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 or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large Accelerated Filer o     Accelerated Filer þ     Non-accelerated filer o

 

As of November 6, 2007 there were 28,822,063 shares of the issuer’s common stock outstanding.

 

ONLINE RESOURCES CORPORATION

 

FORM 10-Q

 

TABLE OF CONTENTS

 

 

PART I.  FINANCIAL INFORMATION

 

 

ONLINE RESOURCES CORPORATION

CONSOLIDATED BALANCE SHEETS
(In thousands, except par values)

 

 

See accompanying notes to consolidated unaudited financial statements.

ONLINE RESOURCES CORPORATION

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

 

 

See accompanying notes to consolidated unaudited financial statements.

ONLINE RESOURCES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 

 

See accompanying notes to consolidated unaudited financial statements.

ONLINE RESOURCES CORPORATION

 

CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(In thousands except share data)

 

SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING ACTIVITIES:

 

On August 10, 2007, the Company acquired all the outstanding shares of Internet Transaction Solutions, Inc. for an aggregate amount of $48 million including transaction costs, see Note 2.

 

The following represents the fair value of assets acquired, net of liabilities assumed at the acquisition date, August 10, 2007 (unaudited):

 

 

SUPPLEMENTAL SCHEDULE OF NON-CASH FINANCING ACTIVITIES:

 

On August 10, 2007, the Company issued 2,216,552 shares of its common stock having a fair value of $24,713 at the date of issuance to the former shareholders of ITS, pursuant to the acquisition agreement.

 

See accompanying notes to consolidated unaudited financial statements.

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

 

Online Resources Corporation (the “Company”) provides outsourced, web-based financial technology services branded to thousands of financial institution, biller, card issuer and creditor clients. With four business lines in two primary vertical markets, the Company serves 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 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. The operating results of the business segments exclude general corporate overhead expenses and intangible asset amortization.

 

INTERIM FINANCIAL INFORMATION

 

The accompanying 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. In the opinion of management, the 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 consolidated unaudited financial statements should be read in conjunction with our consolidated audited financial statements for the year ended December 31, 2006 included in the Annual Report on Form 10-K filed by the Company with the Securities and Exchange Commission on March 16, 2007. 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 reclassed to conform to current period presentation.

 

CHANGE IN ACCOUNTING POLICY

 

Theoretical Swap Derivative

 

During third quarter of 2007, the Company changed how it defines the embedded derivative associated Series A-1 Preferred Stock issued in conjunction with the Princeton acquisition on July 3, 2006. At the time of acquisition, the embedded derivative was defined as the right to receive interest like returns on accrued, but unpaid dividends, and was included in other long-term liabilities on the balance sheet at its fair value at the date of acquisition. The fair value of the embedded derivative was marked-to-market at the end of each reporting period by adjusting interest expense, and therefore, income. During the third quarter of 2007, the Company determined that it was more appropriate to define the embedded derivative as the difference between the right to receive a fixed rate of return on the accrued, but unpaid dividends and the variable negotiated rate, which created 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. The theoretical swap had no value at the date of issuance and this embedded derivative should be marked-to-market at each period through earnings, with the fair value of the theoretical swap recognized as an asset or liability at each balance sheet date. The cumulative

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

impact of the change in definition as of and for the three and nine months ended September 30, 2007 was as follows:

 

 

Change in Method of Recognition of Revenue and Deferred Costs

 

Additionally, the Company changed the manner in which they recognized revenue and costs associated with up-front implementation fees received to install a new client on its system and new-user setup fees received to create payment delivery instructions for the end users of our clients. The Company defers these fees upon receipt along with the costs incurred in providing these services and has historically recognized the revenues and costs related to these fees on a straight-line basis over the client’s remaining contract term. In accordance with EITF 00-21, the implementation fees, new user set-up fees, and service revenues are considered a single unit of accounting. Therefore, both the service revenues and the implementation and new user fees are required to be accounted for in a consistent manner. As the service revenues are recognized on a proportionate performance basis, the Company has changed its methodology for recognition of the implementation and new user fees to the proportionate performance method. The Company further determined that the implementation costs should be charged to expense proportionally and over the same period that associated fees are recognized as revenue in accordance with SAB No. 104. The cumulative impact of the change recognition method of revenue and costs of revenue for the three and nine months ended September 30, 2007 was as follows:

 

 

The Company assessed the cumulative impact these changes would have on the statement of operations for the three and nine months ended September 30, 2007 and the balance sheet as of September 30, 2007 and determined that the changes would not have a material impact on the current or prior interim or annual consolidated financial statements. Consequently, the changes were made effective July 1, 2007.

