UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-Q

 

 

 

COMMISSION FILE NUMBER 0-26123

 

ONLINE RESOURCES CORPORATION

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

 

 

 

(703) 653-3100

(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

 

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

As of November 4, 2008 there were 29,342,241 shares of the issuer’s common stock outstanding.

 

 

ONLINE RESOURCES CORPORATION

 

FORM 10-Q

 

TABLE OF CONTENTS

 

 

 

ONLINE RESOURCES CORPORATION

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par values)

 

 

See accompanying notes to condensed consolidated unaudited financial statements.

ONLINE RESOURCES CORPORATION

 

 

See accompanying notes to condensed consolidated unaudited financial statements.

 

 

See accompanying notes to condensed consolidated unaudited financial statements.

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

 

Online Resources Corporation (the “Company”) provides outsourced financial technology services to financial institution, biller, card issuer and creditor clients. The Company serves billable consumer and business end-users within four business lines in two primary vertical markets. End-users may access and view their accounts online and perform various web-based, self-service functions. They may also make electronic bill payments and funds transfers, utilizing the Company’s unique, real-time debit architecture, ACH and other payment methods. The Company’s value-added relationship management services reinforce a favorable user experience and drive a profitable and competitive Internet channel for its clients. Further, the Company provides professional services, including software solutions, which enable various deployment options, a broad range of customization and other value-added services. The Company currently operates in two business segments — Banking and eCommerce.

 

INTERIM FINANCIAL INFORMATION

 

The accompanying condensed consolidated unaudited financial statements have been prepared in conformity with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the Securities and Exchange Commission. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. In the opinion of management, the condensed consolidated unaudited financial statements include all adjustments necessary (which are of a normal and recurring nature) for the fair presentation of the results of the interim periods presented. These condensed consolidated unaudited financial statements should be read in conjunction with the consolidated audited financial statements for the year ended December 31, 2007 included in the Annual Report on Form 10-K filed by the Company with the Securities and Exchange Commission (“SEC”) on April 9, 2008. The results of operations for any interim period are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year. Certain amounts from prior periods have been reclassified to conform to current period presentation.

 

CONSUMER DEPOSITS RECEIVABLE AND PAYABLES

 

In 2007, following the Company’s acquisition of Internet Transaction Solutions, Inc. (“ITS”), the Company’s balance sheet, in relation to its ITS operations, reflected consumer deposit receivables which consisted of in-transit customer payment transactions that had not yet been received by the Company and consumer deposit payables which consisted of cash held or in transit, that were to be remitted for the benefit of customers for collections made on their behalf. In the first quarter of 2008, the Company changed the manner in which the ITS payment processing operations were structured. As a result of the change, the Company has only fiduciary responsibility over the bill payment funds associated with its ITS operations. Therefore, the Company no longer has rights and obligations associated with ITS bill payment funds and no longer reports consumer deposit receivables, payables and related cash as part of its condensed consolidated balance sheet at September 30, 2008.

 

NEW ACCOUNTING STANDARDS

 

In December 2007, the Financial Accounting Standards Board (“FASB”) issued the Statement of Financial Accounting Standards (“SFAS”) No. 141(R), Business Combinations, (“SFAS No. 141(R)”), which replaces SFAS No. 141. SFAS No. 141(R) will significantly change the way the Company accounts for business combinations. The more significant changes under SFAS No. 141(R) included the treatment of contingent consideration, preacquisition contingencies, transaction costs, in-process research and development and restructuring costs. The standard also requires more assets acquired and liabilities assumed to be measured at fair value as of the acquisition

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

date and contingent liabilities assumed to be measured at fair value in each subsequent reporting period. In addition, under SFAS No. 141(R), changes in deferred tax asset valuation allowances and acquired income tax uncertainties in a business combination after the measurement period will affect the income tax provision. This pronouncement is effective for annual reporting periods beginning after December 15, 2008. Early adoption is not permissible; therefore the Company will apply this standard to acquisitions made after January 1, 2009. The provisions of the standard related to changes in deferred tax assets valuation allowances and income tax uncertainties will be applied to acquisitions entered into prior to the adoption of this standard.

