholders of record. See the information with respect to quarterly market information and dividend information for the Company's common stock, which is set forth on page
. The Company has an established policy of making quarterly dividend payments to shareholders. The Company expects to pay future cash dividends depending upon the Company's pattern of growth, profitability, financial condition and other factors which the Board of Directors may deem appropriate.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
See the information with respect to selected financial data on page.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
See the information under the caption Management's Discussion and Analysis of Results of Operations and Financial Condition on pages through.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See the information with respect to Quantitative And Qualitative Disclosures About Market Risk on page under the caption Interest Rate Risk.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the information with respect to Financial Statements and Supplementary Data on pages through.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
The Company's disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
As of the end of the period covered by this report, the Company evaluated, under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, the effectiveness of the design and operation of the Company's disclosure controls and procedures, pursuant to Exchange Act Rule 13a-14 and Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective. There have been no significant changes in the Company's internal controls during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information regarding Directors required herein is incorporated by reference to the information under the captions "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Registrant's Proxy Statement for the 2004 Annual Meeting of Shareholders (the "Proxy Statement").
The information regarding Executive Officers required herein is included in Part I of this Annual Report on Form 10-K and under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement and incorporated herein by reference.
The Company has adopted a Code of Business Conduct and Ethics. A copy of the Code of Business Conduct and Ethics is attached to this Annual Report on Form 10-K as Exhibit 14.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information regarding executive compensation required herein is incorporated by reference to the information under the caption "Executive Compensation and Other Information" in the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table presents information regarding securities authorized for issuance under equity compensation plans as of December 31, 2003:
The other information regarding security ownership of certain beneficial owners and management required herein is incorporated by reference to the information under the caption "Stock Ownership of Directors and Executive Officers and Certain Other Persons" in the Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not applicable.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information regarding principal accountant fees and services required herein is incorporated by reference to the information under the caption entitled "Fees Paid to Independent Auditors" in the Proxy Statement.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K
Page in this Annual Report on Form 10-K ------- (a)1. Financial Statements:
Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Cash Flows Consolidated Statements of Shareholders' Equity Notes to Consolidated Financial Statements Independent Auditors' Report Management's Responsibility for Financial Statements Supplemental Financial Information (unaudited)
(a)2. Financial Statement Schedule:
Schedule II. Valuation and Qualifying Accounts S1
All other schedules have been omitted since the information required is either in the financial statements or notes thereto or is not required.
(a)3. Exhibits
(Asterisk (*) indicates exhibit previously filed with the Securities and Exchange Commission as indicated in parentheses and incorporated herein by reference. Plus (+) indicates management contracts and compensatory arrangements required to be filed pursuant to Item 15(c) of this annual report).
3.1 * Amended and Restated Articles of Incorporation (Exhibit B to Registrant's Proxy Statement dated March 12, 1999). 3.2 * Bylaws, as amended through December 19, 2002 (Exhibit 3.2 to the Registrant's Annual Report on Form 10-K ("10-K") for the year ended December 31, 2002). 4.1 * Rights Agreement, dated as of December 17, 1998, between Registrant and First Chicago Trust Company of New York (Exhibit 4.1 to the 8-K dated July 1, 1999). 4.2 See Articles IV, V and VII of Registrant's Amended and Restated Articles of Incorporation, filed as Exhibit 3.1, and Articles I, V and VIII of Registrant's Bylaws, filed as Exhibit 3.2. 10.1 * + Form of Noncompete and Termination Agreement between Registrant and Arlene S. Bates, Charles B. Carden and John C. Walters (Exhibit 10.1 to the 2002 10-K). 10.2 * + Employment Agreement, dated December 2, 2002, between Registrant and John T. Heald, Jr. (Exhibit 10.2 to the 2002 10-K). 10.3 * + Noncompete and Termination Agreement, dated as of January 1, 2002, between Registrant and Timothy C. Tuff (Exhibit 10.3 to the 2001 10-K). 10.4 * + Form of Restricted Stock Agreement between Registrant and Ms. Bates, Messrs. Carden, Heald and Walters (Exhibit 10.4 to the 2000 10-K). 10.5 * + Restricted Stock Agreement dated April 24, 2002 between Registrant and Mr. Tuff (Exhibit 10.6 to the 2002 10-K). 10.6 * + Supplemental Retirement Agreement, dated as of January 1, 2002, between Registrant and Mr. Tuff (Exhibit 10.7 to the 2001 10-K).
10.7 * John H. Harland Company 1999 Stock Option Plan, as amended (Exhibit 99.1 to the Registrant's Registration Statement on Form S-8, dated January 14, 2000, File No. 333-94727). 10.8 * John H. Harland Company 2000 Stock Option Plan, as amended (Exhibit 99.1 to the Registrant's Registration Statement on Form S-8, dated November 29, 2000, File No. 333-70386). 10.9 * John H. Harland Company 2002 Stock Option Plan (Exhibit A to the Registrant's Proxy Statement dated March 20, 2002). 10.10 John H. Harland Company Employee Stock Purchase Plan, as amended through July 24, 2003. 10.11 * John H. Harland Company Compensation Plan for Non-Employee Directors, as amended (Exhibit 10.12 to the 2001 10-K). 10.12 Amended and Restated Credit Agreement dated as of February 4, 2004 among Registrant and the Lenders named therein. 11.1 Computation of Per Share Earnings.+ 14 Code of Business Conduct and Ethics. 21 Subsidiaries of the Registrant. 23 Consent of Deloitte & Touche, LLP. 31.1 Certification Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K.
On November 3, 2003, the Registrant furnished to the Securities and Exchange Commission a Report on Form 8-K dated October 29, 2003 including its Press Release for the quarter ended September 26, 2003, as well as the transcript of its conference call on October 30, 2003 discussing its third quarter results.
- -------- + Data required by SFAS No. 128, "Earnings Per Share," is provided in Note 1 to the Consolidated Financial Statements included in this report. + Data required by SFAS No. 128, "Earnings Per Share," is provided in Note 1 to the Consolidated Financial Statements included in this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
JOHN H. HARLAND COMPANY
/s/ J. Michael Riley 3/08/2004 - ------------------------ --------- J. Michael Riley Date Vice President and Controller
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
/s/ William S. Antle III 3/8/2004 /s/ Charles B. Carden 3/8/2004 - --------------------- --------- ------------------------ --------- William S. Antle III Date Charles B. Carden Date Director Senior Vice President and Chief Financial Officer (Principal Financial Officer)
/s/ Robert J. Clanin 3/8/2004 /s/ John D. Johns 3/8/2004 - ------------------------ --------- ------------------------ --------- Robert J. Clanin Date John D. Johns Date Director Director
/s/ John J. McMahon, Jr. 3/3/2004 - ----------------------- --------- ------------------------ --------- Richard K. Lochridge Date John J. McMahon, Jr. Date Director Director
/s/ G. Harold Northrop 3/4/2004 /s/ Larry L. Prince 3/3/2004 - ----------------------- --------- ------------------------ --------- G. Harold Northrop Date Larry L. Prince Date Director Director
/s/ J. Michael Riley 3/8/2004 /s/ Eileen M. Rudden 3/8/2004 - ----------------------- --------- ------------------------ --------- J. Michael Riley Date Eileen M. Rudden Date Vice President and Director Controller (Principal Accounting Officer)
/s/ Jesse J. Spikes 3/8/2004 /s/ Timothy C. Tuff 3/8/2004 - ----------------------- --------- ------------------------ --------- Jesse J. Spikes Date Timothy C. Tuff Date Director Chairman, President and Chief Executive Officer (Principal Executive Officer)
JOHN H. HARLAND COMPANY AND SUBSIDIARIES
Index to Information For Inclusion in the Annual Report on Form 10-K for the year ended December 31, 2003
Management's Discussion and Analysis of Results of Operations and Financial Condition
Consolidated Financial Statements and Notes to Consolidated Financial Statements
Independent Auditors' Report
Management's Responsibility For Financial Statements
Supplemental Financial Information (Unaudited)
Financial Statement Schedule S1
JOHN H. HARLAND COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
John H. Harland Company (the "Company") operates its business in three segments. The Printed Products segment ("Printed Products") includes checks, direct marketing activities and analytical services marketed primarily to financial institutions. The Software and Services segment ("Software & Services") is focused on the financial institution market and includes core processing applications and services for credit unions and community banks, lending and mortgage origination applications, mortgage servicing applications, branch automation applications and customer relationship management applications. The Scantron segment ("Scantron") includes scanning equipment and software, scannable forms, survey solutions, curriculum development, testing and assessment tools, training and field maintenance services. Scantron sells these products and services to the education, commercial and financial institution markets.
Critical Accounting Policies
The Company has identified certain of its accounting policies as critical to its business operations and the understanding of its results of operations. These policies include revenue recognition, impairment of long-lived assets, goodwill and other intangible assets, income taxes and stock-based compensation.
The Company considers its revenue recognition policy as critical to its reported results of operations primarily in its Software & Services and Scantron segments. For software that is installed, customized and integrated by the Company, revenue is recognized on a percentage-of-completion basis as the services are performed. Estimates of efforts to complete a project are used in the percentage-of-completion calculation. Due to the uncertainties inherent in these estimates, actual results could differ from those estimates.
The Company reviews long-lived assets and certain intangible assets for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In the third quarter of 2001 and in the second quarter of 2002, the Company recorded charges of $7.8 million and $0.3 million, respectively, before income taxes for write-downs of an equity investment that was subsequently disposed of during the fourth quarter of 2002.
The Company makes estimates and assumptions regarding future cash flows in its review of the carrying values of goodwill and other intangible assets to assess recoverability. If these estimates and assumptions change in the future (which may occur due to changes in the Company's business prospects, market trends or other economic factors which would impact projected annual sales, operating profit and cash flows), the Company may be required to record impairment charges. The Company analyzes its goodwill for impairment on an annual basis. In 2002, the Company engaged an independent valuation firm to perform a goodwill impairment test. Based upon the analysis, there was no impairment of goodwill. In 2003, the Company's annual review of goodwill indicated there was no impairment.
The carrying value of the Company's net deferred tax assets (net of valuation allowances) assumes the Company will be able to generate sufficient future taxable income in certain tax jurisdictions. The Company may be required to record additional valuation allowances against its deferred tax assets resulting in additional income tax expense if the Company's estimates of future taxable income in those jurisdictions decrease. The Company may be required to release all or a portion of recorded valuation allowances against its deferred tax assets resulting in lower income tax expense, except for such allowances for deferred tax assets related to acquisitions, the release of which would reduce goodwill. The release of valuation allowances would result from changes in the Company's estimates of realized capital gains, utilization of state net operating loss carryforwards and utilization of acquired tax credits subject to annual limitations.
-F2-
The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for its stock-based compensation plans and applies the disclosure-only provisions of the Financial Accounting Standards Board ("FASB") Statement No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), as amended by FASB Statement No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" ("SFAS 148"). No stock-based compensation cost is reflected in net income for options or purchases under the employee stock purchase plan. Pro forma disclosures of net income and earnings per share are included in the Stock-Based Compensation section of Note 1 to the Consolidated Financial Statements as if compensation cost for options granted under the Company's stock-based compensation plans and purchases under the employee stock purchase plan had been determined based on the fair value at the grant dates consistent with the provisions of SFAS 123.
Reclassifications
During 2003, the Company reclassified certain items in its consolidated income statements. The reclassifications affected the categories of Selling, General and Administrative expenses and Other Income (Expense). The change primarily reflects the reclassification of gains or losses on the sale of assets as well as certain other expenses from Other Income (Expense) to Selling, General and Administrative expenses. Also in 2003, the Company transferred a business unit from Software & Services to Printed Products and transferred certain support activities to Printed Products from the corporate operations. Financial data for all periods presented have been reclassified for comparability. The reclassifications and transfers had no impact on net income or shareholders' equity as previously reported. Certain other reclassifications have been made in the 2002 and 2001 financial statements and notes to financial statements to conform to the 2003 classifications.
