News Column

IPAYMENT HOLDINGS, INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 14, 2014

Executive Overview We are a provider of credit and debit card payment processing services to small merchants across the United States. Our payment processing services enable our merchants to accept credit cards as well as other forms of payment, including debit cards, checks, gift cards and loyalty programs in traditional card-present, or swipe transactions, as well as card-not-present transactions, such as those done over the phone or through the internet. During the three months ended June 30, 2014, we generated revenue from approximately 150,000 merchants. Of these merchants, approximately 106,000 were active merchants that had each processed at least one Visa or MasterCard transaction during that month. We market and sell our services through independent sales groups, or "ISGs," which are non-employee, external sales organizations, an employee sales force, telesales, marketing directly to merchants using electronic media, and other third party resellers of our products and services. In addition, we partner with banks such as Wells Fargo to sponsor us for membership in the Visa, MasterCard or other card brand associations and to settle card payment transactions with our merchants. We perform core functions for small merchants such as application processing, underwriting, account set-up, risk management, fraud detection, merchant assistance and support, equipment deployment, and chargeback services, primarily at our main operating facility in Westlake Village, California. Our strategy has been to increase profits by increasing our penetration of the small merchant marketplace for payment services. Our charge volume increased by 0.5% to $11.0 billion for the six months ended June 30, 2014 from $10.9 billion for the six months ended June 30, 2013. This increase in charge volume was due primarily to higher transactions per merchant per month partially offset by lower number of merchants on file for the first six months of 2014 compared to 2013. Our revenues increased $11.1 million or 3.4% to $341.0 million in the first six months of 2014 from $329.9 million in the same period in 2013. The increase in revenues was due primarily to an increase in average revenue per merchant and slightly higher volume. Our net revenue decreased $0.3 million or 0.2% to $132.4 million for the six months ended June 30, 2014 from $132.7 million during the same period in 2013. Our net revenue is composed of total revenue reduced by interchange fees and network fees. Income from operations increased $4.1 million, or 21.6%, to $22.8 million for the six months ended June 30, 2014, from $18.7 million during the same period in 2013. This increase in income from operations was primarily due to higher net revenues and lower one-time charges related to an amended purchase agreement and the related employment agreements related to the acquisition of Flagship Merchant Services in 2012, offset by a decrease in embezzlement recoveries received by the Company. Excluding stock based compensation, the Flagship one-time charges, and embezzlement recoveries and costs, income from operations for the first six months would have been $24.5 million or 10.1% lower than the comparable period in 2013. Our loss before income taxes was $10.1 million for iPayment and its consolidated subsidiaries and $24.1 million for Holdings and its consolidated subsidiaries during the six months ended June 30, 2014, compared to $14.8 million of loss before income taxes for iPayment and its consolidated subsidiaries and $28.1 million of loss before income taxes for Holdings and its consolidated subsidiaries in the same period in 2013. Critical Accounting Policies The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP"), which require that management make numerous estimates and assumptions. Actual results could differ from those estimates and assumptions, impacting our reported results of operations and financial position. The critical accounting policies described here are those that are most important to the depiction of our financial condition and results of operations and their application requires management's most subjective judgment in making estimates about the effect of matters that are inherently uncertain. Accounting for Goodwill and Intangible Assets. We follow ASC 350, Intangibles-Goodwill and Other Topics, which addresses financial accounting and reporting for acquired goodwill and other intangible assets, and requires that goodwill is subject to at least an annual assessment for impairment. If facts and circumstances indicate goodwill may be impaired, we perform a recoverability evaluation. In accordance with ASC 350, the recoverability analysis is based on fair value. The calculation of fair value includes a number of estimates and assumptions, including projections of future income and cash flows, the identification of appropriate market multiples and the choice of an appropriate discount rate. We engage, on a periodic basis, an independent third party to aid management in determining the fair value of our goodwill. We also periodically evaluate the carrying value of long-lived assets in relation to the respective projected future undiscounted cash flows to assess recoverability. An impairment loss is recognized if the sum of the expected net cash flows is less than the carrying amount of the long-lived assets being evaluated. The difference between the carrying amount of the long-lived assets being evaluated and their fair value, calculated as the sum of the expected cash flows discounted at a market rate, represents the impairment loss. Based on an analysis we performed during the fourth quarter of 2013, we concluded that our "iPayment Inc." trade name was impaired by $5.0 million and recognized the applicable charge in the year ended December 31, 2013. 28