 

In December 2007, the FASB issued SFAS No. 160, Non-controlling Interests in Consolidated Financial Statements, (“SFAS No. 160”), which amends Accounting Research Bulletin No. 51. SFAS No. 160 establishes accounting and reporting standards that require 1) non-controlling interests held by non-parent parties to be clearly identified and presented in the consolidated statement of financial position within equity, separate from the parent’s equity and 2) the amount of consolidated net income attributable to the parent and to the non-controlling interest to be clearly presented on the face of the consolidated statement of income. SFAS No. 160 also requires consistent reporting of any changes to the parent’s ownership while retaining a controlling financial interest, as well as specific guidelines over how to treat the deconsolidation of controlling interests and any applicable gains or losses. This standard is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008 and earlier adoption is prohibited. The standard currently does not affect the Company’s consolidated financial statements; however the Company will adopt this standard beginning January 1, 2009.

 

On January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (“SFAS No. 157”), for financial assets and liabilities. The standard defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In addition, the standard specifies that the fair value should be the exit price, or price received to sell the asset or liability as opposed to the entry price, or price paid to acquire an asset or assume a liability. In February 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-2 which delays the effective date of SFAS No. 157 for all nonfinancial assets and liabilities, except for those that are disclosed in the condensed consolidated financial statements on a recurring basis, until fiscal years beginning after November 15, 2008. The Company is currently assessing the impact, if any, adoption of the statement for nonfinancial assets and liabilities will have on its consolidated financial statements.

 

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, which requires enhanced disclosures about an entity’s derivative and hedging activities. Constituents have expressed concerns that the existing disclosure requirements in SFAS No. 133, Accounting for Derivative Instruments and Hedging Activity, do not provide adequate information about how derivative and hedging activities affect an entity’s financial position, financial performance, and cash flows, and accordingly this new standard improves the transparency of financial reporting. This standard is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. This standard encourages, but does not require, comparative disclosures for earlier periods at initial adoption. At this time, the Company is assessing the impact on our consolidated financial statements and has not determined if it will adopt early.

 

In April 2008, the FASB issued FSP No. 142-3, Determination of the Useful Life of Intangible Assets (“FSP No. 142-3”). This guidance is intended to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”), and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141(R) when the underlying arrangement includes renewal or extension of terms that would require substantial costs or result in a material modification to the asset upon renewal or extension. Companies estimating the useful life of a recognized intangible asset must now consider their historical experience in renewing or extending similar arrangements or, in the absence of historical experience, must consider assumptions that market participants would use about renewal or extension as adjusted for SFAS No. 142’s entity-specific factors. FSP No. 142-3 is effective beginning January 1, 2009 and

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

will be applied prospectively to intangible assets acquired after the effective date. The company is currently assessing the impact this adoption will have on its consolidated financial statements.

 

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (GAAP), which is a hierarchy of authoritative accounting guidance. The current GAAP hierarchy is included in the American Institute of Certified Public Accountants Statement of Auditing Standards No. 69, The Meaning of Present Fairly in Confirmation with Generally Accepted Accounting Principles. The new statement is explicitly and directly applicable to preparers of financial statements as opposed to being directed to auditors and will not result in a change in current practice. The new statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to remove the GAAP hierarchy from auditing standards, where it has resided for some time.

 

In May 2008, the FASB issued SFAS No. 163, Accounting for Financial Guarantee Insurance Contracts — an interpretation of FASB Statement No. 60, which requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. The standard currently does not affect the Company’s consolidated financial statements.

 

In October 2008, the FASB issued Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active (FSP No. 157-3). FSP No. 157-3 clarifies the application of SFAS No. 157, which the Company adopted as of January 1, 2008, in cases where a market is not active. The Company has considered the guidance provided by FSP No. 157-3 and determined that the impact was not material on estimated fair values as of September 30, 2008.

 

 

On February 21, 2007, the Company entered into an agreement with Bank of America to refinance its then existing debt with $85.0 million in senior secured notes (“2007 Notes”). The agreement also provides a $15 million revolver (“Revolver”) under which the Company can secure up to $5 million in letters of credit. Currently, there are no amounts outstanding under the Revolver, but available credit under the Revolver has been reduced by approximately $1.8 million as a result of letters of credit the bank has issued. The Company had made principal payments of $6.4 million on the 2007 Notes in the nine months ended September 30, 2008, reducing the outstanding principal from $85.0 million to $78.6 million. The Company will make principal payments each quarter until the 2007 Notes are due in 2012 as noted in the table below.