Reorganization
In September 2003, the Company announced a reorganization of its Printed Products operations including a plan to consolidate its domestic manufacturing operations from 14 plants to 9 plants, with the first plant closing in the first quarter of 2004 and the last affected plant closing in the third quarter of 2004. Two of the facilities being closed are leased. One facility is under lease through late 2005 and the other is under lease through mid 2010. In addition to the plant consolidation, Printed Products implemented other staffing reductions beginning in the fourth quarter of 2003 and will continue with additional staffing reductions throughout 2004. These actions are primarily due to excess capacity in production facilities resulting from efficiencies realized from digital printing technology and other production and support systems and lower volumes attributable to the losses of certain large customers, including a direct check marketer, and general market volume decline. The Company believes these actions will bring its production and support structures in line with its business levels. Management expects to achieve savings increasing to approximately $20 million on an annual run rate basis by the end of 2005 as a result of the reorganization.
The Company estimates net pre-tax expenses associated with the plant consolidations will total $10.7 million consisting of employee severance ($3.1 million), revision of depreciable lives and salvage values of furniture and equipment, asset impairment charge and disposal gains and losses ($2.2 million), relocation and other costs ($2.8 million) and contract termination costs related to leaseholds ($2.6 million). The other staffing reduction actions will result in a total estimated expense of $5.9 million related to employee severance costs.
In 2003, plant consolidation costs totaled $4.0 million, which consisted of $2.1 million related to the revision of depreciable lives and salvage values of furniture and equipment, $1.7 million for employee severance costs and $0.2 million for relocation and other costs. Employee severance costs for other staffing reduction actions totaled $2.9 million. These costs are included in the results of operations in 2003 with plant consolidation costs included in cost of goods sold and the other staffing reduction costs included in selling, general and administrative expenses (see Note 5 to the Consolidated Financial Statements).
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RESULTS OF OPERATIONS 2003 versus 2002
Sales
Consolidated sales for the years ended December 31, 2003 and 2002 were as follows (in thousands):
Consolidated sales for the year ended December 31, 2003 were $786.7 million, compared to $767.8 million for the year ended December 31, 2002, an increase of $18.9 million, or 2.5%. Software & Services and Scantron sales increases more than offset a decrease in Printed Products sales. Sales of products decreased $11.6 million, or 1.8%, from $652.5 million in 2002 to $640.9 million in 2003. Sales of services increased $30.5 million, or 26.5%, to $145.8 million in 2003 compared to $115.3 million in 2002. Sales of products consist of all Printed Products sales (except for analytical services), software licensing sales, scanning equipment and scannable forms, hosted software applications and other products. Sales of services consist of software maintenance services, field maintenance services, analytical and consulting services and other services.
Printed Products sales were $498.3 million in 2003 compared to $526.2 million in 2002, a decrease of $27.9 million, or 5.3%. Lower volumes in domestic imprint check printing operations, which decreased 9.4% in 2003 from 2002, accounted for a majority of the decrease in Printed Product sales. The volume decline was primarily attributable to losses of certain large customers, lower volumes from a direct check marketer due to the loss of that business in late 2003 and general market volume decline. The Company estimates the general market volume decline in check products due to the continuing expansion of alternative payment systems is currently 4% to 5% on an annual basis. The impact of the volume decline was moderated by an improvement of 3.8% in average price per unit primarily due to a price increase implemented in July 2002 and the impact of the loss of certain large customers that were less favorably priced. Sales of computer checks and related products also decreased in 2003 compared to 2002 due primarily to the loss of business with a software company in late 2002, partially offset by the addition of business with another software company in early 2003. Sales in direct marketing increased slightly due to higher volumes of statement mailings, partially offset by lower volumes from credit card promotions. Sales of analytical services also increased in 2003 compared to 2002 due primarily to services rendered to two large customers.
Software & Services sales for 2003 increased $41.3 million, or 30.4%, from 2002, due primarily to the impact of a full year of operations for acquisitions that were made in 2002 as well as an acquisition made in June 2003 (see Note 2 to the Consolidated Financial Statements). Excluding the impact of acquisitions, Software & Services sales increased 2.2% in 2003 compared to 2002 due primarily to increases in sales of core processing products and services, lending and deposit origination products and services and branch automation applications, which more than offset decreases in sales of mortgage loan origination, production and servicing solutions and sales of customer relationship management software and related database marketing applications and
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add-on products. Sales of core processing products and services increased due primarily to an increase in credit union customer installations, seat licenses and ship and book sales as well as increased hardware sales for banking systems. Sales of lending products and services increased primarily due to higher ship and book sales, higher maintenance revenue and the impact of subscription contracts over the past year. Retail solutions sales were unfavorably impacted by a decrease in sales of customer relationship management applications, database marketing applications and add-on products, partially offset by higher sales of branch automation applications.
At December 31, 2003, Software & Services backlog was $101.6 million, an increase of $57.7 million from the backlog at December 31, 2002. The increase in backlog was due primarily to acquisitions and stronger bookings. Excluding the impact of acquisitions, backlog increased 24.1% from December 31, 2002. Approximately $49.7 million or 48.9% of the backlog at December 31, 2003 is expected to be delivered over the next twelve months and $51.9 million or 51.1% is expected to be delivered beyond the next twelve months due to the long-term nature of certain service contracts.
Scantron sales were $113.2 million in 2003 compared to $107.8 million in 2002, an increase of $5.4 million, or 5.0%, due primarily to a full year of operations in 2003 from the acquisition of EdVISION in July 2002 (see Note 2 to the Consolidated Financial Statements), increases in sales of standard forms in the education market, imaging products and services, survey services and field services, which were partially offset by reduced sales of custom forms. Sales of custom forms were lower for commercial market applications and non-testing applications in the education market due to a continuing trend in data collection methods moving from optical mark reading to imaging and other direct input technologies.
Gross Profit
Consolidated gross profit and gross profit by segment for the years ended December 31, 2003 and 2002 were as follows (in thousands):
Consolidated gross profit of $381.8 million in 2003 increased $17.4 million, or 4.8%, from $364.4 million in 2002 and increased as a percentage of sales from 47.5% in 2002 to 48.5% in 2003. The increase in consolidated gross profit was the result of a favorable change in sales mix, cost management and productivity improvement initiatives.
Printed Products gross profit decreased $7.5 million, or 3.6%, in 2003 from 2002 but increased as a percentage of sales from 39.3% to 40.0% in 2003. The decrease in gross profit occurred primarily in domestic imprint check operations due to plant consolidation costs and reduced volume, an unfavorable change in mix in direct marketing activities and decreases in sales of computer checks and related products partially offset by increases in analytical services gross profit. The improvement in gross profit as a percentage of sales was due primarily to efficiencies realized from digital printing technology, process improvements and a favorable change in price and product mix. As stated earlier, Printed Products gross profit was unfavorably impacted in 2003 by plant consolidation costs of $4.0 million, which were incurred primarily during the fourth quarter of 2003. These plant consolidation costs relate to a plan to consolidate Printed Products manufacturing operations from 14 plants to 9 plants
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during 2004 (see Note 5 to the Consolidated Financial Statements). Excluding the impact of the plant consolidation costs, Printed Products gross profit decreased $3.5 million or 1.7% in 2003 from 2002 and as a percentage of sales was 40.8% in 2003.
Software & Services gross profit for 2003 increased $23.9 million, or 24.8%, over 2002, due primarily to acquisitions. As a percentage of sales, Software & Services gross profit decreased to 68.0% for 2003 compared to 71.1% for 2002 due primarily to the impact of acquired operations and a change in sales mix. Excluding the impact of acquisitions, Software & Services gross profit increased approximately 1.3% in 2003 compared to 2002 primarily due to an increase in sales in bank core processing applications and branch automation applications for financial institutions.
Scantron gross profit increased by $1.0 million, or 1.6%, over 2002 to $62.4 million in 2003 due primarily to the addition of the former EdVISION products and services acquired in July 2002. As a percentage of sales, Scantron gross profit decreased from 57.0% for 2002 to 55.1% in 2003 due primarily to an unfavorable change in sales mix and to costs and production inefficiencies experienced during a facility relocation that occurred in the first quarter of 2003.
Selling, General and Administrative Expenses ("SG&A")
Consolidated SG&A for the years ended December 31, 2003 and 2002 were as follows (in thousands):
Consolidated SG&A increased by $24.1 million, or 9.1%, from $265.1 million in 2002 to $289.2 million in 2003. These expenses as a percentage of sales were 36.8% in 2003 compared to 34.5% in 2002.
Printed Products SG&A increased $11.5 million, or 9.7%, in 2003 over 2002 due in part to $2.9 million of reorganization costs incurred during the fourth quarter of 2003 (see Note 5 to the Consolidated Financial Statements), increased selling and marketing activities and customer care activities, partially offset by an $0.8 million gain realized in the third quarter of 2003 on the sale of a former check printing facility. Also, Printed Products SG&A in 2003 included $2.1 million of incentive compensation costs that were classified as corporate costs in prior years.
Software & Services SG&A increased $21.7 million, or 27.9%, in 2003 over 2002 due primarily to the impact of acquisitions and to increased expenditures related to product development of a mortgage services application. Also in 2003, Software & Services SG&A included $2.2 million of incentive compensation costs that were classified as corporate costs in prior years.
Scantron's SG&A increased $4.9 million, or 15.4%, in 2003 compared to 2002 due primarily to the acquisition of EdVISION, increased selling and marketing expenses related to developing a national sales force for software products and services in the education market and increased product development costs.
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Corporate SG&A decreased $14.0 million, or 37.4%, in 2003 compared to 2002 due primarily to decreases in stock-based compensation costs related to restricted stock grants and the transfer in 2003 of certain incentive compensation costs to Printed Products and Software & Services that were classified as corporate costs in prior years. Stock-based compensation totaled $2.4 million in 2003 compared to $9.9 million in 2002. The decrease in stock-based compensation was due primarily to expenses resulting from the accelerated vesting of certain restricted stock grants in 2002 (see Note 9 to the Consolidated Financial Statements). These grants vested as a result of the Company's favorable stock price performance.
Amortization of Other Intangible Assets/Acquired In-Process Research and Development Charge
Amortization of other intangible assets increased to $3.3 million in 2003 compared to $2.6 million in 2002 due primarily to the impact of acquired operations partially offset by the impact of certain intangible assets that were fully amortized during 2002. In 2002, the Company wrote off $3.0 million of acquired in-process research and development costs related to the acquisition of INTERLINQ (See Note 2 to the Consolidated Financial Statements).
Consolidated Income from Operations
Consolidated income from operations decreased $4.4 million, or 4.7%, to $89.4 million for 2003 from $93.8 million for 2002 due primarily to Printed Products SG&A staffing reduction costs of $2.9 million in 2003 and other increases in SG&A in 2003 discussed above, partially offset by the impact of an acquired in-process research and development charge in 2002.
Other Income (Expense)
Other Income (Expense) decreased by $5.9 million from an expense of $8.5 million for 2002 to an expense of $2.6 million for 2003. The decrease was due primarily to gains on sales of investments of $3.0 million in 2003 (see Note 1 to the Consolidated Financial Statements) and a loss of $1.8 million in 2002 on the disposition of equity and debt investments in Netzee, Inc. ("Netzee"). Interest expense decreased $0.9 million from 2002 primarily due to lower interest rates during 2003 compared with 2002, which was partially offset by the impact of higher average borrowings.
Consolidated Income Before Income Taxes
Consolidated income before income taxes increased $1.5 million, or 1.8%, to $86.8 million for 2003 from $85.3 million for 2002. The impact of investment gains in 2003 and investment losses in 2002 more than offset the decrease in consolidated income from operations in 2003.
Income Taxes
The Company's consolidated effective income tax rates were 35.5% and 38.5% for 2003 and 2002, respectively. The lower effective income tax rate for 2003 resulted primarily from the release of a valuation allowance related to the utilization of capital loss carryforwards, a reduction in the effective state tax rate, a favorable renewal of an industrial revenue grant related to the Company's operations in Puerto Rico and a reduction of certain estimated permanent tax differences. The effective tax rate for 2002 included favorable adjustments related to state tax credits and adjustments related to prior years due to the resolution of an IRS examination, which were partially offset by the impact of an in-process research and development charge that was nondeductible for tax purposes. See Note 7 to the Consolidated Financial Statements for factors affecting the tax rate in each year.