--------------------------------------------------------------------------------

Table of Contents

During the quarter ended June 30, 2014, the Company voluntarily changed the date of its annual goodwill and indefinite-lived intangible assets impairment testing from May 31 to October 1. This voluntary change is preferable under the circumstances as it provides the Company with appropriate time to complete its annual goodwill and indefinite-lived intangible asset impairment testing in advance of its year-end reporting and results in better alignment with the Company's strategic planning and forecasting process. The voluntary change in accounting principle related to the annual testing date will not delay, accelerate or avoid an impairment charge. This change is not applied retrospectively as it is impracticable to do so because retrospective application would require application of significant estimates and assumptions with the use of hindsight. Accordingly, the change will be applied prospectively. Purchased merchant processing portfolios are recorded at cost and are evaluated by management for impairment at the end of each fiscal quarter through review of actual attrition and cash flows generated by the portfolios in relation to the expected attrition and cash flows and the recorded amortization expense. Amortization of intangible assets results from our acquisitions of portfolios of merchant contracts, revenue streams related to residual agreements related to merchant portfolios, or residual buyouts or acquisitions of a business where we allocated a portion of the purchase price to the existing merchant processing portfolios and other intangible assets. The estimated useful lives of our merchant processing portfolios are assessed by evaluating each portfolio to ensure that the recognition of the costs of revenues, represented by amortization of the intangible assets, approximate the distribution of the expected revenues from each processing portfolio. If, upon review, actual attrition and cash flows indicate impairment of the value of the merchant processing portfolios, an impairment loss would be recognized. Historically, we have experienced monthly volume attrition ranging from 1.5% to 2.2% of our total charge volume on our various merchant portfolios. We utilize an accelerated method of amortization over a 15-year period, which we believe approximates the distribution of actual cash flows generated by our merchant processing portfolios. All other intangible assets are amortized using the straight-line method over an estimated life of three to seven years. In addition, we have implemented both quarterly and annual procedures to determine whether a significant change in the trend of the current attrition rates being used has occurred on a portfolio-by-portfolio basis. In reviewing the current attrition rate trends, we consider relevant benchmarks such as charge volume, revenues, number of merchant accounts, gross profit and future expectations of the aforementioned factors compared to historical amounts and rates. If we identify any significant changes or trends in the attrition rate of any portfolio, we will adjust our current and prospective estimated attrition rates so that the amortization expense better approximates the distribution of actual cash flows generated by the merchant processing portfolios. Any adjustments made to the amortization schedules would be treated as a change in estimate and accounted for prospectively. Revenue and Cost Recognition. Substantially all of our revenues are generated from fees charged to merchants for payment processing services. We typically charge these merchants a bundled rate, primarily based upon each merchant's monthly charge volume and risk profile. Our fees principally consist of discount fees, which are a percentage of the dollar amount of each credit or debit transaction. We charge merchants higher discount rates for card-not-present transactions than for card-present transactions in order to provide compensation for the higher risk of underwriting these transactions. We derive the balance of our revenues from a variety of fixed transaction or service fees, including fees for monthly minimum charge volume requirements, statement fees, annual fees, payment card industry compliance fees, ancillary products, and fees for other miscellaneous services, such as handling chargebacks. We recognize discounts and other fees related to payment transactions at the time a merchant's transactions are processed. Related interchange and assessment costs are also recognized at that time. We recognize revenues derived from service fees at the time the service is performed. Generally, where we have ultimate responsibility for the merchant, as evidenced by our liability for merchant losses or credit risk, or portability with respect to such merchant, revenues are reported at the time of sale on a gross basis equal to the full amount of the discount charged to the merchant pursuant to ASC 605. This amount includes interchange paid to card issuing banks and assessments paid to payment card associations pursuant to which such parties receive payments based primarily on processing volume for particular groups of merchants. Interchange fees are recognized at the time transactions are processed. Revenues generated from merchant contracts where we do not have liability for merchant losses or credit risk or rights of portability, such as certain merchant portfolios we acquired from FDMS and certain of our other portfolios and merchant contracts, are reported net of interchange, as required by ASC 605. The most significant component of operating expenses is interchange fees, which are amounts we pay to the card issuing banks. Interchange fees are primarily based on transaction processing volume, except in the case of regulated debit transactions, where they are based primarily on a per transaction basis and are recognized at the time transactions are processed. Other costs of services include costs directly attributable to our provision of payment processing and related services to our merchants and primarily includes residual payments to ISGs, which are commissions we pay to our sales partners based upon a percentage of the net revenues we generate from their merchant referrals, and assessment fees payable to card associations, which are a percentage of the charge volume we generate from Visa and MasterCard. In addition, other costs of services include telecommunications costs, personnel costs, occupancy costs, bonuses and commissions to our sales employees, losses 29