 

The interest rate on both the Revolver and the 2007 Notes is the one-month London Interbank Offered Rate (“LIBOR”) plus 225 to 275 basis points based upon the ratio of the Company’s funded indebtedness to its earnings before interest, taxes, depreciation and amortization (“EBITDA,” as defined in the 2007 Notes), and it is payable monthly. During the third quarter of 2008, the margin was 250 basis points and the average interest rate was 4.98%. The 2007 Notes and the Revolver are secured by the assets of the Company.

 

Maturities of long-term debt for each of the next 4.25 years are as follows (in thousands):

 

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

 

Cash Flow Hedging Strategy

 

On March 30, 2007, the Company entered into an interest rate cap agreement (“2007 Hedge”) that protected the cash flows on designated one-month LIBOR-based interest payments beginning on April 3, 2007 through July 31, 2009. The 2007 Hedge limits the exposure to interest rate increases in excess of 5.5%. The 2007 Hedge had a notional value of $65.0 million through June 30, 2008 and $42.5 million through July 31, 2009. Approximately 54%, or $42.5 million of the Company’s $78.6 million outstanding principal of the 2007 Notes at September 30, 2008, had its interest payments perfectly hedged against increases in variable-rate interest payments above 5.5% by the 2007 Hedge.

 

The counter party for the 2007 Hedge became insolvent during the third quarter of 2008. As such, the Company declared the 2007 Hedge to have no fair value as of September 30, 2008 and expensed the remaining fair value of the cash flow hedge and the unrealized losses previously recorded in other comprehensive income, totaling $0.1 million, through interest expense. On October 17, 2008, the Company entered into an interest rate swap agreement, with a large commercial bank, swapping the one-month LIBOR interest rate for a fixed interest rate equal to 2.9% plus 225 to 275 basis points based upon the ratio of the Company’s funded indebtedness to its EBITDA, through December 31, 2009. The interest rate swap is designated as a hedge and any unrealized gains or losses related to changes in the fair market value of the hedge will be recorded in other comprehensive income until realized. The interest rate swap has a notional value of $78.6 million, the principal amount outstanding on our 2007 Notes on October 31, 2008, the effective date. Subsequent notional amounts will equal the outstanding principal at the end of each month.

 

Theoretical Swap Derivative

 

The Company bifurcated the fair market value of the embedded derivative associated with the Series A-1 Redeemable Convertible Preferred Stock (“Series A-1 Preferred Stock”) issued in conjunction with the Princeton eCom acquisition on July 3, 2006 in accordance with SFAS No. 133. The Company determined that the embedded derivative is defined as the right to receive a fixed rate of return on the accrued, but unpaid dividends and the variable negotiated rate, which creates a theoretical swap between the fixed rate of return on the accrued, but unpaid dividends and the variable rate actually accrued on the unpaid dividends. This embedded derivative is marked to market at the end of each reporting period through earnings and an adjustment to other assets in accordance with SFAS No. 133. There is no active market quote available for the fair value of the embedded derivative. Thus, management measures fair value of the derivative by estimating future cash flows related to the asset using a forecasted iMoney Net First Tier rate based on the one-month LIBOR rate adjusted for the historical spread for the estimated period in which the Series A-1 Preferred Stock will be outstanding. The fair value of the theoretical swap derivative was $1.7 million at September 30, 2008 and $1.0 million at December 31, 2007.

 

ITS Price Protection

 

As part of the purchase consideration for ITS, the Company also agreed to provide the former shareholders of ITS with price protection related to the 2,216,653 shares issued to them for a period of one year from the date the shares were issued, which was August 10, 2007 (the “Closing Date”). Under the protection, if the volume weighted average price of the Company’s shares for the 10 trading-day period ending two business days before the six, nine and twelve month anniversary dates of the Closing Date was less than $11.15, these shareholders had the right to ask us to restore them to a total value per share equal to the issuance price, either through the issuance of additional stock or through the repurchase of the stock issued as consideration.

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

On the six month anniversary date, which occurred during the first quarter of 2008, certain shareholders exercised their price protection rights. The Company acquired 189,917 common shares subject to the price protection for $2.2 million, including $0.1 million for the difference under the price protection. These shares are classified as treasury shares on the Company’s condensed consolidated balance sheet. In addition, the Company issued 25,209 shares of the Company’s common stock to shareholders who owned 497,751 shares and exercised their price protection rights in the first quarter of 2008.