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Net Income and Earnings Per Share
The Company's net income for 2003 was $56.0 million compared to $52.4 million for 2002, an increase of $3.6 million, or 6.9%. Basic and diluted earnings per share were $2.02 and $1.97, respectively, for 2003 compared to basic and diluted earnings per share of $1.80 and $1.73, respectively, for 2002. Net income for 2003 included pre-tax charges totaling $6.9 million related to the Printed Products reorganization, equivalent to $0.15 per share on a diluted basis, and a $3.0 million pre-tax gain on the sale of investments equivalent to $0.11 per share on a diluted basis. Net income for 2002 included pre-tax charges totaling $13.0 million, equivalent to $0.30 per share on a diluted basis related to accelerated vesting of certain restricted stock grants, an in-process research and development charge related to an acquisition, and the loss on the disposition of debt and equity investments resulting from the sale of Netzee. Lower weighted average shares outstanding in 2003 compared to 2002 also had a favorable impact on basic and diluted earnings per share in 2003. The lower shares outstanding were primarily the result of the Company's share repurchase program (see Note 8 to the Consolidated Financial Statements).
RESULTS OF OPERATIONS 2002 versus 2001
Sales
Consolidated sales for the years ended December 31, 2002 and 2001 were as follows (in thousands):
Consolidated sales for the year ended December 31, 2002 were $767.8 million compared to $743.2 million for the year ended December 31, 2001, an increase of $24.6 million, or 3.3%. Software & Services and Scantron sales increases more than offset a decrease in Printed Products sales. Sales of products, which consist of all of Printed Products sales (except for analytical services), software licensing sales, scanning equipment and scannable forms and other products, were $652.5 million in 2002 compared to $636.1 million in 2001, an increase of $16.4 million, or 2.6%. Sales of services, which consist of software maintenance services, field maintenance services, analytical and consulting services and other services were $115.3 million in 2002 compared to $107.1 million in 2001, an increase of $8.2 million, or 7.6%.
Printed Products sales were $526.2 million in 2002 compared to $528.4 million in 2001, a decrease of $2.2 million, or 0.4%. Lower volumes in domestic check printing operations, which decreased 6.6% in 2002 from 2001, accounted for a majority of the decrease in sales. The volume decline was primarily attributable to a loss of market share and a decline in orders received from a direct check marketer. The impact of these two factors was moderated by an improvement of 5.1% in average price per unit due to lower volume with a direct check marketer that is less favorably priced than traditional customers, and also due to price increases. Sales in direct marketing operations also decreased due to the general economic slowdown, which resulted in lower credit card promotions and fewer openings of online brokerage accounts. The sales decreases were partially offset by an increase in sales of analytical services in 2002 compared to 2001 and by sales of computer checks and related products, which increased in 2002 compared to 2001 due to a fulfillment program for a software customer initiated in late 2001 and increases in the computer checks commercial referral business.
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Software & Services sales increased from $120.2 million in 2001 to $135.6 million in 2002, an increase of $15.4 million, or 12.8%, primarily due to the acquisitions of Easy Systems, SPARAK and INTERLINQ (see Note 2 to the Consolidated Financial Statements) and also to increased sales of core processing applications, customer relationship management applications and branch automation applications. Sales of lending and account opening applications increased slightly in 2002 compared to 2001, primarily due to a trend of a higher proportion of term license agreements during 2001 and the first six months of 2002 whereby revenue recognition was deferred from the current period into future periods. This trend changed during the latter portion of 2002 with a higher proportion of ship and book sales, which are recognized as revenue when shipped. The change during the latter portion of 2002 was enough to offset the effect of higher term license sales during the first six months of 2002. Sales of mortgage lending solutions increased in 2002 due to the INTERLINQ acquisition, which was partially offset by the decision of a major customer to bring software development in-house in late 2001.
Scantron sales were $107.8 million in 2002 compared to $95.9 million in 2001, an increase of $11.9 million, or 12.4%. The increase was due in part to the Scanning Systems and EdVISION acquisitions made by Scantron during 2001 and 2002 (see Note 2 to the Consolidated Financial Statements), internal growth in field services and growth in sales of imaging products. Increases in sales of scannable forms were offset by reduced sales of optical mark reading equipment due to a continuing trend in data collection methods moving from optical mark reading to imaging and other direct input technologies.
Gross Profit
Consolidated gross profit and gross profit by segment for the years ended December 31, 2002 and 2001 were as follows (in thousands):
Consolidated gross profit increased by $23.7 million, or 7.0%, from $340.7 million in 2001 to $364.4 million in 2002 and increased as a percentage of sales from 45.8% in 2001 to 47.5% in 2002. The increase in consolidated gross profit was the result of a favorable change in sales mix, cost management and productivity improvement initiatives including process improvements and new digital printing technology.
Printed Products gross profit increased $5.5 million, or 2.8%, in 2002 from 2001 and increased as a percentage of sales from 38.0% in 2001 to 39.3% in 2002, a result of the combination of an increase in average price per unit and cost reductions resulting from process improvements and new digital printing technology. The increase in Printed Products gross profit in 2002 from 2001 occurred primarily in its checks operations and was partially offset by a decrease in gross profit in direct marketing operations due primarily to the decrease in direct marketing sales.
Software & Services gross profit increased $11.4 million, or 13.4%, in 2002 from 2001 and, as a percent of sales, increased to 71.1% in 2002 from 70.7% in 2001 primarily due to acquired businesses with higher gross profit, increased sales of products and services, and cost management activities.
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Scantron gross profit increased by $6.8 million, or 12.5%, in 2002 over 2001 and as a percentage of sales remained constant at 57.0% in 2002 and 2001 due to stable margins in existing products and services.
Selling, General and Administrative Expenses
Consolidated SG&A for the years ended December 31, 2002 and 2001 were as follows (in thousands):
Consolidated SG&A totaled $265.1 million in 2002 compared to $237.8 million in 2001, an increase of $27.3 million, or 11.5%. As a percentage of sales, SG&A increased from 32.0% in 2001 to 34.5% in 2002. The increase occurred in all business segments and Corporate.
Printed Products SG&A increased $8.3 million, or 7.5%, in 2002 over 2001 due primarily to higher expenses for customer care initiatives. Customer care initiatives were focused on improving systems that support sales, marketing and customer service. Printed Products SG&A was also unfavorably impacted in 2002 by higher costs associated with the move of customer service activities in-house, which were provided by an outside provider in prior years, increases in marketing expenditures, upgrade expenses for the Company's financial and human resource systems and severance expenses related to management reductions in 2002.
Software & Services SG&A increased $3.3 million, or 4.4%, in 2002 over 2001 due primarily to the impact of acquisitions, which was partially offset by cost management activities.
Scantron SG&A increased $4.3 million, or 15.8%, in 2002 over 2001 due primarily to the impact of the EdVISION acquisition.
Corporate SG&A increased $11.5 million, or 44.3%, in 2002 over 2001 due primarily to stock-based compensation costs related to restricted stock grants, incentive compensation costs and a favorable adjustment to the provision for uncollectible accounts in 2001. Stock-based compensation costs totaled $9.9 million in 2002 compared to $5.3 million in 2001 primarily due to accelerated vesting of restricted stock grants during 2002 that vested as a result of the Company's favorable stock price performance (see Note 9 to the Consolidated Financial Statements). Incentive compensation costs increased $1.4 million in 2002 over 2001 related to achievement of certain performance objectives in 2002 in Corporate, Printed Products and Software & Services operations. In 2001, the Company recorded a favorable adjustment to its provision for uncollectible account of $1.8 million related to improvements in the Company's collection activities.
Amortization of Intangible Assets/Acquired In-Process Research and Development Charge
Amortization of intangible assets in 2002 decreased by $11.4 million from 2001 primarily due to the elimination of goodwill amortization in 2002 as a result of the adoption of the FASB Statement No. 142, "Goodwill and
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Other Intangible Assets" ("SFAS 142") (see Note 3 to the Consolidated Financial Statements). In 2002, the Company wrote off $3.0 million of acquired in-process research and development costs related to the acquisition of INTERLINQ (see Note 2 to the Consolidated Financial Statements).
Consolidated Income from Operations
Consolidated income from operations increased $4.9 million, or 5.4%, to $93.8 million in 2002 from $88.9 million in 2001 due to the elimination of goodwill amortization in 2002, which was partially offset by increases in SG&A expenses discussed above and the write-off of acquired in-process research and development costs in 2002.
Other Income (Expense)
Other Income (Expense) decreased from an expense of $18.1 million in 2001 to an expense of $8.5 million in 2002. The decrease was primarily due to a $7.8 million write-down in 2001 of the Company's equity investment in Netzee and to decreased interest expense. Interest expense was lower in 2002 due to lower interest rates and lower average levels of debt outstanding in 2002 compared with 2001. In December 2002, the Company realized a loss of $1.8 million on the disposition of debt and equity investments resulting from the sale of Netzee.
Consolidated Income Before Income Taxes
Consolidated income before income taxes increased $14.5 million, or 20.4%, to $85.3 million in 2002 compared to $70.8 million in 2001 as a result of the aforementioned items.
Income Taxes
The Company's effective income tax rate was 38.5% in 2002 and 45.0% in 2001. The decrease in the effective tax rate was primarily due to the elimination of goodwill amortization in 2002, most of which was nondeductible for tax purposes, and to a $1.3 million valuation allowance included in 2001 for a portion of the capital loss tax benefit related to the write-down of the investment in Netzee. The tax rate in 2002 was also affected by state tax credits and favorable adjustments related to prior years resulting from the resolution of an IRS examination for the years 1996 through 1998, which were partially offset by the impact of the in-process research and development charge that was nondeductible for tax purposes. See Note 7 to the Consolidated Financial Statements for factors affecting the tax rate in each year.
Net Income and Earnings Per Share
Net income for 2002 was $52.4 million compared to $39.0 million for 2001. Basic and diluted earnings per share for 2002 were $1.80 and $1.73, respectively, compared to basic and diluted earnings per share of $1.34 and $1.31, respectively, in 2001. Net income for 2002 included charges related to accelerated vesting of certain restricted stock grants, net of the resulting reduction of amortization expense, an in-process research and development charge related to an acquisition, and the loss on the disposition of debt and equity investments resulting from the sale of Netzee. These adjustments reduced diluted earnings per share by $0.28. Net income for 2001 included charges for the write-down of the investment in Netzee, costs associated with accelerated vesting of certain restricted stock grants and severance costs related to a plant consolidation, all of which reduced diluted earnings per share by $0.27. Net income for 2001 also included goodwill amortization equivalent to $0.34 per share. Effective January 1, 2002, goodwill amortization was discontinued as a result of the adoption of SFAS 142 (see Note 3 to the Consolidated Financial Statements).
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FINANCIAL CONDITION, CAPITAL RESOURCES AND LIQUIDITY
Sources and Uses of Cash
The Company has historically generated positive cash flows from its operations and continually evaluates uses of such cash flows to strengthen shareholder value through a combination of internal development, acquisitions, repurchases of stock and repayment of debt. Cash flows provided from operations in 2003 decreased $65.6 million to $74.7 million from $140.3 million in 2002 due primarily to $44.0 million of refundable contract incentive payments made in 2003 compared with $7.6 million of such payments in 2002, changes in deferred income taxes and changes in working capital, which were partially offset by a $10.0 million increase in net income adjusted for depreciation and amortization. The primary uses of cash in 2003 were for repurchases of stock ($39.1 million), capital expenditures ($28.1 million), a reduction of borrowed amounts ($17.0 million), the acquisition of Premier Systems, Inc. ($11.3 million) and dividend payments to shareholders ($9.8 million).