--------------------------------------------------------------------------------

Table of Contents

due to merchant defaults, other miscellaneous merchant supplies and services expenses, bank sponsorship costs and other third-party processing costs. Other costs of services also include depreciation expense, which is recognized on a straight-line basis over the estimated useful life of the assets, and amortization expense which is primarily recognized using an accelerated method over a 15-year period. Amortization of intangible assets results from our acquisitions of portfolios of merchant contracts or acquisitions of a business where we allocated a portion of the purchase price to the existing merchant processing portfolios and other intangible assets. Selling, general and administrative expenses consists primarily of salaries and wages, as well as other general administrative expenses such as marketing expenses and professional fees. Reserve for Merchant Losses. Disputes between a cardholder and a merchant periodically arise as a result of, among other things, cardholder dissatisfaction with merchandise quality or merchant services. Such disputes may not be resolved in the merchant's favor. In these cases, the transaction is "charged back" to the merchant, which means the purchase price is refunded to the customer through the merchant's acquiring bank and charged to the merchant. If the merchant has inadequate funds, we or, under limited circumstances, the acquiring bank and us, must bear the credit risk for the full amount of the transaction. We evaluate the merchant's risk for such transactions and estimate its potential loss for chargebacks based primarily on historical experience and other relevant factors and record a loss reserve accordingly. At June 30, 2014, and December 31, 2013, our reserve for losses on merchant accounts included in accrued liabilities and other totaled $1.2 million and $1.2 million, respectively. We believe our reserve for charge-back and other similar processing-related merchant losses is adequate to cover both the known probable losses and the incurred but not yet reported losses at June 30, 2014. Income Taxes. We account for income taxes pursuant to the provisions of ASC 740, Income Taxes. Under this method, deferred tax assets and liabilities are recorded to reflect the future tax consequences attributable to the effects of differences between the carrying amounts of existing assets and liabilities for financial reporting and for income tax purposes. Authoritative guidance requires the recording of a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Under this guidance, forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years. Such objective evidence limits the ability to consider other evidence such as our projections for future growth. We have reported a cumulative pretax book loss for the current and two preceding years. Considering the likelihood of realization of deferred tax assets, in 2013 we reached the determination that a valuation allowance was appropriate. Management assesses the ability to realize the deferred tax assets based on the criteria of authoritative guidance each reporting period. If future events differ from management's estimates, the valuation allowance may change in future periods. Seasonality Our revenues and earnings are impacted by the volume of consumer usage of credit and debit cards at the point of sale. For example, we experience increased point of sale activity during the traditional holiday shopping period in the fourth quarter. Revenues during the first quarter tend to be less than the remaining three quarters of our fiscal year on a same store basis, particularly in comparison to our fourth quarter. Off-Balance Sheet Arrangements We do not have transactions, arrangements or other relationships with unconsolidated entities that are reasonably likely to affect our liquidity or capital resources. We have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity or market or credit risk support, engage in leasing, hedging, research and development services, or other relationships that expose us to liability that is not reflected in our financial statements. 30