 

NEW ACCOUNTING STANDARDS

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”, (“SFAS 157”). This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. SFAS 157 provides a common fair value hierarchy for companies to follow in determining fair value measurements in the preparation of financial statements and expands disclosure requirements relating to how such fair value measurements were developed. SFAS 157 clarifies the principle that fair value should be based on the assumptions that the marketplace would use when pricing an asset or liability, rather than company specific data. The Company is currently assessing the impact that SFAS 157 will have on its results of operations and financial position.

 

In January 2007, the FASB issued SFAS No. 159, The Fair Value Options for Financial Assets and Financial Liabilities (“SFAS 159”). This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

liabilities. The Company is currently assessing the impact that SFAS 159 will have on its results of operations and financial position.

 

 

On August 10, 2007, pursuant to the terms of the Agreement and Plan of Merger dated July 26, 2007, as thereafter amended and restated, the Company and its wholly-owned subsidiary, ITS Acquisition Sub, LLC, completed the merger under which the Company acquired all of the outstanding stock of Internet Transaction Solutions, Inc. (“ITS”), a Delaware corporation, for an acquisition price of approximately $47.8 million and incurred transaction related costs of $0.2 million. The Company agreed to issue 2,216,552 shares of its common stock to the stockholders and preferred rights holder of ITS in partial payment of the purchase price. These shares have been valued at $24.7 million, and the balance of the purchase price, approximately $20.3 million, was paid in cash. Of the $20.3 million paid in cash, $3.6 million has been escrowed to cover indemnification claims, if any, that may arise in favor of the Company within one year from the closing of the Merger.

 

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 2,216,552 shares issued at the issuance price for a period of one year from the date the share issuance price was established, which was July 26, 2007 (the “Effective Date”). Under the guarantee, the sellers have the right to put the stock issued as consideration back to the Company at three dates if the Company’s common stock has declined in value since the acquisition date. If the volume weighted average price of the Company’s shares for the 10-day period ending two days before the six, nine and twelve month anniversary dates of the Effective Date is less than $11.15 (issuance price), these shareholders have the right to ask the Company to restore them to a total value per share equal to the issuance price. Additionally, on any trading day that the closing price of the Company’s shares is 20% or more below the issuance price, the Company has the right to restore the shareholders to a total value per share equal to the issuance price. In either case, the Company can choose to repurchase the shares or give the shareholders either additional shares or cash for the value difference. Any repurchase of shares or issuance of additional value by the Company, whether at the request of the shareholders or at the Company’s option, relieves the Company of any future price protection obligations.

 

These rights represent 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 the Effective Date and recorded it as other short-term liabilities on its balance sheet for this amount. The liability will be marked-to-market each period to reflect changes in the value of the option driven by share price, share price volatility and time to maturity. At September 30, 2007, the value of the option, using the same valuation model, was determined to be $1.2 million. The derivative will be marked-to-market until it is exercised or expires. During the three and nine month periods ended September 30, 2007, the liability associated with this derivative decreased $1.6 million which is recognized as a reduction of interest expense in the consolidated statements of operations. The liability will generally increase should the Company’s share price decline, and will also decline due to the passage of time.