In March 2000, the Company's Board of Directors authorized the purchase of 2,900,000 shares of the Company's outstanding common stock. In January 2003, the Board authorized the repurchase of an additional 3,000,000 shares. Shares purchased under these programs may be held in treasury, used for acquisitions, used to fund the Company's stock benefit and compensation plans or for other corporate purposes. In 2003, the Company purchased a total of 1,569,532 shares under these programs at a cost of $39.1 million or an average cost of $24.92 per share. Of the total shares purchased in 2003, 1,147,554 shares concluded the authorization approved in 2000 to purchase 2,900,000 shares and the remaining 421,978 shares were purchased under the authorization approved in 2003 to purchase 3,000,000 shares.
Purchases of property, plant and equipment totaled $28.1 million in 2003, a decrease of $4.0 million compared to 2002 and were primarily for customer care infrastructure initiatives. In 2002, purchases of property, plant and equipment were primarily for customer care infrastructure initiatives and for digital printing equipment. The Company's customer care infrastructure initiatives focus on improving systems that support sales, marketing and customer service to ensure exceptional service and added functionality for the Company's call centers. The Company currently estimates it will spend approximately $60 to $65 million on customer care infrastructure initiatives over the four year period ending in 2004. As of December 31, 2003, $45.4 million has been expended on these initiatives, of which $32.0 million was capitalized. The Company currently estimates it will spend approximately $15 to $20 million on customer care infrastructure initiatives in 2004. Although development of customer care infrastructure will continue throughout 2004, the Company expects to delay implementation of certain functionality in the second half of 2004 in order to evaluate controls and processes as required by Section 404 of the Sarbanes-Oxley Act, thereby deferring certain expenditures into 2005.
In February 2004, the Company amended its credit facility (the "Credit Facility") with a syndicate of banks increasing the amount from $325.0 million to $425.0 million. The Credit Facility is comprised of a $100.0 million term loan and a $325.0 million revolving loan, both of which mature in 2009. The term loan requires annual repayments of $5.0 million, therefore the Credit Facility will decrease by $5.0 million per annum to $400.0 million at the 2009 maturity date. The Credit Facility may be used for general corporate purposes, including acquisitions, and includes both direct borrowings and letters of credit. The Credit Facility is unsecured and the Company presently pays a commitment fee of 0.175% on the unused amount of the Credit Facility. Borrowings under the Credit Facility bear interest, at the Company's option, based upon one of the following indices (plus a margin as defined): the Federal Funds Rate, the SunTrust Bank Base Rate or LIBOR. The Credit Facility has certain financial covenants including, among other items, leverage, fixed charge and minimum net worth requirements. The Credit Facility also has restrictions that limit the Company's ability to incur additional indebtedness, grant security interests or sell its assets beyond certain amounts.
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At December 31, 2003, the Company's previous credit facility consisted of $127.1 million in outstanding cash borrowings and $5.1 million in outstanding letters of credit. At December 31, 2003, the Company's previous credit facility permitted borrowings of $325.0 million, and had $192.8 million of availability. As discussed above, the amount of the Company's previous credit facility was increased by $100.0 million to $425.0 million in February 2004 thereby increasing the Company's borrowing capacity. The average interest rate in effect on outstanding cash borrowings at December 31, 2003, including the effect of the Company's interest rate hedging program (see Note 12 to the Consolidated Financial Statements), was 2.94%. At December 31, 2003, the Company had $8.5 million in cash and cash equivalents. The Company believes that its current cash position, funds from operations and the availability of funds under its Credit Facility will be sufficient to meet anticipated requirements for working capital, dividends, capital expenditures and other corporate needs. Management is not aware of any condition that would materially alter this trend.
The Company also believes that it possesses sufficient unused debt capacity and access to equity capital markets to pursue additional acquisition opportunities if funding beyond that available under the Credit Facility were required.
Contractual Obligations and Commitments
The following table aggregates the Company's contractual obligations and commitments with definitive payment terms, which will require significant cash outlays in the future. The commitment amounts are as of December 31, 2003 (in millions):
The Company's long-term debt obligations are described in Note 6 to the Consolidated Financial Statements. The Company's operating and capital lease obligations are described in Note 13 to the Consolidated Financial Statements. The Company has obligations, under contracts and purchase orders, to purchase goods or services, which are not recorded as obligations in the Company's Consolidated Financial Statement until contract terms take effect. The Company has acquisition related contingent payments that are described in Note 2 to the Consolidated Financial Statements. The Company's other long-term liabilities obligations are primarily for unfunded deferred compensation contracts with certain current and former officers.
The Company has postretirement benefit plans, which are described in Note 11 to the Consolidated Financial Statements. At December 31, 2003, the Company's accrued postretirement costs totaled $13.7 million. Because the determination of this amount is affected by changes in plan demographics and assumptions, it does not represent expected liquidity needs and has not been included in the above table of obligations. The Company expects to fund $1.6 million to these plans each year during 2004 through 2008 and expects to fund $7.5 million to these plans during 2009 through 2013.
At December 31, 2003, the Company had a net non-current deferred tax liability of $5.1 million. Deferred income tax liabilities are temporary differences between financial statement and tax bases of assets and liabilities and do not directly relate to the amount of income taxes to be paid in future periods. Therefore these liabilities have not been included in the above table of obligations.
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The Company has entered into a contract with a customer that contains provisions that call for future payments to the customer if the Company does not meet certain performance measures. The contract also contains provisions that call for the reduction or elimination of the Company's payment obligations if the customer does not meet certain performance requirements. The Company does not anticipate any payments pursuant to these contract provisions at this time.
ACCUMULATED OTHER COMPREHENSIVE LOSS
As of December 31, 2003, the Company's accumulated other comprehensive loss was $0.7 million and consisted primarily of foreign currency translation adjustments and fair value adjustments to cash flow hedging instruments.
ACQUISITIONS
All acquisitions in 2003, 2002 and 2001 were paid for with cash provided from operating activities and proceeds from the Company's previous credit facility. The acquisitions were accounted for using the purchase method of accounting and, accordingly, the results of operations of the acquired businesses have been included in the Company's operations since the particular acquisition closing dates (see Note 2 to the Consolidated Financial Statements).
2004 OUTLOOK
Net income during the first half of 2004 is expected to be less than net income during the comparable period of 2003 due to anticipated lower earnings in Printed Products. Reorganization expenses and anticipated inefficiencies related to plant consolidation activities during the first half of 2004 are expected to more than offset improved profitability in Software & Services and Scantron operations. The Company expects more favorable results in the second half of 2004 compared with the same period in 2003. Net income for the full year of 2004 is expected to be slightly lower than 2003 net income.
The Printed Products segment income is expected to improve during the year as cost reductions are implemented and after the bulk of the reorganization expenses and expenses required to support the increased use of an outsourcing model by many financial institutions have been incurred. Some duplicate costs will be incurred earlier in the year as the remaining plants are staffed up in anticipation of the actual closure of the plants already announced. The increased use of an outsourcing model by many financial institutions, which is expected to have a favorable impact on revenue per unit later in the year, and anticipated growth in other areas should contribute to a favorable earnings trend.
The Software & Services segment income is expected to improve in 2004 as a result of a full-year impact of a 2003 acquisition as well as the impact of new products and services including a new mortgage product scheduled for release during the first half of 2004.
The Scantron segment is expected to benefit from continuing strong sales of traditional products as well as growth in the sales of existing and new technology products. Scantron should also benefit from cost reduction initiatives implemented throughout 2003.
The Company believes cash flow will remain strong in all business units in 2004. The Company currently estimates that capital expenditures will be in the range of $27 million to $32 million. The Company believes refundable contract payments in 2004 will be made at a higher level than existed before 2003, but expects such payments to be less than in 2003 depending upon the timing and extent of new contracts in 2004. The Company currently expects depreciation and amortization will total approximately $80 million in 2004, a $17 million increase over 2003, primarily due to the amortization of refundable contract payments (see Note 1 to the Consolidated Financial Statements). The Company expects its effective tax rate will be approximately 38% in 2004.
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RISK FACTORS AND CAUTIONARY STATEMENTS
When used in this report and in subsequent filings by the Company with the Securities and Exchange Commission, in the Company's press releases and in written or oral statements made by authorized representatives of the Company, the words or phrases "believe," "should result," "are expected to," "will continue," "is anticipated," "estimate," "project" or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are necessarily subject to certain risks and uncertainties, including, but not limited to, those discussed below that could cause actual results to differ materially from the Company's historical experience and its present expectations or projections. Caution should be taken not to place undue reliance on any such forward-looking statements, which speak only as of the date such statements are made and which may or may not be based on historical experiences and/or trends which may or may not continue in the future. The Company does not undertake and specifically declines any obligation to update any forward-looking statements to reflect events or circumstances occurring after the date of such statements or to reflect the occurrence of unanticipated events.
Various factors may affect the Company's financial performance, including, but not limited to, those factors discussed below which could cause the Company's actual results for future periods to differ from any opinions, statements or projections expressed with respect thereto. Such differences could be material and adverse. Many variables will impact the ability to achieve sales levels, improve service quality, achieve production efficiencies and reduce expenses in Printed Products. These include, but are not limited to, the continuing upgrade of the Company's customer care infrastructure and systems used in the Company's manufacturing, sales, marketing, customer service and call center operations.
Several factors outside the Company's control could negatively impact check revenues. These include the continuing expansion of alternative payment systems such as credit cards, debit cards and other forms of electronic commerce or on-line payment systems. Check revenues may continue to be adversely affected by continued consolidation of financial institutions, competitive check pricing including significant up-front contract incentive payments, and the impact of governmental laws and regulations. There can be no assurances that the Company will not lose significant customers or that any such losses could be offset by the addition of new customers.
While the Company believes substantial growth opportunities exist in the Software & Services segment, there can be no assurances that the Company will achieve its revenue or earnings growth targets. The Company believes there are many risk factors inherent in its Software & Services business, including but not limited to the retention of employee talent and customers. Also, variables exist in the development of new Software & Services products, including the timing and costs of the development effort, product performance, functionality, product acceptance, competition, the Company's ability to integrate acquired companies, and general changes in economic conditions or U.S. financial markets.
Several factors outside of the Company's control could affect results in the Scantron segment. These include the rate of adoption of new electronic data collection solutions and testing and assessment methods, which could negatively impact forms, scanner sales and related service revenue. The Company continues to develop products and services that it believes offer state-of-the-art electronic data collection and testing and assessment solutions. However, variables exist in the development of new testing methods and technologies, including the timing and costs of the development effort, product performance, functionality, market acceptance, adoption rates, competition, the Company's ability to integrate acquired companies, and the funding of education at the federal, state and local levels, all of which could have an impact on the Company's business.
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As a matter of due course, the Company and its subsidiaries are subject to various federal and state tax examinations. The Company believes that it is in compliance with the various federal and state tax regulations imposed and such returns and reports filed with respect to such tax regulations are materially correct. The results of these various federal and state tax examinations could produce both favorable and unfavorable adjustments to the Company's total tax expense either currently or on a deferred basis. At such time when a favorable or unfavorable adjustment is known, the effect on the Company's consolidated financial statements is recorded.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
All financial instruments held by the Company are held for purposes other than trading. The Company is exposed primarily to market risks related to interest rates.
Interest Rate Risk
The Company is exposed to interest rate risk on its variable rate debt. At December 31, 2003, the Company had outstanding variable rate debt of $127.1 million. In order to manage its exposure to fluctuations in interest rates, the Company has entered into interest rate swap agreements, which allow it to raise funds at floating rates and effectively swap them into fixed rates. The notional principal amount of interest rate swaps outstanding was $59.0 million at December 31, 2003 and $114.0 million at December 31, 2002. These derivative financial instruments are viewed as risk management tools and are entered into for hedging purposes only. The Company does not use derivative financial instruments for trading or speculative purposes. The Company believes that its interest rate risk at December 31, 2003 was minimal. The impact on annual results of operations of a hypothetical one-point interest rate change on the outstanding debt as of December 31, 2003 would be approximately $681,000.