 

On the nine month anniversary date, which occurred during the second quarter of 2008, the remaining shareholders exercised their price protection rights. The Company issued an additional 238,396 shares of the Company’s common stock to shareholders who owned 1,528,985 shares and exercised their price protection rights in the second quarter of 2008. As of September 30, 2008, all obligations under the price protection have been fulfilled.

 

This purchase price protection represents a stand-alone derivative which was included as part of the consideration issued for the acquisition. Using a trinomial tree model, the Company determined that the value of this option was $2.8 million as of July 26, 2007, the date the share issuance price was established, and recorded this amount in other current liabilities on the condensed consolidated balance sheet. The liability was marked to market, each period, through the second quarter of 2008 until all rights were exercised and reflected changes in the value of the option that were driven by share price, share price volatility and time to maturity. Interest expense of $1.6 million was recorded during the first half of 2008, before all rights had been exercised, related to the mark to market adjustment of the derivative. Since all rights had been exercised during the first half of 2008, the value of the option liability at September 30, 2008 is zero. The value of the remaining portion of the option, using the same trinomial tree model, was determined to have been $2.4 million at December 31, 2007.

 

 

Series A-1 Redeemable Convertible Preferred Stock

 

Pursuant to the restated certificate of incorporation, the Board of Directors has the authority, without further action by the stockholders, to issue up to 3,000,000 shares of preferred stock in one or more series. Of these 3,000,000 shares of preferred stock, 75,000 shares have been designated Series A-1. The Series A-1 Preferred Stock has a redemption value of 115% of the face value of the stock, on or after seven years from the date of issuance, or July 3, 2013. The Company recognized $0.4 million for the three months ended September 30, 2008 and 2007 and $1.2 million and $1.1 million for the nine months ended September 30, 2008 and 2007, respectively, to adjust for the redemption value at maturity.

 

Additionally, the Series A-1 Preferred Stock has a feature that grants holders the right to receive interest-like returns on accrued, but unpaid, dividends that accumulate at 8% per annum. For each of the three months ended September 30, 2008 and 2007 and for each of the nine months ended September 30, 2008 and 2007, $1.5 million and $4.5 million, respectively, of preferred stock accretion was recognized in the condensed consolidated statements of operations, for the 8% per annum cumulative dividends. The right to receive the accrued, but unpaid dividends is based on a variable interest rate, and as such the difference between the fixed and variable rate of returns is a theoretical swap derivative. The Company bifurcates this feature and accretes it to the Series A-1 Preferred Stock over the life of the security. For the three months ended September 30, 2008 and 2007, respectively, $0.1 million of preferred stock accretion expense and $0.1 million of preferred stock accretion income was recognized for the theoretical swap derivative in the condensed consolidated statement of operations. For the nine months ended September 30, 2008 and 2007, respectively, $0.4 million and an insignificant amount of preferred stock accretion was recognized for the theoretical swap derivative in the condensed consolidated statements of operations.

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Finally, the cost to issue the Series A-1 Preferred Stock of $5.1 million is being accreted back to the redemption value of the Series A-1 Preferred Stock through July 2013, and generated an additional $0.2 million of preferred stock accretion for the three months ended September 30, 2008 and 2007 and an additional $0.5 million for the nine months ended September 30, 2008 and 2007 in the condensed consolidated statements of operations.

 

 

The Company manages its business through two reportable segments: Banking and eCommerce. The Banking segment’s market consists primarily of banks, credit unions and other depository financial institutions in the United States. The segment’s fully integrated suite of account presentation, bill payment, relationship management and professional services are delivered through the Internet. The eCommerce segment’s market consists of billers, card issuers, processors, and other creditors such as payment acquirers and very large online billers. The segment’s account presentation, payment, relationship management and professional services are distributed to these clients through the Internet.

 

Factors used to identify the Company’s reportable segments include the organizational structure of the Company and the financial information available for evaluation by the chief operating decision-maker in making decisions about how to allocate resources and assess performance. The Company’s operating segments have been broken out based on similar economic and other qualitative criteria. The Company operates both reporting segments in one geographical area, the United States. The Company’s management assesses the performance of its assets in the aggregate, and accordingly, they are not presented on a segment basis.

 

The Company changed the way it determines operating results of the business segments during the third quarter of 2008. Intangible asset amortization that previously had been unallocated is now allocated to the respective Banking or eCommerce segments. For each of the three months ended September 30, 2008 and 2007, $2.1 million of intangible asset amortization was reclassified from unallocated to the Banking and eCommerce segments. For the nine months ended September 30, 2008 and 2007, $7.3 million and $6.8 million, respectively, of intangible asset amortization were reclassified from unallocated to the Banking and eCommerce segments.