 

ITS is a leading provider of electronic payment solutions to receivable management companies and utilties. ITS’ solutions enable consumers to process bill payments through the Web, telephone (integrated voice response) or a customer service representative, resulting in significant cost savings, faster collections, and improved service for its biller customers. ITS’ services are primarily utilized by receivable management companies and utilities billers. ITS generates revenue from billpay transaction fees, which are either paid by the end-user or the client biller. The Company operates the ITS business segment within its eCommerce division. The acquisition has been accounted for using the purchase method of accounting. The purchase price allocation and the tax effect of the acquisition is preliminary. The purchase price was allocated to the estimated fair value of the assets acquired and liabilities assumed. The estimated fair value of the tangible

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

assets acquired and liabilities assumed approximated the historical basis. ITS had significant intangible assets related to its customer list and employee base. An identified value was assigned to the customer list, and the identified value assigned to the employee base was included within goodwill. No other significant intangible assets were identified or included in goodwill.

 

The preliminary purchase price allocations to identifiable intangible asset and goodwill were $21.0 million and $32.9 million, respectively. The identifiable intangible asset will be amortized over its useful life of ten years based on an accelerated amortization schedule that approximates the pattern in which economic benefit of the intangible asset is consumed or otherwise used up.

 

The results of operations for ITS are included in the unaudited consolidated statements of operations beginning August 11, 2007. The financial information in the table below summarizes the results of operations of the Company and ITS on a pro forma basis, as though the companies had been combined as of the beginning of the periods presented. This pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that would have been achieved had the acquisition actually taken place as of the beginning of the periods presented (in thousands except per share amounts).

 

 

 

On February 21, 2007, the Company entered into an agreement with Bank of America to refinance its existing debt with $85 million in term loans (“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. Interest on both the Revolver and the 2007 Notes is one-month 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. Currently, the margin is 275 basis points. The 2007 Notes and the Revolver are secured by the assets of the Company. The Company incurred $1.5 million in deferred financing costs in conjunction with the credit facility and these costs are being amortized using the effective interest rate method over the term of the term loans. In addition, the Company incurs a commitment fee of 0.5% on any unused portion of the Revolver.

 

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

 

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The Company issued $85 million of senior secured notes (the “2006 Notes”) on July 3, 2006. Interest on the 2006 Notes was one-month LIBOR plus 700 basis points, and it was payable quarterly. The 2006 Notes were refinanced with the issuance of the 2007 Notes. The Company paid a $1.7 million pre-payment penalty and wrote-off $3.9 million in deferred financing costs in conjunction with the transaction.

 

 

DERIVATIVES INSTRUMENTS AND HEDGING ACTIVITIES

 

Cash Flow Hedging Strategy

 

On March 30, 2007, the Company entered into an interest rate cap agreement (“2007 Hedge”) that protects 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 has a notional value of $70.0 million through September 28, 2007, $65.0 million through June 30, 2008 and $42.5 million through July 31, 2009. Approximately 76%, or $65 million, of the Company’s $85.0 million 2007 Notes had its interest payments perfectly hedged against increases in variable-rate interest payments above 5.5% by the 2007 Hedge.

 

The Company entered into an interest rate cap agreement (“2006 Hedge”) on July 3, 2006 that protected cash flows on designated one-month LIBOR-based payments beginning on July 3, 2006 through July 1, 2008. The 2006 Hedge limited the exposure to interest rate increases in excess of 5.5%. The 2006 Hedge had a notional value of $75.0 million through January 1, 2007, $70.0 million through July 1, 2007 and $65.0 million through July 1, 2008. Approximately, 82%, or $70.0 million, of the Company’s 2006 Notes had its interest payments perfectly hedged against increases in variable-rate interest payments over 5.5% by the 2006 Hedge up until the 2006 Notes were refinanced on February 21, 2007. The 2006 Hedge was de-designated on February 21, 2007 and was sold on April 3, 2007. The 2006 Hedge was replaced by the 2007 Hedge in order to hedge against the 2007 Notes.