The fair value of the swaps, which represent what the Company would have to pay to terminate the swaps, reflected a loss of $0.4 million ($0.3 million net of income taxes) at December 31, 2003. The fair value of the swaps was recognized on the balance sheet in other liabilities with a corresponding charge to accumulated other comprehensive income, a component of shareholders' equity. Charges and credits to other comprehensive income will net to zero over the term of interest rate swap agreements.
ACCOUNTING PRONOUNCEMENTS
See Note 1 to the Consolidated Financial Statements regarding the impact of recent accounting pronouncements on the Company's financial condition and results of operations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Significant Accounting Policies
Consolidation
The consolidated financial statements include the financial statements of John H. Harland Company and its majority-owned subsidiaries (the "Company"). Intercompany balances and transactions have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash Equivalents
The Company considers all highly liquid debt instruments with a maturity, when purchased, of three months or less to be cash equivalents.
Inventories
Inventories are stated at the lower of cost or market. Cost of inventory for checks and related forms is determined by average costing. Cost of scannable forms and hardware component parts inventories is determined by the first-in, first-out method. Cost of data entry terminals is determined by the specific identification method.
Impairment of Long-Lived Assets
Assets held for disposal are carried at the lower of carrying amount or fair value, less estimated cost to sell such assets. The Company reviews long-lived assets and certain intangible assets for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.
Investments
The Company classifies all of its investments as available-for-sale securities. Such investments consist of U.S. corporate securities and other equity interests which are stated at market value, with unrealized gains and losses on such investments reflected, net of tax, as other comprehensive income in shareholders' equity. Realized gains and losses on investments are included in earnings and are derived using the specific identification method. If the market value of an investment declines below its cost, the Company evaluates whether the decline is temporary or other than temporary. The Company considers several factors in determining whether a decline is temporary including the length of time market value has been below cost, the magnitude of the decline, financial prospects of the business and the Company's intention to hold the security. If a decline in market value of an investment is determined to be other than temporary, the carrying amount is written down and included in current earnings. In June 2002 and September 2001, the Company determined that the decline in market value of Netzee, Inc. ("Netzee") was other than temporary. Accordingly, the Company's investment in Netzee was written down resulting in a recognized loss of $0.3 million in 2002 and $7.8 million in 2001. In December 2002, the Company realized a $1.8 million loss on the disposition of debt and equity investments resulting from the sale of Netzee. In 2003, the Company sold its investments in U.S. corporate securities and recorded a gain before income taxes of $3.0 million.
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The following is a summary of investments at December 31, 2003 and 2002 (in thousands):
Goodwill and Other Intangible Assets
In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement No. 141, "Business Combinations" ("SFAS 141") and Statement No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), which address, among other things, accounting for goodwill and other intangible assets. On July 1, 2001, the Company adopted SFAS 141 and adopted the portions of SFAS 142 that were effective for goodwill and intangible assets acquired after June 30, 2001. Effective January 1, 2002, the Company adopted the remaining portions of SFAS 142 and discontinued amortizing goodwill (see Note 3 for the effects of adopting this standard).
Goodwill represents the excess of acquisition costs over the fair value of net assets of businesses acquired. Goodwill acquired prior to July 1, 2001 was amortized on a straight-line basis (over periods ranging from 11 to 40 years) through 2001 after which time amortization of goodwill was discontinued. The Company reviews goodwill for impairment annually in accordance with the provisions of SFAS 142. In 2002, the Company engaged an independent valuation firm to perform a goodwill impairment test. Based on the analysis, there was no impairment of goodwill upon adoption of SFAS 142. In 2003, the Company's annual review of goodwill indicated there was no impairment.
Other intangible assets consist primarily of purchased customer lists, developed technology, content and trademarks that were acquired in business combinations. Other intangible assets are generally amortized on a straight-line basis over periods ranging from four to ten years. Amortization periods of other intangible assets are periodically reviewed to determine whether events or circumstances warrant revision to estimated useful lives. Carrying values of other intangible assets are periodically reviewed to assess recoverability based on expectations of undiscounted cash flows and operating income for each related business unit.
Refundable Contract Payments
Certain contracts with the Company's customers involve up-front payments to the customer. These payments are amortized as a reduction of sales over the life of the related contract and are refundable from the customer on a pro-rata basis if the contract is terminated.
Software and Other Development Costs
The Company expenses research and development costs, including expenditures related to development of software products that do not qualify for capitalization. Research and development costs, which are primarily costs incurred related to the development of software, totaled $22.6 million, $14.5 million and $15.0 million in 2003, 2002 and 2001, respectively.
Software development costs incurred prior to the establishment of technological feasibility are expensed as incurred. Software development costs incurred after the technological feasibility of the subject software product has
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been established are capitalized in accordance with FASB Statement No. 86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed." Capitalized software development costs are amortized on a product-by-product basis using the estimated economic life of the product on a straight-line basis over three to six years. Unamortized software development costs in excess of estimated future net revenues from a particular product are written down to their estimated net realizable value.
The Company accounts for costs to develop or obtain computer software for internal use in accordance with Accounting Standards Executive Committee Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," which requires certain costs to be capitalized.
Property, Plant and Equipment
Property, plant and equipment are carried at cost. Depreciation of buildings is computed primarily by the declining balance method. Depreciation of equipment, furniture and fixtures is calculated by the straight-line or sum-of-the-years digits method. Leasehold improvements are amortized by the straight-line method over the life of the lease or the life of the property, whichever is shorter. The Company capitalizes the qualifying costs of software developed or obtained for internal use. Depreciation is computed for internal use software by using the straight-line method over three to seven years.
Depreciation expense was $39.5 million, $36.9 million and $33.3 million in 2003, 2002 and 2001, respectively.
Self-Insurance
The Company is primarily self-insured for workers' compensation and group medical costs. Provisions for losses expected under these programs are recorded based on the Company's estimates of the aggregate liabilities for the claims incurred. Payments for claims beyond one year have been discounted. As of December 31, 2003 and 2002, the combined liabilities for workers compensation and group medical liability were $9.6 million and $8.8 million, respectively.
Risk Management Contracts
The Company recognizes all derivatives at fair value as either assets or liabilities in the consolidated balance sheets and changes in the fair values of such instruments are recognized currently in earnings unless specific hedge accounting criteria are met. If specific hedge accounting criteria are met, the Company recognizes the changes in fair value of these instruments in other comprehensive income.
The Company uses derivative financial instruments to manage interest rate risk. On the date the interest rate derivative contract is entered into, the Company designates the derivative as either a fair value hedge or a cash flow hedge. The Company formally documents the relationship between hedging instruments and the hedged items, as well as its risk-management objectives and strategy for undertaking various hedge transactions. The Company links all hedges that are designated as fair value hedges to specific assets or liabilities on the balance sheet or to specific firm commitments. The Company links all hedges that are designated as cash flow hedges to forecasted transactions or to floating-rate liabilities on the balance sheet. The Company also assesses, both at the inception of the hedge and on an on-going basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. Should it be determined that a derivative is not highly effective as a hedge, the Company will discontinue hedge accounting prospectively.
During 2003, 2002 and 2001, the Company recorded the changes in values related to cash flow hedges in other comprehensive income and such changes were not material. In 2003, 2002 and 2001, the Company did not have any hedging instruments that were designated as fair value hedges.
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Translation of Foreign Currencies
Financial statement accounts that are maintained in foreign currencies are translated into U.S. dollars. Assets and liabilities denominated in foreign currencies are translated at end-of-period exchange rates. Results of operations denominated in foreign currencies are translated using average exchange rates for the year. The resulting currency translation adjustments are reported in accumulated other comprehensive income. Realized currency exchange gains and losses resulting from transactions are included in earnings as incurred and were not significant in 2003, 2002 or 2001. The Company considers undistributed earnings of foreign subsidiaries to be permanently invested. As a result, no income taxes have been provided on these undistributed earnings or on the foreign currency translation adjustments recorded as a part of other comprehensive income.
Revenue Recognition
The Company recognizes product and services revenue when persuasive evidence of a non-cancelable arrangement exists, delivery has occurred and/or services have been rendered, the price is fixed or determinable, collectibility is reasonably assured, legal title and economic risk is transferred to the customer and when an economic exchange has taken place.
For multiple-element software arrangements, total revenue is allocated to each element based on the fair value method or the residual method when applicable. Under the fair value method, the total revenue is allocated among the elements based upon the relative fair value of each element as determined through vendor-specific objective evidence. Under the residual method, the fair value of the undelivered maintenance, training and other service elements, as determined based on vendor-specific objective evidence, is deferred and the remaining (residual) arrangement is recognized as revenue at the time of delivery. Maintenance fees are deferred and recognized ratably over the maintenance period, which is usually twelve months. Training revenue is recognized as the services are performed.
Revenue from licensing of software under usage-based contracts is recognized ratably over the term of the agreement or on an actual usage basis. Revenue from licensing of software under limited term license agreements is recognized ratably over the term of the agreement.
For software that is installed and integrated by the Company or customer, revenue is recognized upon shipment assuming functionality has already been proven and there are no customizations that would cause a substantial acceptance risk. For software that is installed, customized and integrated by the Company, revenue is recognized on a percentage-of-completion basis as the services are performed. Estimates of efforts to complete a project are used in the percentage-of-completion calculation. Due to the uncertainties inherent in these estimates, actual results could differ from those estimates.
The contractual terms of software sales do not provide for product returns or allowances. However, on occasion, the Company may allow for returns or allowances primarily in the case of a new product release. Provisions for estimated returns and sales allowances are established by the Company concurrently with the recognition of revenue and are based on a variety of factors including actual return and sales allowance history and projected economic conditions. The Company has not incurred any significant amount of returns or sales allowances in 2003, 2002 or 2001.
Service revenues are comprised of revenues derived from software maintenance agreements, field maintenance services, core processing service bureau deliverables, analytical services, consulting services and training services.
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Shipping and Handling
Revenue received from shipping and handling fees is reflected in net sales. Costs related to shipping and handling are included in cost of goods sold.
Stock-Based Compensation
The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations in accounting for its stock-based compensation plans and applies the disclosure-only provisions of FASB Statement No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), as amended by FASB Statement No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" ("SFAS 148").
The Company recognizes stock-based compensation expense for restricted stock granted to employees and also for the deferred compensation plan for non-employee directors. No stock-based compensation cost is reflected in net income for options or purchases under the employee stock purchase plan. Had compensation cost for options granted under the Company's stock-based compensation plans and purchases under the employee stock purchase plan been determined based on the fair value at the grant dates consistent with SFAS 123, the Company's net income and earnings per share would have changed to the pro forma amounts listed below (in thousands, except per share amounts):
See Note 9 for more information regarding the Company's stock compensation plans and the assumptions used to prepare the pro forma information presented above.
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Earnings Per Common Share
Earnings per common share for the years ended December 31, 2003, 2002 and 2001 have been computed under the provisions of FASB Statement No. 128, "Earnings Per Share." The computation of basic and diluted earnings per share was as follows (in thousands, except per share amounts):
The potentially dilutive common shares relate to options and restricted stock granted under stock compensation plans. Potentially dilutive common shares that were not included in the calculation of diluted earnings per share for 2003, 2002 and 2001 because they were anti-dilutive were 77,530, 57,000 and 151,000, respectively.
Income Taxes
The Company recognizes a liability or asset for the deferred tax consequences of temporary differences between financial statement and tax bases of assets and liabilities. A valuation allowance is provided for deferred tax assets for which realization cannot be considered likely.
New Accounting Standards
In April 2002, the FASB issued Statement No. 145, "Rescission of FASB Statements 4, 44 and 64, Amendment to FASB Statement 13, and Technical Corrections" ("SFAS 145"). One of the major changes of SFAS 145 is to change the accounting for the classification of gains and losses from the extinguishment of debt. The Company adopted SFAS 145 on January 1, 2003 and uses APB Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" in determining whether such extinguishment of debt may be classified as extraordinary. Adoption of SFAS 145 did not have a material effect on the Company's financial position or results of operations.