--------------------------------------------------------------------------------

Table of Contents

Results of Operations Three Months Ended June 30, 2014, Compared to Three Months Ended June 30, 2013 Three months ended June 30, Change (Dollars in thousands, % of Total % of Total



except percentages) 2014 Revenue 2013 Revenue

Amount % Revenues $ 182,875 100.0 % $ 173,939 100.0 % $ 8,936 5.1 % Operating expenses Interchange 97,335 53.2 % 90,602 52.1 % 6,733 7.4 % Other costs of services (1) 63,215 34.6 % 62,069 35.7 % 1,146 1.8 % Selling, general and administrative (2) 6,822 3.7 % 13,855 8.0 % (7,033 ) (50.8 )% Embezzlement costs (156 ) (0.1 )% (458 ) (0.3 )% 302 (65.9 )% Total operating expenses (3) 167,216 91.4 % 166,068 95.5 % 1,148 0.7 % Income from operations 15,659 8.6 % 7,871 4.5 % 7,788 98.9 % Other expense Interest expense, net (4) 16,497 9.0 % 15,485 8.9 % 1,012 6.5 % Other expense (income), net (155 ) (0.1 )% 189 0.1 % (344 ) (182.0 )%

Total other expense (5) 16,342 8.9 % 15,674 9.0 % 668 4.3 % Loss before income taxes (6) (683 ) (0.4 )% (7,803 ) (4.5 )% 7,120 (91.2 )% Income tax provision (benefit) (7) (374 ) (0.2 )% 13,779 7.9 % (14,153 ) (102.7 )% Net loss (8) $ (309 ) (0.2 )% $ (21,582 ) (12.4 )% $ 21,273 (98.6 )%



(1) Other costs of services of Holdings and its consolidated subsidiaries for the

three months ended June 30, 2014, and June 30, 2013, are $63.2 million and

$62.1 million, respectively.

(2) Selling, general and administrative expense of Holdings and its consolidated

subsidiaries for the three months ended June 30, 2014, and June 30, 2013, are

$6.9 million and $13.9 million, respectively.

(3) Total operating expenses of Holdings and its consolidated subsidiaries for

the three months ended June 30, 2014, and June 30, 2013, are $167.3 million

and $166.1 million, respectively.

(4) Net interest expense of Holdings and its consolidated subsidiaries for the

three months ended June 30, 2014, and June 30, 2013, are $23.5 million and

$22.0 million, respectively.

(5) Total other expense of Holdings and its consolidated subsidiaries for the

three months ended June 30, 2014, and June 30, 2013, are $23.4 million and

$22.2 million, respectively.

(6) Loss before income taxes of Holdings and its consolidated subsidiaries for

the three months ended June 30, 2014, and June 30, 2013, are $7.8 million and

$14.3 million, respectively.

(7) Income taxes of Holdings and its consolidated subsidiaries for the three

months ended June 30, 2014, and June 30, 2013, consists of an income tax

benefit of $0.4 million and an income tax expense of $13.6 million,

respectively.

(8) Net loss of Holdings and its consolidated subsidiaries for the three months

ended June 30, 2014, and June 30, 2013, are $7.4 million and $27.9 million,

respectively.

Revenues. Revenues increased 5.1% to $182.9 million in the second quarter of 2014 from $173.9 million during the same period in 2013. This increase was driven by a higher number of transactions processed and average volume per merchant, partially mitigated by a lower number of total merchants, year over year. Interchange Expenses. Interchange expense was $97.3 million in the second quarter of 2014, compared with $90.6 million for the same period in 2013. Interchange expenses increased due to an increase in the average interchange rate as a percentage of merchant processing volume from 1.6% during the second quarter of 2013 to 1.7% for the same period in 2014, as well as, due to an increase in credit type transactions as opposed to debit type transactions during the second quarter of 2014 compared to the same period in 2013. Other Costs of Services. Other costs of services increased 1.8% to $63.2 million for iPayment and its consolidated subsidiaries in the second quarter of 2014 as compared to $62.1 million during the same period in 2013. The increase in other costs of services was primarily due to higher residual expense, higher marketing and advertising expense, offset by lower portfolio amortization and depreciation expense for the three months ended June 30, 2014. 31