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The results of operations from these reportable segments were as follows for the three and nine months ended September 30, 2008 and 2007 (in thousands):

 

 

 

 

 

In December 2007, the Company reclassified its investment (“investment”) in the Columbia Strategic Cash Portfolio (the “Fund”) from cash and cash equivalents to short-term investments. The Fund was short-term and highly liquid in nature prior to the fourth quarter of 2007 and was classified as a cash equivalent. During the fourth quarter of 2007, the Fund was closed by the Fund administrator to future investment, partially due to the subprime credit market crisis, and began liquidating the Fund in an orderly manner. The Funds were then converted to a net asset value basis and marked to market daily. The Company intends to remain in the Fund through the liquidation period. Approximately half of the balance of the Company’s investment in the Fund at September 30, 2008 is expected to substantially liquidate over the next twelve months. This portion of the investment is classified in short-

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

term investments at fair value on the condensed consolidated balance sheet. The remainder of the investment, or $1.5 million, is expected to liquidate beyond twelve months and as such this portion of the Fund is classified in long-term other assets on the condensed consolidated balance sheet.

 

The value of the investment was $3.3 million and $9.1 million at September 30, 2008 and December 31, 2007, respectively. During the nine months ended of 2008, the Company received $5.7 million in liquidation payments from the Fund administrator and recognized a loss of $0.2 million for the nine months ended September 30, 2008, related to the investment in the Fund and liquidation, as other expense in the condensed consolidated statement of operations.

 

The value of the Company’s investment in the Fund may fluctuate based on changes in market values of the securities held in the Fund. To the extent the Company determines there is an increase or decrease in fair value, the Company may recognize additional unrealized gains or losses in future periods.

 

 

At September 30, 2008, the Company had three stock-based employee compensation plans, which are described in detail in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. The Company used the modified-prospective transition method of SFAS No. 123(R), Share-Based Payment, to recognize compensation costs which include (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all share-based payments granted on or subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). The compensation expense for stock-based compensation was $1.0 million for the three months ended September 30, 2008 and 2007, respectively. For the nine months ended September 30, 2008 and 2007, compensation expense for stock based compensation was $4.1 million and $2.3 million, respectively. A portion of the stock based compensation cost has been capitalized as part of software development costs in accordance with Statements of Position (“SOP”) No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use and SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed . For the three months ended September 30, 2008 and 2007, approximately $30,000 and $137,000, respectively, and for the nine months ended September 30, 2008 and 2007, approximately $137,000 and $227,000 was capitalized as part of software development costs.

 

Stock Options

 

The fair value of each option award is estimated on the date of grant using a Black-Scholes-Merton option-pricing formula that uses the assumptions noted in the table and discussion that follows:

 

 

Dividend Yield.  The Company has never declared or paid dividends and has no plans to do so in the foreseeable future.

 

Expected Volatility.  Volatility is a measure of the amount by which a financial variable, such as a share price, has fluctuated (historical daily volatility) or is expected to fluctuate (expected volatility) during a period. The

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Company uses the historical average daily volatility over the average expected term of the options granted to estimate expected volatility.

 

Risk-Free Interest Rate.  The risk-free interest rate is the average U.S. Treasury rate for the week of each option grant during the period having a term that most closely resembles the expected term of the option.

 

Expected Life of Option Term.  Expected life of option term is the period of time that the options granted are expected to remain unexercised. Options granted during the period have a maximum term of seven to ten years. The Company uses historical expected terms, with further consideration given to the class of employees to whom the equity awards were granted, to estimate the expected life of the option term.

 

Forfeiture Rate.  Forfeiture rate is the estimated percentage of equity awards granted that are expected to be forfeited or canceled on an annual basis before becoming fully vested. The Company estimates forfeiture rate based on past turnover data ranging anywhere from one to five years with further consideration given to the class of employees to whom the equity awards were granted.