In June 2002, the FASB issued Statement No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS 146"). SFAS 146 requires
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recording costs associated with exit or disposal activities at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management's commitment to an exit plan, which is generally before an actual liability has been incurred. The Company adopted SFAS 146 on January 1, 2003. Adoption of SFAS 146 did not have a material effect on the Company's financial position or results of operations. The Company has applied the provisions of SFAS 146 to the Company's reorganization actions initiated in September 2003 (see Note 5).
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Guarantees of Indebtedness of Others" ("FIN 45"), which requires companies to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45 provides specific guidance identifying the characteristics of contracts that are subject to its guidance in its entirety from those only subject to the initial recognition and measurement provisions. The recognition and measurement provisions of FIN 45 are effective on a prospective basis for guarantees issued or modified after December 31, 2002. The Company adopted the recognition and measurement provisions of FIN 45 on January 1, 2003. Adoption of these provisions did not have a material effect on the Company's financial position or results of operations.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"). FIN 46 provides accounting requirements for business enterprises to consolidate related entities in which they are determined to be the primary beneficiary as a result of their variable economic interests. The interpretation provides guidance in judging multiple economic interests in an entity and in determining the primary beneficiary. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied in 2004. In December 2003, the FASB published a revision to FIN 46 ("FIN 46R") to clarify some of the provisions of the interpretation and to defer the effective date for certain entities. Under the guidance of FIN 46R, entities that do not have an interest in structures that are commonly referred to as special purpose entities are required to apply the provisions of the interpretation in financial statements for periods ending after March 14, 2004. The Company adopted certain provisions of FIN 46 during the second quarter of 2003 and this adoption did not have a material effect on the Company's financial position or results of operations. The Company believes that the adoption of the remaining provisions of FIN 46 will not have a material effect on its financial position or results of operations.
In April 2003, the FASB issued Statement No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS 149"). SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS 149 requires that contracts with comparable characteristics be accounted for similarly for contracts entered into or modified after June 30, 2003. The Company adopted SFAS 149 on July 1, 2003. Adoption of SFAS 149 did not have a material effect on the Company's financial position or results of operations.
In May 2003, the FASB issued Statement No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity" ("SFAS 150"). SFAS 150 requires that an issuer classify financial instruments that are within its scope as a liability (or an asset in some circumstances) instead of equity as previously classified. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise effective at the beginning of the first interim period beginning after June 15, 2003. As a result of concerns over implementation and measurement issues, the FASB unanimously decided on October 29, 2003 to defer the application of SFAS 150 to certain non-controlling interests of limited-life entities that are consolidated in the financial statements. Adoption of SFAS 150 did not have a material effect on the Company's financial position or results of operations.
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Reclassifications
During the third quarter of 2003, the Company reclassified certain items in its consolidated income statements. The reclassifications affected the categories of Selling, General and Administrative expenses and Other Income (Expense). The change primarily reflects the reclassification of gains or losses on the sale of assets as well as certain other expenses from Other Income (Expense) to Selling, General and Administrative expenses. Financial data for all periods presented have been reclassified for comparability. The reclassifications had no impact on net income or shareholders' equity as previously reported. Certain other reclassifications have been made in the 2002 and 2001 financial statements and notes to financial statements to conform to the 2003 classifications.
2. Acquisitions
All acquisitions in 2003, 2002 and 2001 were paid for with cash provided from operating activities and proceeds from the Company's credit facility. The results of operations of each acquired business have been included in the Company's operations beginning as of the date of the particular acquisition.
2003 Acquisition
On June 3, 2003, Harland Financial Solutions, Inc. ("HFS"), a wholly owned subsidiary of the Company, extended its core systems offering with the acquisition of 100% of the equity of Premier Systems, Inc. ("PSI") for approximately $11.3 million, net of cash acquired. The fair value of assets and liabilities at the date of acquisition consisted of non-deductible goodwill of $9.5 million, customer list of $6.0 million (estimated useful life of ten years), other assets of $4.3 million and assumed liabilities of $8.5 million. The allocation of purchase price is subject to refinement as the Company finalizes the valuation of certain assets and liabilities. The pro forma effects on the results of operations for the acquisition were not material. PSI was a provider of core processing service bureau deliverables that were based on HFS' widely used ULTRADATA(R) System. With the addition of PSI, HFS now provides core processing applications and services to more than 1,000 financial institutions.
2002 Acquisitions
On October 15, 2002, HFS, acquired 100% of the equity in INTERLINQ Software Corporation ("INTERLINQ") for approximately $23.0 million, net of cash acquired. INTERLINQ was a leading provider of mortgage loan origination, production and servicing solutions. As part of the acquisition, the Company acquired in-process research and development costs totaling $3.0 million, which were immediately expensed following the acquisition. These costs represented the fair value of certain acquired research and development projects that were determined to have not reached technological feasibility. As a result of the acquisition, the Company believes HFS has a leadership position in the mortgage loan origination market and good growth opportunity in the mortgage servicing market.
On September 20, 2002, HFS extended its core systems offering with the acquisition of certain assets and related liabilities of SPARAK Financial Systems, LLC ("SPARAK") for approximately $31.9 million, net of cash acquired. The acquisition agreement included a contingent purchase payment not to exceed $2.0 million to be made in the event certain growth targets were achieved as defined in the agreement. As of December 31, 2003, the end of the measurement period, those growth targets were not achieved and as a result, no contingent payments will be made. SPARAK was a leading provider of integrated hardware and software systems for community banks. The acquisition was completed to build on the HFS leadership position in the financial institutions market and add additional value for SPARAK's existing customers.
On July 24, 2002, Scantron Corporation ("Scantron"), a wholly owned subsidiary of the Company, acquired 100% of the equity in EdVISION Corporation ("EdVISION") for approximately $28.8 million, net of cash acquired. Related to the acquisition of EdVISION, the Company entered into an incentive agreement with certain individuals that includes contingent payments to be made in the event certain growth targets are achieved as defined in the incentive agreement. These contingent payments, which will not exceed $2.0 million, are payable
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during or before 2005 and will be expensed at the time of payment to the extent such payments are ultimately made. As of December 31, 2003, no contingent payments have been made. EDVISION was a leading provider of curriculum development and assessment tools for the education industry. This acquisition expands Scantron's ability to offer advanced testing and assessment tools in the education market.
On May 28, 2002, HFS acquired 100% of the equity in Easy Systems, Inc. ("Easy Systems") for approximately $10.8 million, net of cash acquired. Easy Systems was a software solutions company that provided turnkey branch automation solutions for the community bank market. The addition of Easy Systems allows HFS to offer financial institutions proven and leading-edge solutions to help them strengthen customer relationships while improving operations.
The combined purchase price for net assets acquired through acquisitions in 2002 totaled $94.5 million, net of cash acquired. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed on the acquisition dates (in thousands):
The allocation of purchase price to intangible assets included $3.0 million for acquired in-process research and development costs that were written off at the date of acquisition. Those write-offs are disclosed separately in the statements of income. The remaining $25.8 million of acquired intangible assets have a weighted average useful life of approximately 7.7 years.
The allocations of the purchase price to the assets and liabilities acquired in 2002 resulted in $79.1 million allocated to goodwill of which $26.4 million is expected to be deductible for tax purposes. Goodwill of $54.2 million and $24.9 million was assigned to the Company's Software & Services and Scantron business segments, respectively.
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The following unaudited pro forma summary presents information as if the acquisitions of the businesses acquired in 2002 occurred at the beginning of that year, as well as the beginning of the immediately preceding year (in thousands, except per share amounts):
The unaudited pro forma summary for all periods presented includes adjustments for increased amortization of intangible assets and increased interest expense. The pro forma summary also includes the write-off of acquired in-process research and development costs totaling $3.0 million for each of the years ended December 31, 2002 and 2001. The unaudited pro forma summary does not purport to be indicative of either the results of operations that would have occurred had the acquisitions taken place at the beginning of the periods presented or of future results.
2001 Acquisitions
In March 2001, Scantron acquired 100% of the equity in ImTran, Inc. ("ImTran"). ImTran was a data collection and document capture solutions firm specializing in automated data collection and document imaging. In October 2001, the Company's Printed Products segment acquired the assets of DocuPrint, Incorporated ("DocuPrint"). DocuPrint produced forms for major financial institutions. Also in October 2001, the Company's Scantron subsidiary acquired substantially all the assets of the Scanning Systems division of Associated Business Products, Inc., a subsidiary of Global DocuGraphix, Inc., for approximately $6.0 million in cash.
Assets acquired through acquisitions in 2001 totaled $7.5 million. Of the total 2001 consideration paid, $5.8 million was allocated to goodwill of which $5.7 million was assigned to the Scantron segment. The pro forma effects on results of operations for the 2001 business acquisitions were not material.
3. Goodwill and Intangible Assets
Under SFAS 142, goodwill and intangible assets with indefinite lives are no longer amortized but are tested at least annually for impairment. Separable intangible assets with definitive lives will continue to be amortized over their useful lives.
The following presents a reconciliation of net income and earnings per share information for the years ended December 31, 2003, 2002 and 2001 adjusted for the provisions of SFAS 142 to exclude the amortization of goodwill and other indefinite-lived intangible assets (in thousands, except per share amounts):
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The changes in the carrying amounts of goodwill by business segment for the years ended December 31, 2003 and 2002 are as follows (in thousands):
Intangible assets with definitive lives at December 31, 2003 and 2002 were comprised of the following (in thousands):
Carrying amounts of developed technology and content are included in the other assets caption on the balance sheets and the related amortization expense is included in the cost of goods sold caption on the statements of income.
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Aggregate amortization expense for intangible assets totaled $8.8 million and $7.5 million for the years ended December 31, 2003 and 2002, respectively.
The estimated intangible amortization expense for each of the next five years beginning January 1, 2004 is as follows (in thousands):
4. Property Held for Sale
At December 31, 2003, property held for sale consisted of the Company's Printed Products facility in St. Louis, Missouri. At December 31, 2002, property held for sale consisted of Printed Products facilities in Portland, Oregon and St. Louis, Missouri. These facilities were closed in 2002 as part of a production consolidation program and reclassified as held for sale during 2002. In 2003, the Company sold the Portland facility and realized a pre-tax gain of $0.8 million, which was included as a reduction of selling, general and administrative expenses on the statements of income. Management is actively marketing the sale of the St. Louis facility and believes this facility will be sold within the next 12 months.
Property held for sale at December 31, 2003 and 2002 consists of the following (in thousands):
5. Reorganization
In September 2003, the Company announced a reorganization of its Printed Products operations including a plan to consolidate its domestic manufacturing operations from 14 plants to 9 plants, with the first plant closing in the first quarter of 2004 and the last affected plant closing in the third quarter of 2004. Two of the facilities being closed are leased. One facility is under lease through late 2005 and the other is under lease through mid 2010. In addition to the plant consolidation, Printed Products implemented other staffing reductions beginning in the fourth quarter of 2003 and will continue with additional staffing reductions throughout 2004. These actions are primarily due to excess capacity in production facilities resulting from efficiencies realized from digital printing technology and other production and support systems and lower volumes attributable to the losses of certain large customers including a direct check marketer and general market volume decline.
The Company estimates net pre-tax expenses associated with the plant consolidations will total $10.7 million consisting of employee severance ($3.1 million), revision of depreciable lives and salvage values of furniture and equipment, asset impairment charge and disposal gains and losses ($2.2 million), relocation and other costs ($2.8 million) and contract termination costs related to leaseholds ($2.6 million). The other staffing reduction actions will result in a total estimated expenses of $5.9 million related to employee severance costs. The Company believes these actions will bring its production and support structures in line with its business levels.
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In 2003, plant consolidation costs totaled $4.0 million, which consisted of $2.1 million related to the revision of depreciable lives and salvage values of furniture and equipment, $1.7 million for employee severance costs and $0.2 million for relocation and other costs. Employee severance costs for other staffing reduction actions totaled $2.9 million. These costs are included in the results of operations in 2003 with plant consolidation costs included in cost of goods sold and the other staffing reduction costs included in selling, general and administrative expenses.
Severance and other cash payments made in 2001 and 2002 related primarily to costs recognized in 2000 when the Company reorganized into three distinct segments.