 

During the three months ended September 30, 2007 and 2006, the Company recorded unrealized losses of $59,000 and $397,000, respectively, and for the nine months ended September 30, 2007 and 2006, the Company recorded unrealized losses of $89,000 and $397,0000, respectively, as part of the comprehensive loss recorded in stockholders’ equity to reflect the change in the fair value of the 2006 Hedge through February 21, 2007, the date of de-designation for the interest rate cap, and the 2007 Hedge through September 30, 2007. During the three and nine months ended September 30, 2007, the Company recorded realized losses of $67,000 and $210,000, respectively, with the maturation of the 2006 and 2007 Hedge’s caplets. As additional interest rate caplets mature, the portions of the changes in fair value that are associated with the cost of the maturing caplet will be recognized as interest expense. There is no published exchange information containing the price of the Company’s interest rate cap instruments. Thus, the fair value of the interest rate caps are based on estimated fair value quotes from a broker and market maker in derivative instruments. Their estimates are based upon the September 28, 2007 LIBOR forward curve, which implies that the caplets had minimal intrinsic value at September 30, 2007.

 

At September 30, 2007, the Company expects to reclassify approximately $277,000 of net losses from derivative instruments from accumulated other comprehensive loss to operations (i.e., as “interest expense”) during the next twelve months due to actual payments of variable interest associated with the floating rate debt.

 

Theoretical Swap Derivative

 

The Series A-1 Redeemable Convertible Preferred Stock (“Series A-1 Preferred Stock”) has a feature that grants holders the right to receive interest-like returns on accrued but unpaid dividends. Prior to third quarter 2007, the entire accrual amount was defined as the embedded derivative. The definition of the embedded

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

feature was changed in third quarter 2007. As of third quarter 2007, this feature is bifurcated as an embedded derivative and defined as the right to receive fixed rate of return on the accrued, but unpaid dividends and the variable rate negotiated which created a theoretical swap between the fixed rate of return on the accrued, but unpaid dividends and the variable rate actually accrued for the unpaid dividends. The fair value of the derivative is included in other long-term assets on the accompanying consolidated balance sheet. See Note 1 for the impact of the change. The derivative is marked-to-market at the end of each reporting period by adjusting interest expense for the current period. The impact for the three and nine months ended September 30, 2007 is $0.3 million. The fair value of the derivative is estimated using the discounted cash flow method. The calculated fair value is affected substantially by management’s expected term (periods outstanding) of the Series A-1 Preferred Stock and the discount rate used to compute the present value of the expected cash flows from the interest-like returns feature. The fair value of the theoretical swap derivative was $0.4 million at September 30, 2007. The calculated fair value is based on an assumed conversion date. See Note 5 for terms of the preferred stock.

 

Series A-1 Preferred Stock

 

The Company’s Series A-1 Preferred Stock is carried at its fair value at inception adjusted for accretion of unpaid dividends, a redemption price of 115% of the original issue price and the amortized portion of its original issuance costs, which approximates its redemption value. At September 30, 2007 its carrying value is $80,370,000. See Note 5 for a detailed explanation of the Series A-1 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 Preferred Stock.

 

Shares of the Series A-1 Preferred Stock are initially convertible into common shares at a rate of $16.22825 per share, or 4,621,570 shares in the aggregate. Although the Series A-1 Preferred Stock has anti-dilution protection, in no event can the number of shares of common stock issued upon conversion of the Series A-1 Preferred Stock exceed 5,102,986 common shares. The anti-dilution protection of the Series A-1 Preferred Stock is based on the weighted average price of shares issued below the conversion price, provided that (a) shares issued in connection with compensatory equity grants, (b) shares issued above $12.9826 and (c) other issuances as set forth in the certificate of designations of the Series A-1 Preferred Stock are excluded from the anti-dilution protections of the Series A-1 Preferred Stock.