--------------------------------------------------------------------------------

Table of Contents

Selling, General and Administrative. Selling, general and administrative expenses decreased 50.8% to $6.8 million for iPayment and its consolidated subsidiaries in the second quarter of 2014 as compared to $13.9 million during the same period in 2013. This decrease was primarily driven by lower expense due to one-time charges incurred in the second quarter of 2013 related to the amendment of the Flagship purchase agreement and related employment agreements, offset by higher marketing and advertising expenses during the second quarter of 2014. Excluding stock based compensation, the Flagship-related charges, and remediation costs, selling, general and administrative expense increased $1.0 million or 17.9%. Other Expense. Total other expense increased $0.7 million to $16.3 million for iPayment and its consolidated subsidiaries and increased $1.2 million to $23.4 million for Holdings and its consolidated subsidiaries in the second quarter of 2014, from $15.7 million for iPayment and its consolidated subsidiaries and $22.2 million for Holdings and its consolidated subsidiaries during the same period in 2013. Other expense in the second quarter of 2014 primarily consisted of interest expense. Interest expense increased to $16.5 million for iPayment and its consolidated subsidiaries and increased to $23.5 million for Holdings and its consolidated subsidiaries in the second quarter of 2014 from $15.5 million for iPayment and its consolidated subsidiaries and $22.0 million for Holdings and its consolidated subsidiaries in the same period in 2013. Income Tax. iPayment and its consolidated subsidiaries and Holdings and its consolidated subsidiaries had an income tax benefit of $0.4 million and $0.4 million, respectively, during the second quarter of 2014, compared to an income tax expense of $13.8 million and $13.6 million, respectively, during the same period in 2013. iPayment and its consolidated subsidiaries and Holdings and its consolidated subsidiaries had effective tax rates of 54.7% and 4.8%, respectively, during the second quarter of 2014, compared to effective tax rates of (176.6)% and (95.0)% respectively, during the same period in 2013. For both iPayment and its consolidated subsidiaries and Holdings and its consolidated subsidiaries, the effective tax rate for the second quarter of 2014 was primarily due to a $1.5 million tax benefit from a state tax refund received during the quarter. The difference between the effective tax rates for Holdings and its consolidated subsidiaries and iPayment and its consolidated subsidiaries relates to the interest deductibility limitations with respect to Holdings' 15.00%/15.00% Notes, which constitute an "Applicable High Yield Discount Obligation" for U.S. federal income tax purposes. We have reported a cumulative pretax book loss for 2014, 2013 and 2012. Considering the likelihood of realization of deferred tax assets, in the second quarter of 2013 we reached the determination that a valuation allowance was appropriate. Management assesses the realizability of the deferred tax assets based on the criteria of authoritative guidance each reporting period. If future events differ from management's estimates, the valuation allowance may change in future periods. 32



--------------------------------------------------------------------------------

Table of Contents

Six Months Ended June 30, 2014, Compared to Six Months Ended June 30, 2013

Six months ended June 30, Change (Dollars in thousands, % of Total % of Total



except percentages) 2014 Revenue 2013 Revenue

Amount % Revenues $ 340,982 100.0 % $ 329,889 100.0 % $ 11,093 3.4 % Operating expenses Interchange 183,341 53.8 % 172,443 52.3 % 10,898 6.3 % Other costs of services (1) 121,891 35.7 % 121,765 36.9 % 126 0.1 % Selling, general and administrative (2) 13,237 3.9 % 19,722 6.0 % (6,485 ) (32.9 )% Embezzlement costs (272 ) (0.1 )% (2,777 ) (0.8 )% 2,505 (90.2 )% Total operating expenses (3) 318,197 93.3 % 311,153 94.3 % 7,044 2.3 % Income from operations 22,785 6.7 % 18,736 5.7 % 4,049 21.6 % Other expense Interest expense, net (4) 32,947 9.7 % 30,854 9.4 % 2,093 6.8 % Other expense (income), net (68 ) - % 2,726 0.8 % (2,794 ) (102.5 )% Total other expense (5) 32,879 9.6 % 33,580 10.2 % (701 ) (2.1 )% Loss before income taxes (6) (10,094 ) (3.0 )% (14,844 ) (4.5 )% 4,750 (32.0 )% Income tax provision (benefit) (7) 1,762 0.5 % 10,405 3.2 % (8,643 ) (83.1 )% Net loss (8) $ (11,856 ) (3.5 )% $ (25,249 ) (7.7 )% $ 13,393 (53.0 )%