 

A summary of stock option activity under the 1989, 1999 and 2005 Plans as of September 30, 2008, and changes in the period then ended is presented below (in thousands, except exercise price and remaining contract term data):

 

 

During the second quarter of 2008, the Company’s Board of Directors approved the 2005 Amended and Restated Restricted Stock and Option Plan (“2005 Plan”), making certain technical changes to the operation of the 2005 Plan. The amended 2005 Plan was filed by the Company on Form 8-K with the Securities and Exchange Commission on April 22, 2008. On May 21, 2008, the stockholders approved the 2005 Amended and Restated Restricted Stock and Option Plan (“2005 Plan”), which increased the number of authorized shares under the 2005 Plan from 1,700,000 to 3,500,000.

 

The weighted-average grant-date fair value of options granted was $3.99 and $6.74 per share during the three months ended September 30, 2008 and 2007, respectively and $5.31 and $5.44 per share for the nine months ended September 30, 2007 and 2008, respectively. In the table above, the total intrinsic value is calculated as the difference between the market price of the Company’s stock on the last trading day of the quarter and the exercise price of the options. For options exercised, intrinsic value is calculated as the difference between the market price on the date of exercise and the grant price. The intrinsic value of options exercised in the three months ended September 30, 2008 and 2007 was $0.7 million and $0.9 million, respectively, and $1.6 million and $4.4 million, respectively, for the nine months ended September 30, 2008 and 2007.

 

As of September 30, 2008, there was $2.4 million of total unrecognized compensation cost related to stock options granted under the 1999 and 2005 Plans. This cost is expected to be recognized over a weighted average period of 1.7 years.

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Cash received from option exercises under all share-based payment arrangements for the three months ended September 30, 2008 and 2007 was $0.2 million and $0.7 million, respectively, and $0.8 million and $3.3 million for the nine months ended September 30, 2008 and 2007, respectively, net of shares repurchased for tax withholding purposes. The tax benefits related to the deductions from option exercises of the share-based payment arrangements will be recognized when those deductions, currently being carried forward as net operating losses, reduce taxes payable.

 

Restricted Stock Units

 

A summary of the Company’s non-vested restricted stock units as of the nine months ended September 30, 2008, and changes for the period then ended, is presented below (in thousands, except grant-date fair value data):

 

 

The fair value of non-vested units is determined based on the opening trading price of the Company’s shares on the grant date. As of September 30, 2008, there was $3.5 million of total unrecognized compensation cost related to non-vested restricted stock units granted under the 2005 Plan. This cost is expected to be recognized over a weighted average period of 1.7 years.

 

In the fourth quarter of 2008, certain Company officers have elected to receive approximately 29,000 shares of restricted stock units that vest ratably each month through year end 2008, in lieu of cash compensation. In addition, certain members of the Company’s Board of Directors elected to receive approximately 23,500 shares of restricted stock units that vest ratably each month through year end 2008, in lieu of cash compensation.

 

 

The Company recorded an income tax expense based on the estimated effective tax rate for the full year, adjusted for discrete items recorded during the third quarter of 2008.

 

The Company’s effective tax rate was 30.6% and 2.6% for the three months ended September 30, 2008 and 2007, respectively, and 12.2% and (12.6)% for the first nine months of 2008 and 2007, respectively. The difference between the effective tax rate and the federal statutory rate for the three and nine months ended September 30, 2008, is primarily due to non-taxable items and state taxes. The non-taxable items include the mark to market adjustment valuation of the ITS price protection and interest expense for the accretion of the Series A-1 Preferred Stock.

 

At December 31, 2007, the Company has federal net operating loss carryforwards of approximately $117.4 million that expire at varying dates from 2012 to 2026. The timing and the manner in which the Company may utilize the net operating loss carryforwards in subsequent tax years will be limited to the Company’s ability to generate future taxable income and, potentially, by the application of the ownership change rules under Section 382 of the Internal Revenue Code. While Section 382 limitations apply to the Company, the limitations alone are not expected to result in the expiration of tax benefits should the Company produce taxable income sufficient to utilize the loss carryforwards. Our estimates of future taxable income represent critical accounting estimates because such estimates are subject to change and a downward adjustment could have a significant impact on future earnings. Furthermore, the Company continues to evaluate its net deferred tax asset valuation allowance, in regards to the likelihood of realization of the deferred tax assets.

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The Company has adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), as of January, 1, 2007. This standard modifies the previous guidance provided by SFAS No. 5, Accounting for Contingencies, and SFAS No. 109, Accounting for Income Taxes, for uncertainties related to the Company’s income tax liabilities. The Company has determined that there has been no material changes in tax positions taken in the prior periods, tax positions taken in the current period, settlements with taxing authorities resulting from lapses in the statute of limitations and unrecognized tax benefits that if recognized would affect the effective tax rate and amount of interest and penalties recognized in the condensed consolidated statement of operations and the condensed consolidated balance sheets.