 

The Series A-1 Preferred Stock votes on an as converted basis with the common stock and as a single class as to certain amendments to the certificate of incorporation the issuance of additional securities or debt and the payment of dividends. The amount of the liquidation preference of the Series A-1 Preferred Stock increases at a rate of 8% per annum of the original issuance price with an interest factor thereon based upon the iMoneyNet First Tier Institutional Average (the “Cumulative Amount”). This 8% per annum increase is convertible into shares of common stock, subject to the conversion limit noted above; however, the Company has the right to pay the 8% per annum increase in cash in lieu of conversion into common stock. The Series A-1 Preferred Stock has a right to participate in dividends with common stock, on an as if converted basis, when the cumulative total of common dividends paid, or proposed, exceeds the Cumulative Amount. Shares of Series A-1 Preferred Stock are subject to put and call rights following the seventh anniversary of their issuance for an amount equal to 115% of the original issuance price plus the 8% per annum increase with the interest factor thereon. The Corporation can require the conversion of the Series A-1 Preferred Stock if the 30 day weighted closing price per share of the Corporation’s common stock is at least 165% of the initial conversion price.

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

As discussed above, the Series A-1 Preferred Stock redemption value is 115% of the face value of the stock, on or after seven years from the date of issuance. Emerging Issues Task Force Topic D-98, Classification and Measurement and of Redeemable Securities, requires the Company to account for the securities by accreting to its expected redemption value over the period from the date of issuance to the first expected redemption date. The Company recognized $0.4 million of preferred stock accretion for the three months ended September 30, 2007 and 2006, and $1.1 and $0.4 million of preferred stock accretion for the nine months ended September 30, 2007 and 2006, 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. Given that the right to receive accrued, but unpaid dividends is based on a variable interest rate, the Company defined the embedded derivative as the theoretical swap between the fixed and variable rates of return. The Company bifurcated this feature at the date of issuance, at which time the value was determined to be zero. Additionally, the value of the theoretical fixed interest-like return on the accrued, but unpaid, dividends will be accreted to the Series A-1 Preferred Stock over the life of the security. For the three and nine months ended September 30, 2007, $0.1 and $0.2 million, respectively, of accretion has been recognized for the value of this interest-like return. See Note 1 for change in definition of the embedded derivative and Note 3 for impact of the change in fair value of the bifurcated feature.

 

An additional $1.5 million of accretion was recognized during the three months ended September 30, 2007 and 2006 and $4.5 million and $1.5 million was recognized during the nine months ended September 30, 2007 and 2006, respectively, for the 8% per annum cumulative dividends. Finally, the cost to issue the Series A-1 Preferred Stock of $5.1 million is also accreted back to the redemption value of the Series A-1 Preferred Stock and generated an additional $0.2 million of accretion for the three months ended September 30, 2007 and 2006 and an additional $0.5 million of accretion for the nine months ended September 30, 2007 and 2006.

 

 

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 U.S. The segment’s fully integrated suite of account presentation, 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. 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 operating results of the business segments exclude general corporate overhead expenses and intangible asset amortization.

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The results of operations from these reportable segments were as follows for the three and nine months ended September 30, 2007 and 2006 (in thousands):

 

 

 

 

 

At September 30, 2007, the Company had three stock-based employee compensation plans, which are described more fully below. Prior to January 1, 2006, the Company accounted for those plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees , and related interpretations, as permitted by Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”). Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R), Share-Based Payment (“SFAS No. 123(R)”), using the modified-prospective transition method. Under that transition method, compensation cost recognized includes: (a) compensation cost for all share-based payments granted prior to,

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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).

 

A portion of the stock based compensation cost has been capitalized as part of software development costs in accordance with Statement of Position No. 98-1, Accounting for Costs of Computer Software Developed or Obtained for Internal Use, and SFAS No. 86, Accounting for Costs of Software to be Sold, Leased, or Otherwise Marketed. For the three months ended September 30, 2007 and 2006, approximately $137,000 and $39,000, respectively, was capitalized, and $227,000 and $149,000 for the nine months ended September 30, 2007 and 2006, respectively. No income tax benefit was recognized in the statement of operations for share-based compensation arrangements since the Company currently recognizes a full valuation allowance against that benefit.

 

At the beginning of each year, the Management Development and Compensation (“MD&C”) Committee of the Board of Directors approves a bonus plan for the Company’s management. These plans grant a combination of cash and restricted stock units that vest based upon the attainment of approved corporate goals. On July 31, 2007, the Company estimated it was improbable the shares of the original plan would vest. At this time, the MD&C approved the cancellation of the 2007 bonus plan and the creation of a new 2007 bonus plan based on corporate goals established for the second half of 2007. In canceling the original 2007 bonus plan, the Company cancelled 153,683 unvested restricted stock units related to that plan and will recognize $1.2 million in total incremental compensation cost as a result of the modification.