(1) Other costs of services of Holdings and its consolidated subsidiaries for the

six months ended June 30, 2014 and 2013, are $121.9 million and $121.8

million, respectively.

(2) Selling, general and administrative expense of Holdings and its consolidated

subsidiaries for the six months ended June 30, 2014 and 2013, are $13.3

million and $19.8 million, respectively.

(3) Total operating expenses of Holdings and its consolidated subsidiaries for

the six months ended June 30, 2014 and 2013, are $318.3 million and $311.2

million, respectively.

(4) Net interest expense of Holdings and its consolidated subsidiaries for the

six months ended June 30, 2014 and 2013, are $46.9 million and $44.1 million,

respectively.

(5) Total other expense of Holdings and its consolidated subsidiaries for the six

months ended June 30, 2014 and 2013, are $46.8 million and $46.8 million,

respectively.

(6) Loss before income taxes of Holdings and its consolidated subsidiaries for

the six months ended June 30, 2014 and 2013, are $24.1 million and $28.1

million, respectively.

(7) Income taxes of Holdings and its consolidated subsidiaries for the six months

ended June 30, 2014 and 2013, consists of an income tax expense of $1.8

million and $11.0 million, respectively.

(8) Net loss of Holdings and its consolidated subsidiaries for the six months

ended June 30, 2014 and 2013, are $25.9 million and $39.1 million,

respectively.

Revenues. Revenues increased 3.4% to $341.0 million for the six months ended June 30, 2014 from $329.9 million during the same period in 2013. This increase was driven by a higher number of transactions processed and average volume per merchant, partially mitigated by a lower number of total merchants, year over year. Interchange Expenses. Interchange expense was $183.3 million for the six months ended June 30, 2014, compared to $172.4 million for the same period in 2013. Interchange expenses increased due to an increase in the average interchange rate as a percentage of merchant processing volume from 1.6% during the second quarter of 2013 to 1.7% for the same period in 2014. Other Costs of Services. Other costs of services increased 0.1% to $121.9 million for iPayment and its consolidated subsidiaries for the six months ended June 30, 2014 as compared to $121.8 million during the same period in 2013. The increase in other costs of services was primarily due to higher residual expense, higher marketing and advertising expense offset by lower portfolio amortization and depreciation expense for the six months ended June 30, 2014. Selling, General and Administrative. Selling, general and administrative expenses decreased 32.9% to $13.2 million for iPayment and its consolidated subsidiaries for the six months ended June 30, 2014 as compared to $19.7 million during the same 33