 

The tax return years since 2000 in the Company’s major tax jurisdictions, both federal and various states, have not been audited and are not currently under audit. The Company does not have reason to expect any changes in the next twelve months regarding uncertain tax positions.

 

 

The following table sets forth the computation of basic and diluted net (loss) income available to common stockholders per share (in thousands, except per share amounts):

 

 

Approximately 7,580,909 and 6,791,000 shares of common stock equivalents for the three months ended September 30, 2008 and 2007, respectively, and approximately 7,480,408 and 8,730,000 shares of common stock equivalents for the nine months ended September 30, 2008 and 2007, respectively, were excluded from the calculation of diluted earnings per share because of their anti-dilutive effect.

 

 

SFAS No. 130, Reporting Comprehensive Income, requires that items defined as comprehensive income (loss) be separately classified in the financial statements and that the accumulated balance of other comprehensive income (loss) be reported separately from accumulated deficit and additional paid-in capital in the equity section of the

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

balance sheet. The following table reconciles the Company’s net income (loss) and its total comprehensive net income (loss) for the three and nine months ended September 30, 2008 and 2007 (in thousands):

 

 

 

On January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (“SFAS No. 157”), for financial assets and liabilities. The standard defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In addition, the standard specifies that the fair value should be the exit price, or price received to sell the asset or liability as opposed to the entry price, or price paid to acquire an asset or assume a liability.

 

In February 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-2 which delays the effective date of SFAS No. 157 for all nonfinancial assets and liabilities, except for those that are disclosed in the condensed consolidated financial statements on a recurring basis, until fiscal years beginning after November 15, 2008. The Company is currently assessing the impact, if any, adoption of the statement for nonfinancial assets and liabilities will have on its consolidated financial statements.

 

The standard provides valuation techniques and a fair value hierarchy used to measure fair value. The hierarchy prioritizes inputs for valuation techniques used to measure fair value into three categories:

 

(1) Level 1 inputs, which are considered the most reliable, are quoted prices in active markets for identical assets or liabilities.

 

(2) Level 2 inputs are those that are observable in the market place, either directly or indirectly for the asset or liability.

 

(3) Level 3 inputs are unobservable due to unavailability and as such the entity’s own assumptions are used.

 

The Company primarily utilizes Level 2 and Level 3 inputs for valuation techniques used to measure its financial assets and liabilities, as shown in the table below:

 

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

The following table is a summary of the Company’s financial assets that use Level 3 inputs to measure fair value (in thousands):

 

 

 

 

CAUTIONARY NOTE

 

The following management’s discussion and analysis should be read in conjunction with the accompanying Condensed Consolidated Unaudited Financial Statements and Notes thereto. This Quarterly Report on Form 10-Q may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, but not limited to:

 

 

These forward-looking statements represent our best judgment as of the date of the Quarterly Report on Form 10-Q, and we caution readers not to place undue reliance on such statements. Actual performance and results of operations may differ materially from those projected or suggested in the forward-looking statements due to certain risks and uncertainties, including but not limited to, the risks and uncertainties described or discussed in the section “Risk Factors” in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 9, 2008. These risks include, among others, the following:

 

 

 

OVERVIEW

 

We provide outsourced financial technology services branded to thousands of financial institutions, billers and credit service providers. With four business lines in two primary vertical markets, we serve over 10 million billable consumer and business end-users. End-users may access and view their accounts online and perform various web-based self-service functions. They may also make electronic bill payments and funds transfers utilizing our unique, real-time debit architecture, ACH and other payment methods. Our value-added relationship management services reinforce a favorable user experience and drive a profitable and competitive Internet channel for our clients. Further, we have professional services, including software solutions, which enable various deployment options, a broad range of customization and other value-added services. We currently operate in two business segments — Banking and eCommerce. The operating results of the business segments exclude general corporate overhead expenses.

Registered end-users using account presentation, payment services or both, and the payment transactions executed by those end-users are the major drivers of our revenues. Since September 30, 2008, the number of account presentation services users decreased by 5%, and the number of payment services users increased 21%, for an overall 12% increase in users. The decline in account presentation services users is primarily due to the departure of a card account presentation services client in the second quarter of 2008. eCommerce payment services users increased at a higher rate than usual due to our acquisition of Internet Transaction Solutions, Inc. (“ITS”) in August of 2007.