 

Option Plans

 

During 1989, the Company adopted an Incentive Stock Option Plan (the “1989 Plan”), which has since been amended to allow for the issuance of up to 2,316,730 shares of common stock. The option price under the 1989 Plan cannot be less than fair market value of the Company’s common stock on the date of grant. The vesting period of the options is determined by the Board of Directors and is generally four years. Outstanding options expire after ten years.

 

During 1999, the Company adopted the 1999 Stock Option Plan (the “1999 Plan”), which permits the granting of both incentive stock options and nonqualified stock options to employees, directors and consultants. The aggregate number of shares that can be granted under the 1999 Plan is 5,858,331. The option exercise price under the 1999 Plan cannot be less than the fair market value of the Company’s common stock on the date of grant. The vesting period of the options is determined by the Board of Directors and is generally four years. Outstanding options expire after seven to ten years.

 

In May 2005, the stockholders approved the 2005 Restricted Stock and Option Plan (the “2005 Plan”), which permits the granting of restricted stock units and awards, stock appreciation rights, incentive stock options and non-statutory stock options to employees, directors and consultants. The aggregate number of shares that can be granted under the 2005 Plan is 1.7 million. The vesting period of the options and restricted stock is determined by the Board of Directors and is generally one to three years. Outstanding options expire after seven to ten years.

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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 volatility) or is expected to fluctuate (expected volatility) during a period. The Company uses the historical volatility over the average expected term of the options granted.

 

Risk-Free Interest Rate.  This is the U.S. Treasury rate for the week of each option grant during the quarter 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 quarter have a maximum term of seven to ten years. The Company used 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 option activity under the 1989, 1999 and 2005 Plans as of September 30, 2007, and changes in the period then ended is presented below (in thousands, except exercise price and remaining contract term data):

 

 

The weighted-average grant-date fair value of options granted during the three months ended September 30, 2007 and 2006 was $6.74 and $4.93, respectively, and $5.44 and $6.65 for the nine months ended September 30, 2007 and 2006, 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 exercise price. The intrinsic value of options exercised in the

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

three months ended September 30, 2007 and 2006 was $0.9 million and $0.2 million, respectively, and $4.4 million and $1.9 million for the nine months ended September 30, 2007 and 2006, respectively.

 

As of September 30, 2007, there was $2.3 million of total unrecognized compensation cost related to stock options granted under the 1999 and 2005 Plans. That cost is expected to be recognized over a weighted average period of 1.6 years.

 

Restricted Stock Units

 

A summary of the Company’s non-vested restricted stock units as of September 30, 2007, and changes for the nine months 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, 2007, there was $3.1 million of total unrecognized compensation cost related to non-vested restricted stock units granted under the 2005 Plan. That cost is expected to be recognized over a weighted average period of 1.3 years.

 

Cash received from option exercises under all share-based payment arrangements for the three months ended September 30, 2007 and 2006 was $0.7 million and $0.3 million, respectively, and $3.3 million and $2.8 million for the nine months ended September 30, 2007 and 2006. There was no tax benefit realized for the tax deductions from option exercise of the share-based payment arrangements since the Company currently recognizes a full valuation allowance against that benefit.

 

 

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 analyzed its income tax posture using the criteria required by FIN 48 and concluded that there is no cumulative effect allocable to equity as a result of adopting this standard, or any derecognition in deferred tax assets that were previously offset by a partial valuation allowance as a result of adopting FIN 48, which has no net balance sheet impact and has not been charged to equity in the transition.

 

As of September 30, 2007 and December 31, 2006, the Company doesn’t have any unrecognized tax benefits.