The following reconciles the beginning and ending liability balances for 2003, 2002 and 2001 related to these actions and are included in the other accrued liabilities caption on the balance sheet (in thousands):
6. Long-Term Debt
In February 2004, the Company amended its credit facility (the "Credit Facility") with a syndicate of banks increasing the amount from $325.0 million to $425.0 million. The Credit Facility is comprised of a $100.0 million term loan and a $325.0 million revolving loan, both of which mature in 2009. The term loan requires annual repayments of $5.0 million. As a result, the Credit Facility will decrease by $5.0 million per annum to $400.0 million at the 2009 maturity date. The Credit Facility may be used for general corporate purposes, including acquisitions, and includes both direct borrowings and letters of credit. The Credit Facility is unsecured and the Company presently pays a commitment fee of 0.175% on the unused amount of the Credit Facility. Borrowings under the Credit Facility bear interest, at the Company's option, based upon one of the following indices (plus a margin as defined): the Federal Funds Rate, the SunTrust Bank Base Rate or LIBOR. The Credit Facility has certain financial covenants including, among other items, leverage, fixed charge and minimum net
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worth requirements. The Credit Facility also has restrictions that limit the Company's ability to incur additional indebtedness, grant security interests or sell its assets beyond certain amounts. In order to reflect the terms of the amended Credit Facility, the Company reclassified $122.0 million of its outstanding debt at December 31, 2003 to long-term.
Long-term debt consisted of the following as of December 31, 2003 and 2002 (in thousands):
At December 31, 2003, the Credit Facility consisted of $127.1 million in outstanding cash borrowings and $5.1 million in outstanding letters of credit. At December 31, 2003, the Company's previous credit facility permitted borrowings of $325.0 million and had $192.8 million of availability. Subsequently, the Company's previous credit facility was amended, as described above, increasing by $100.0 million to an amount of $425.0 million. The average interest rate in effect on outstanding cash borrowings at December 31, 2003 and 2002, including the effect of the Company's interest rate hedging program (see Note 12), was 2.94% and 3.98%, respectively.
Other long-term debt relates to other miscellaneous obligations. At December 31, 2003, the Company believes it was in compliance with the covenants associated with all debt instruments. Annual maturities of long-term debt during the next five years are $5.1 million in 2004 and $5.0 million annually during the years 2005 through 2008.
7. Income Taxes
The income tax provision (benefit) for the years ended December 31, 2003, 2002 and 2001 consisted of the following (in thousands):
The Company utilized net operating losses, capital losses and tax credits of $8,623,000, $5,685,000 and $6,551,000 in the calculation of current tax expense for the years ended December 31, 2003, 2002 and 2001, respectively.
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The tax effects of significant items comprising the Company's net deferred tax assets as of December 31 were as follows (in thousands):
At December 31, 2003 and 2002, the total of all deferred tax assets was $135.2 million and $123.3 million, respectively, and the total of all deferred tax liabilities was $79.5 million and $67.5 million, respectively.
At December 31, 2003, there was a $2.5 million valuation allowance for federal and state net operating losses, which will be recorded as a reduction to goodwill if utilized. During 2001, the Company utilized approximately $1.7 million of capital losses recognized in a prior year to offset unrealized capital gains associated with investments recorded in other comprehensive income.
At December 31, 2003, the Company had net operating and capital loss carryforwards and other tax credits available for federal and state income tax purposes, which expire as indicated below (in thousands):
A substantial amount of these federal tax carryforwards were acquired in the acquisitions the Company made in 2000 and 2002. Therefore, utilization of these tax carryforwards is subject to an annual limitation under the Internal Revenue Code and Regulations.
The Company has established a valuation allowance for certain net operating loss and capital loss carryforwards. Management believes that, based on a number of factors, the available objective evidence creates uncertainty regarding the utilization of these carryforwards.
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The following reconciles the income tax provision at the U.S. federal income tax statutory rate of 35% to that in the financial statements (in thousands):
The reduction in the valuation allowance in 2003 was a result of the utilization of capital loss carryforwards for which a valuation allowance had been recorded in 2001. The valuation allowance increased in 2001 as certain capital loss carryforwards were not expected to be utilized before their expiration.
8. Shareholders' Equity
In March 2000, the Company's Board of Directors authorized the purchase of 2,900,000 shares of the Company's outstanding common stock. In January 2003, the Board authorized the purchase of an additional 3,000,000 shares. Shares purchased under these programs may be held in treasury, used for acquisitions, used to fund the Company's stock benefit and compensation plans or for other corporate purposes.
In 2003, the Company purchased a total of 1,569,532 shares under these programs at a cost of $39.1 million or an average cost of $24.92 per share. Of the total shares purchased in 2003, 1,147,554 shares concluded the authorization approved in 2000 to purchase 2,900,000 million shares and the remaining 421,978 shares were purchased under the authorization approved in 2003 to purchase 3,000,000 shares.
In 1999, the Company renewed its Shareholder Rights Agreement. The rights were distributed as a dividend at the rate of one right for each share of common stock of the Company held by shareholders of record. Each right entitles shareholders to buy, upon occurrence of certain events, $180.00 worth of common stock for $90.00, subject to adjustment based on the market value of such common stock at that time. The rights generally will be exercisable only if a person or group acquires beneficial ownership of 15% or more of the Company's common stock, or commences a tender or exchange offer that, upon consummation, would result in a person or group owning 30% or more of the Company's common stock. Under certain circumstances the rights are redeemable at a price of $0.001 per right. The rights expire on July 5, 2009.
9. Stock Compensation Plans
Under the Company's Employee Stock Purchase Plan ("ESPP"), the Company is authorized to issue up to 5,100,000 shares of common stock to its employees, most of whom are eligible to participate. Under the ESPP, eligible employees may exercise an option to purchase shares of Company stock through payroll deductions. The option price is 85% of the lower of the beginning-of-quarter or end-of-quarter market price. During 2003, 2002, and 2001, employees exercised options to purchase 154,953, 111,883 and 116,450 shares, respectively. Options granted under the ESPP were at prices ranging from $18.99 to $22.67 in 2003, $18.30 to $24.51 in 2002 and $12.03 to $18.62 in 2001. At December 31, 2003, there were 484,482 shares of common stock reserved for issuance under the ESPP.
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Under the Company's 1999 Stock Option Plan, the Company may grant stock options to key employees to purchase shares of Company stock at no less than the fair market value of the stock on the date of the grant or issue restricted stock to such employees. The Company is authorized to issue up to 2,000,000 shares of common stock under the plan. Stock options have a maximum life of ten years and generally vest ratably over a five-year period beginning on the first anniversary date of the grant. Upon adoption of the 1999 plan, the Company terminated a previous plan except for options outstanding thereunder. Options granted under such plan are generally exercisable ratably over a five-year period beginning on the first anniversary of the date of grant, and have a maximum life of ten years. Certain options granted in 1998 and 1999 vest per specified schedules beginning one to five years from the date of the grant.
In 2000, the Company adopted the 2000 Stock Option Plan which authorizes the issuance of up to 3,000,000 shares through stock options and grants of restricted stock. The 2000 Plan is substantially similar to the 1999 Plan, except that the Company's executive officers are ineligible to receive options or stock grants thereunder.
In 2002, the Company adopted the 2002 Stock Option Plan which authorizes the issuance of up to 1,000,000 shares through stock options and grants of restricted stock. The 2002 plan is substantially similar to the 1999 plan.
As of December 31, 2003, there were 4,901,857 shares of common stock reserved for issuance under these stock option plans.
Restricted stock grants generally vest over a period of five years, subject to earlier vesting if the Company's common stock outperforms the S&P 500 in two of three consecutive years. Unearned compensation is recorded at the date of the award based on the market value of shares issued and is amortized over the period of restriction. The certificates covering the restricted stock are not issued until the restrictions lapse but the shares have all the rights of other shares of common stock, subject to certain restrictions. The restricted stock is generally forfeited if the employee is terminated for any reason prior to the lapse in restrictions, other than death or disability.
In December 2002, the conditions for early vesting were met on 120,450 shares after the Company's common stock outperformed the S&P 500 in 2002 and 2001.
In February 2001, the Company effected a voluntary program allowing certain officers to exchange certain options for a grant of restricted stock. Options to purchase 840,000 shares with a weighted average exercise price of $24.09 were exchanged for 295,905 shares of restricted stock. At the same time, an additional 105,500 shares of restricted stock were granted to such officers as part of an annual grant. These shares of restricted stock vest to the extent of one third of the grant when the closing stock price reaches at least $22.50 for ten consecutive trading days and two thirds of the grant vest when the closing stock price similarly reaches at least $27.00. In August 2001, the vesting conditions for one third of these shares were met and, in February 2002, the vesting conditions on the remaining two thirds were met.
In April 2002, upon approval of the 2002 Stock Option Plan by the Company's shareholders, the Company's Chief Executive Officer was granted 50,000 restricted shares. The restrictions expire annually on 12,500 shares beginning in December 2002 and are subject to earlier vesting if the Company's common stock outperforms the S&P 500 in two of three consecutive years. All restricted stock granted to the Company's Chief Executive Officer vests in the event of a change in control, termination of employment without cause or resignation for good reason. He was also granted an option at such time to purchase 400,000 shares at $31.00 per share. This option has a ten-year life and was fully vested and exercisable at the date of grant.
In 1998, the Board of Directors granted 50,000 restricted shares of the Company's common stock to the Company's Chief Executive Officer. The restrictions expired on 25,000 shares in October 2001, on 12,500 shares in October 2002 and on the remaining 12,500 shares in October 2003.
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A summary of option transactions during the three years ended December 31, 2003, follows:
The following table summarizes information pertaining to options outstanding and exercisable as of December 31, 2003:
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A summary of restricted stock transactions during the three years ended December 31, 2003, follows:
The Company has a deferred compensation plan for its non-employee directors covering a maximum of 200,000 shares. At December 31, 2003 and 2002, there were 176,757 and 180,385 shares, respectively, reserved for issuance of which 129,845 and 106,800 shares, respectively, were allocated but unissued. The remaining 46,912 and 73,585 shares, respectively, were reserved and unallocated under the directors compensation plan.
For the years ended December 31, 2003, 2002 and 2001, the Company recognized expense related to stock-based compensation (for restricted stock granted to employees and the deferred compensation plan for non-employee directors) of $2,351,000, $9,895,000 and $5,318,000, respectively.
Pro forma compensation costs (see Note 1) associated with options granted under the ESPP were estimated based on the discount from market value. The following presents the estimated weighted average fair value of options granted and the weighted average assumptions used under the Black-Scholes option pricing model for each of the years ended December 31, 2003, 2002 and 2001:
10. Employee Retirement and Savings Plans
The Company's Master 401(k) Plan and Trust ("401(k) plan") is a defined contribution 401(k) plan with an employer match covering any employee of the Company or a participating affiliate. Participants may contribute on a pretax and after-tax basis, subject to maximum IRS limits and not exceeding 17% of annual compensation. The Company matches employee contributions at the rate of $0.50 for every dollar contributed up to a maximum Company-matching contribution of 3% of qualified annual compensation. The Company recognized matching contributions to the 401(k) plan of $4.8 million in 2003, $4.2 million in 2002 and $3.3 million in 2001. Additional contributions may be made from accumulated and/or current net profits. In 2003, 2002 and 2001, additional contributions to the 401(k) plan of $1.8 million, $1.4 million and $1.0 million, respectively, were recognized by the Company.
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The Company has a non-qualifying deferred compensation plan similar to the 401(k) plan. This plan provides an opportunity for eligible employees to contribute additional amounts for retirement savings once they have reached the maximum contribution amount in the 401(k) plan. The Company's contributions to this plan during 2003, 2002 and 2001 were not significant.
The Company has unfunded deferred compensation agreements with certain current and former officers. The present value of cash benefits payable under the agreements is being accrued over the periods of active employment and totaled $3.2 million at December 31, 2003 and $3.6 million at December 31, 2002. The charges to expense for these agreements were not significant.