 

 

We have long-term service contracts with most of our financial services provider clients. The majority of our revenues are recurring, though these contracts also provide for implementation, set-up and other non-recurring fees. Account presentation services revenues are based on either a monthly license fee, allowing our financial institution clients to register an unlimited number of customers, or a monthly fee for each registered customer. Payment services revenues are based on a monthly fee for each customer enrolled, a fee per executed transaction, or a combination of both. Our clients pay nearly all of our fees and then determine if or how they want to pass these costs on to their users. They typically provide account presentation services to users free of charge, as they derive significant potential benefits including account retention, delivery and paper cost savings, account consolidation and cross-selling of other products.

 

As a network-based service provider, we have made substantial up-front investments in infrastructure, particularly for our proprietary systems. While we continue to incur ongoing development and maintenance costs, we believe the infrastructure we have built provides us with significant operating leverage. We continue to automate processes and develop applications that allow us to make only small increases in labor and other operating costs relative to increases in customers and transactions. We believe our financial and operating performance will be based primarily on our ability to leverage additional end-users and transactions over this relatively fixed cost base.

Results of Operations

 

The following table presents the summarized results of operations for our two reportable segments, Banking and eCommerce. We changed the way we determine operating results of the business segments during the third quarter of 2008. Intangible asset amortization costs that previously had been unallocated are now allocated to the respective Banking or eCommerce segments. For each of the three months ended September 30, 2008 and 2007, $2.1 million of intangible asset amortization was reclassified from unallocated to Banking and eCommerce segments.

 

For the nine months ended September 30, 2008 and 2007, $7.3 million and $6.8 million, respectively, of intangible asset amortization were reclassified from unallocated to Banking and eCommerce segments. (dollars in thousands):

 

 

 

 

 

 

 

THREE MONTHS ENDED SEPTEMBER 30, 2008 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 2007

 

Revenues

 

We generate revenues from account presentation, payment, relationship management and professional services and other revenues. Revenues increased $3.9 million, or 11%, to $38.1 million for the three months ended September 30, 2008. The increase is attributable to the addition of revenues from ITS, which we acquired on August 10, 2007. Revenues for the remainder of the Company decreased due to the departures of four large clients in August 2007, December 2007, and April 2008.

 

 

 

Notes:

 

 

Account Presentation Services.  Both the Banking and eCommerce segments contribute to account presentation services revenues, which decreased 17%, or $0.4 million, to $1.9 million. The decrease is due to the departure of a large card account presentation services client in April 2008.

 

Payment Services.  Both the Banking and eCommerce segments contribute to payment services revenues, which increased to $30.5 million for the three months ended September 30, 2008 from $27.2 million in the prior year quarter. The increase was related to the addition of new revenues from the acquisition of ITS. Revenues from the remainder of the Company decreased slightly due to a decrease in the Banking segment; partially offset by an increase in the eCommerce segment. The decrease in the Banking segment was due to the departure of three large banking bill payment clients in August 2007, December 2007 and April 2008 and lower float interest revenues due to lower interest rates. Banking payment transactions decreased by 7% compared to the third quarter of 2007, and biller transactions grew by 28%. Banking payment transactions declined as a result of the departures of three large banking bill payment clients. After excluding transactions from the three departed clients, banking payment transactions grew by 18%. Revenues in the eCommerce segment increased due to growth in biller transactions, excluding ITS, as a result of increased usage at our existing clients and the net addition of new clients since 2007. Biller transaction growth is higher due to the relative immaturity of that market.

 

Relationship Management Services.  Primarily composed of revenues from the Banking segment, relationship management services revenues increased by $0.4 million in the third quarter of 2008, or 23%. Revenues increased as a result of a one-time adjustment that reduced revenue by $0.4 million during the third quarter of 2007 related to a change in method of recognition of deferred revenue and costs for deferred new user setup fees. Revenues would have otherwise remained relatively constant due to our decision to bundle our call center service to banking clients with our account presentation and payment services.

 

Professional Services and Other.  Both the Banking and eCommerce segments contribute to professional services and other revenues, which increased $0.5 million, or 16%. Revenues from professional services and other fees primarily increased due to the timing of sales of our annual compliance package, which occurred in the second quarter last year, but occurred in the third quarter in 2008.

 

Costs and Expenses