 

The tax return years from 1999 forward in the Company’s major tax jurisdictions are not settled as of January 1, 2007 and no changes in settled tax years have occurred through September 30, 2007. Due to the existence of tax attribute carryforwards (which are currently offset by a partial valuation allowance), the Company treats certain post-1999 tax positions as unsettled due to the taxing authorities’ ability to modify these attributes.

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The Company estimates that it is reasonably possible that no reduction in unrecognized tax benefit may occur in the next twelve months due primarily to the expiration of the statute of limitations in various state and local jurisdictions. The Company does not currently estimate any additional material reasonably possible uncertain tax positions occurring within the next twelve month time frame. Furthermore, the Company continues to evaluate its net deferred tax asset valuation allowance, including the effects of the ITS acquisition, in regards to the likelihood of realization of the deferred tax assets.

 

 

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

 

 

Approximately 6,791,000 and 8,645,000 shares of common stock equivalents for the three months ended September 30, 2007 and 2006, respectively, and 8,730,000 and 5,647,000 shares of common stock equivalents for the nine months ended September 30, 2007 and 2006, 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 balance sheet. The following table reconciles the Company’s net income (loss) and its total

 

ONLINE RESOURCES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

comprehensive income (loss) for the three and nine months ended September 30, 2007 and 2006 (in thousands):

 

 

 

CAUTIONARY NOTE

 

The following management’s discussion and analysis should be read in conjunction with the accompanying 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 March 16, 2007. These risks include, among others, the following:

 

 

 

OVERVIEW

 

We provide outsourced, web-based financial technology services branded to thousands of financial institution, biller, card issuer and creditor clients. 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 and intangible asset amortization.

 

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, 2006, the number of users using our account presentation services increased by 40%, and the number of users using our payment services increased 42%, for an overall 42% increase in users.

 

 

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 either 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 (unallocated expenses are comprised of general corporate overhead and intangible asset amortization) (dollars in thousands):

 

 

 

 

 

 

 

THREE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 2006

 

Revenues

 

We generate revenues from account presentation, payment, relationship management and professional services and other revenues. Revenues increased $6.0 million, or 21% to $34.2 million for the three months ended September 30, 2007, from $28.3 million for the same period of 2006. Approximately 49% of the increase was attributable to the addition of revenues from our acquisition of Internet Transaction Solutions, Inc. (“ITS”), which we acquired on August 10, 2007, while the remaining 51% of the increase was attributable

to organic growth relative to 2006. The increase in revenue was partially offset by a change in method of recognition of deferred revenue and deferred costs for deferred new user setup fees.

 

 

Notes:

 

 

 

Account Presentation Services.  Both the Banking and eCommerce segments contribute to account presentation services revenues, which increased 12%, or $0.2 million, to $2.2 million. The increase is the result of growth in eCommerce account presentation services offered to card issuer clients.

 

Payment Services.  Both the Banking and eCommerce segments contribute to payment services revenues, which increased to $27.2 million for the three months ended September 30, 2007 from $21.7 million in the prior year. While approximately 54% of the increase was related to the addition of new revenues from the acquisition of ITS, the remaining 46% was driven by growth in our existing business. The growth in our existing business is the result of growth of payment transactions in both the Banking and eCommerce segments. Banking transactions grew by 13% compared to the third quarter of 2006, and biller transactions grew by 57%. The growth in banking transactions is the result of increased usage at our existing clients and the net addition of new clients since 2006. While the same is true for biller transactions, the growth in biller transactions is higher due to the immaturity of that market relative to the Banking segment.

 

Relationship Management Services.  Primarily composed of revenues from the Banking segment, relationship management services revenues decreased from $2.0 million in 2006 to $1.7 million in 2007. Relationship management services revenues decreased due to a one-time adjustment of $0.4 million that was made during the third quarter of 2007 related to a change in method of recognition of deferred revenue and deferred costs for deferred new user setup fees. Revenues would have otherwise remained 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 by $0.5 million, or 21%, to $3.2 million during the three months ended September 30, 2007 compared to $2.6 million during the same period of 2006. The increase is the result of higher professional services fees in the eCommerce segment and the launch of our new risk-based authentication service in the fourth quarter of 2006.

Costs and Expenses