11. Postretirement Benefits
The Company sponsors two unfunded defined postretirement benefit plans that cover certain salaried and nonsalaried employees. One plan provides health care benefits and the other provides life insurance benefits. The medical plan is contributory and contributions are adjusted annually based on actual claims experience. For retirees who retired prior to December 31, 2002 with twenty or more years of service at December 31, 2000, the Company contributes approximately 50% of the cost of providing the medical plan. For all other retirees, the Company's intent is that the retirees provide the majority of the actual cost of providing the medical plan. The Company's retiree medical plan provides prescription drug benefits that may be affected by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 ("the Act"), signed into law in December 2003. In accordance with FASB Staff Position FAS 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003", the effects of the Act on the Company's medical plans have not been included in the measurement of accumulated postretirement benefit obligation or net periodic postretirement benefit cost for 2003. Specific authoritative guidance from the FASB on the accounting for the federal subsidy is pending and that guidance, when issued, may require the Company to restate previously reported information and may require an amendment to the Company's plans to benefit from the Act. The life insurance plan is noncontributory.
As of December 31, 2003 and 2002, the accumulated postretirement benefit obligation ("APBO") under such plans was $23.4 million and $19.5 million, respectively. Measurement dates of December 31, 2003 and December 31, 2002 were used for these plans. The following table reconciles the plans' beginning and ending balances of the APBO and reconciles the plans' status to the accrued postretirement health care and life insurance liability reflected on the balance sheet as of December 31 (in thousands):
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Net periodic postretirement costs ("NPPC") are summarized as follows (in thousands):
In 2000, the Company eliminated employer subsidies for all future retirees except those that had twenty or more years of service as of December 31, 2000 and retired prior to December 31, 2002.
The weighted average assumptions used to determine benefit obligations as of December 31 were as follows:
The weighted average assumptions used to determine NPPC for years ended December 31 were as follows:
The following trend rate assumptions were used as of December 31:
The medical cost and participant contributions trend rate assumptions could have a significant effect on amounts reported. A change in the assumed trend rate of 1 percentage point would have the following effects (in thousands):
The Company expects to contribute $1.6 million to the plans in 2004. The following reflects the estimated future benefit payments net of estimated participant contributions that are expected to be paid:
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12. Financial Instruments
The Company's financial instruments include cash and cash equivalents, investments, receivables, accounts payable, borrowings and interest rate risk management contracts.
At December 31, 2003 and 2002, the fair values of cash and cash equivalents, receivables, accounts payable and short-term debt approximated carrying values because of the short-term nature of these instruments. The carrying values of investments, long-term debt and interest rate swaps approximate their fair value. The fair values of interest rate swaps were liabilities of $0.4 million and $2.2 million at December 31, 2003 and 2002, respectively.
During 2002 and 2001, the Company entered into interest rate swap agreements to manage its exposure to interest rate movements by effectively exchanging floating rate payments for fixed rate payments without the exchange of the underlying principal. The interest rate swaps are directly matched against U.S. dollar LIBOR contracts outstanding under the Company's Credit Facility and are reset quarterly. The differential between fixed and variable rates to be paid or received is accrued as interest rates change in accordance with the agreements and recognized over the life of the agreements as an adjustment to interest expense. The interest rate swaps mature in 2004. The amended Credit Facility matures in 2009. The Company will continue to evaluate the need to manage its exposure to interest rate movements and may enter into additional interest rate swap agreements from time to time.
At December 31, 2003 and 2002, the notional principal amount of interest rate swaps outstanding was $59.0 million and $114.0 million, respectively. The fair value of the swaps is reported on the balance sheet in other liabilities. The net change in fair value of the swaps at December 31, 2003 and 2002 is reported in other comprehensive income. The swaps are highly effective and no significant amounts for hedge ineffectiveness were reported in net income during 2003 and 2002.
The Company periodically reviews its positions with, and the credit quality of, the financial institutions that are counterparties to its financial instruments, and does not anticipate nonperformance by the counterparties. The Company would not realize a material loss as of December 31, 2003 in the event of nonperformance by any one counterparty. The Company enters into transactions only with financial institution counterparties that have a minimum long-term credit rating of A- or A3 as defined by Standard and Poor's or Moody's Investors Service, respectively. In addition, the Company limits the amount of investment credit exposure with any one institution.
13. Commitments and Contingencies
In the ordinary course of business, the Company is subject to various legal proceedings and claims. The Company believes that the ultimate outcome of these matters will not have a material effect on its financial statements.
Total rental expense was $17.4 million in 2003, $15.9 million in 2002 and $15.8 million in 2001. Minimum annual rentals under noncancelable leases at December 31, 2003 are as follows (in thousands):
At December 31, 2003, imputed interest on capital leases was $2,000 and the present value of minimum capital lease payments was $53,000.
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In connection with an acquisition in 2002, the Company has entered into an agreement to pay up to $2.0 million during and prior to 2005. These payments are contingent on certain growth targets being met (see Note 2).
The Company has entered into a contract with a customer that contains provisions that call for future payments to the customer if the Company does not meet certain performance measures. The contract also contains provisions that call for the reduction or elimination of the Company's payment obligations if the customer does not meet certain performance requirements. The Company does not anticipate any payments pursuant to these contract provisions at this time.
14. Business Segments
The Company operates its business in three segments. The Printed Products segment ("Printed Products") includes checks, direct marketing activities and analytical services marketed primarily to financial institutions. The Software and Services segment ("Software & Services") is focused on the financial institution market and includes core processing applications and services for credit unions and community banks, lending and mortgage origination applications, mortgage servicing applications, branch automation applications and customer relationship management applications. The Scantron segment represents products and services sold by the Company's Scantron subsidiary including scanning equipment and software, scannable forms, survey solutions, curriculum development, testing and assessment tools, training and field maintenance services. Scantron sells these products and services to the education, commercial and financial institution markets.
In 2003, the Company transferred its analytical services business unit from Software & Services to Printed Products and also transferred certain support activities to Printed Products from corporate operations. Accordingly, prior period results reflect reclassifications to conform to the 2003 presentation.
The Company's operations are primarily in the United States and Puerto Rico. There were no significant intersegment sales. The Company does not have sales to any individual customer greater than 10% of total Company sales. Equity investments, as well as foreign assets, are not significant to the consolidated results of the Company. The Company's accounting policies for segments are the same as those described in Note 1.
Management evaluates segment performance based on segment income or loss before income taxes. Segment income or loss excludes interest income, interest expense, certain other non-operating gains and losses, all of which are considered corporate items. Prior to 2003, certain incentive compensation for segment management was considered to be a corporate expense. Corporate assets consist primarily of cash and cash equivalents, deferred income taxes, investments and other assets not employed in production.
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Summarized financial information for 2003, 2002 and 2001 is as follows (in thousands):
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INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of John H. Harland Company:
We have audited the accompanying consolidated balance sheets of John H. Harland Company and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, cash flows and shareholders' equity for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed in the Index at Item 15 (a) 2. These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and the financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of John H. Harland Company and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Notes 1 and 3 to the Consolidated Financial Statements, on January 1, 2002, the Company changed its method of accounting for goodwill to conform to Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets," and on January 1, 2003, the Company changed its method of accounting for exit and disposal activities to conform to Statement of Financial Accounting Standards No. 146, "Accounting for Costs Associated with Exit or Disposal Activities."
/s/ Deloitte & Touche LLP - -------------------------- Deloitte & Touche LLP Atlanta, Georgia February 27, 2004
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JOHN H. HARLAND COMPANY AND SUBSIDIARIES
MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS
The financial statements included in this report were prepared by the Company in conformity with accounting principles generally accepted in the United States of America. Management's best estimates and judgments were used, where appropriate. Management is responsible for the integrity of the financial statements and for other financial information included in this report. The financial statements have been audited by the Company's independent auditors, Deloitte & Touche LLP. As set forth in their report, their audits were conducted in accordance with auditing standards generally accepted in the United States of America and formed the basis for their opinion on the accompanying financial statements. They consider the Company's control structure and perform such tests and other procedures as they deem necessary to express an opinion on the fairness of the financial statements.
The Company maintains a control structure which is designed to provide reasonable assurance that assets are safeguarded and that the financial records reflect the authorized transactions of the Company. As a part of this process, the Company has an internal audit function which assists management in evaluating and monitoring the adequacy and effectiveness of the control structure.
The Audit Committee of the Board of Directors is composed of directors who are neither officers nor employees of the Company. The Committee meets periodically with management, internal audit and the independent auditors to discuss audit matters, the Company's control structure and financial reporting matters. Internal audit and the independent auditors have full and free access to the Audit Committee.
/s/ Timothy C. Tuff /s/ Charles B. Carden - ------------------------- -------------------------
Timothy C. Tuff Charles B. Carden Chairman, President and Senior Vice President and Chief Executive Officer Chief Financial Officer
February 27, 2004
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EXHIBIT LIST
Exhibit Description
3.1 * Amended and Restated Articles of Incorporation (Exhibit B to Registrant's Proxy Statement dated March 12, 1999).
3.2 * Bylaws, as amended through December 19, 2002 (Exhibit 3.2 to the Registrant's Annual Report on Form 10-K ("10-K") for the year ended December 31, 2002).
4.1 * Rights Agreement, dated as of December 17, 1998, between Registrant and First Chicago Trust Company of New York (Exhibit 4.1 to the 8-K dated July 1, 1999).
4.2 See Articles IV, V and VII of Registrant's Amended and Restated Articles of Incorporation, filed as Exhibit 3.1, and Articles I, V and VIII of Registrant's Bylaws, filed as Exhibit 3.2.
10.1 * + Form of Noncompete and Termination Agreement between Registrant and Arlene S. Bates, Charles B. Carden and John C. Walters (Exhibit 10.1 to the 2002 10-K).
10.2 * + Employment Agreement, dated December 2, 2002, between Registrant and John T. Heald, Jr.(Exhibit 10.2 to the 2002 10-K).
10.3 * + Noncompete and Termination Agreement, dated as of January 1, 2002, between Registrant and Timothy C. Tuff (Exhibit 10.3 to the 2001 10-K).
10.4 * + Form of Restricted Stock Agreement between Registrant and Ms. Bates, Messrs. Carden, Heald and Walters (Exhibit 10.4 to the 2000 10-K).
10.5 * + Restricted Stock Agreement dated April 24, 2002 between Registrant and Mr. Tuff (Exhibit 10.6 to the 2002 10-K).
10.6 * + Supplemental Retirement Agreement, dated as of January 1, 2002, between Registrant and Mr. Tuff (Exhibit 10.7 to the 2001 10-K).
10.7 * John H. Harland Company 1999 Stock Option Plan, as amended (Exhibit 99.1 to the Registrant's Registration Statement on Form S-8, dated January 14, 2000, File No. 333-94727).
10.8 * John H. Harland Company 2000 Stock Option Plan, as amended (Exhibit 99.1 to the Registrant's Registration Statement on Form S-8, dated November 29, 2000, File No. 333-70386).
10.9 * John H. Harland Company 2002 Stock Option Plan (Exhibit A to the Registrant's Proxy Statement dated March 20, 2002).
10.10 John H. Harland Company Employee Stock Purchase Plan, as amended through July 24, 2003.
10.11 * John H. Harland Company Compensation Plan for Non-Employee Directors, as amended (Exhibit 10.12 to the 2001 10-K).
10.12 Amended and Restated Credit Agreement dated as of February 4, 2004 Among Registrant and the Lenders named therein.
11.1 Computation of Per Share Earnings.+
- -------- + Data required by SFAS No. 128, "Earnings Per Share," is provided in Note 1 to the Consolidated Financial Statements included in this report. + Data required by SFAS No. 128, "Earnings Per Share," is provided in Note 1 to the Consolidated Financial Statements included in this report.
Exhibit Description
14 Code of Business Conduct and Ethics.
21 Subsidiaries of the Registrant.
23 Consent of Deloitte & Touche, LLP.
31.1 Certification Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Indicates exhibit previously filed with the Securities and Exchange Commission as indicated in parentheses and incorporated herein by reference
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