--------------------------------------------------------------------------------

Table of Contents

period in 2013. This decrease was driven by lower expense due to one-time charges incurred in the second quarter of 2013 related to the amendment of the Flagship purchase agreement and related employment agreements, lower professional services fees for legal and accounting, offset by higher marketing and advertising expenses for the six months ended June 30, 2014. The decline in professional services was largely due to $0.8 million in expenses associated with the embezzlement during the six months ended June 30, 2013. Excluding stock based compensation, the Flagship-related charges, and remediation costs, selling, general and administrative expense increased $1.8 million or 17.8%. Other Expense. Total other expense decreased $0.7 million to $32.9 million for iPayment and its consolidated subsidiaries from $33.6 million during the same period in 2013, but had no change for Holdings and its consolidated subsidiaries for the six months ended June 30, 2014, which remained at $46.8 million compared to the same period in 2013. Other expense for the six months ended June 30, 2014 primarily consisted of interest expense. Interest expense increased to $32.9 million for iPayment and its consolidated subsidiaries and increased to $46.9 million for Holdings and its consolidated subsidiaries for the six months ended June 30, 2014, and other expense decreased from $30.9 million for iPayment and its consolidated subsidiaries and $44.1 million for Holdings and its consolidated subsidiaries in the same period in 2013. Non-interest other expense for both iPayment and its consolidated subsidiaries and Holdings and its consolidated subsidiaries decreased $2.8 million compared to the same period in 2013 due to a legal settlement we incurred in the second quarter of 2013. Income Tax. iPayment and its consolidated subsidiaries and Holdings and its consolidated subsidiaries had an income tax expense of $1.8 million and $1.8 million, respectively, for the six months ended June 30, 2014, compared to an income tax expense of $10.4 million and $11.0 million, respectively, during the same period in 2013. iPayment and its consolidated subsidiaries and Holdings and its consolidated subsidiaries had effective tax rates of (17.5)% and (7.3)%, respectively, for the six months ended June 30, 2014, compared to effective tax rates of (70.1)% and (39.1)%, respectively, during the same period in 2013. For both iPayment and its consolidated subsidiaries and Holdings and its consolidated subsidiaries, the inverse effective tax rate for the six months ended June 30, 2014 was primarily due to the recording of a valuation allowance against our deferred tax assets in the second quarter of 2013, decreased by a $1.5 million tax benefit from a state tax refund received in the second quarter of 2014. The difference between the effective tax rates for Holdings and its consolidated subsidiaries and iPayment and its consolidated subsidiaries relates to the interest deductibility limitations with respect to Holdings' 15.00%/15.00% Notes, which constitute an "Applicable High Yield Discount Obligation" for U.S. federal income tax purposes. We have reported a cumulative pretax book loss for 2014, 2013 and 2012. Considering the likelihood of realization of deferred tax assets, in 2013 we reached the determination that a valuation allowance was appropriate. Management assesses the realizability of the deferred tax assets based on the criteria of authoritative guidance each reporting period. If future events differ from management's estimates, the valuation allowance may change in future periods. Liquidity and Capital Resources As of June 30, 2014 and December 31, 2013, we had cash and cash equivalents of approximately $0.7 million and $8.0 million, respectively. We usually minimize cash balances in order to minimize borrowings and, therefore, interest expense. As of June 30, 2014, iPayment and its consolidated subsidiaries had a net working capital deficit (current liabilities in excess of current assets) of $10.9 million compared to a net deficit of $3.6 million as of December 31, 2013. The increase in current deficit is primarily due to decreases in cash and cash equivalents, accounts receivable and prepaid and other current assets of $7.3 million, $1.2 million and $0.5 million, respectively, and increases in income taxes payable and accounts payable of $0.4 million and $0.7 million, respectively, offset by a decrease in accrued liabilities of $2.7 million. As of June 30, 2014, Holdings and its consolidated subsidiaries had a net working capital deficit of $5.1 million compared to working capital of $2.5 million as of December 31, 2013. The increase in current deficit is primarily due to decreases in cash and cash equivalents, accounts receivable, income taxes receivable and prepaid and other current assets of $7.3 million, $1.2 million, $0.4 million and $0.5 million, respectively, and an increase in accounts payable and accrued interest payable of $0.7 million and $0.1 million, respectively, offset by a decrease in accrued liabilities and other of $2.7 million. We expect that our cash flow from operations and proceeds from borrowings under our revolving facility will be our primary sources of liquidity and will be sufficient to fund our cash requirements for at least the next twelve months. See "Contractual Obligations" below for a description of future required uses of cash. We have significant outstanding long-term debt as of June 30, 2014. The terms of our long-term debt contain various nonfinancial and financial covenants as further discussed in Note 5 to the consolidated financial statements. If we fail to comply with these covenants and are unable to obtain a waiver or amendment or otherwise cure the resulting breach, an event of default would result. If an event of default were to occur, the trustee under the indentures governing the Notes or the lenders 34



--------------------------------------------------------------------------------

Table of Contents

under the Senior Secured Credit Facilities could, among other things, declare outstanding amounts immediately due and payable. We currently do not have available cash and similar liquid resources available to repay all of our debt obligations if they were to become due and payable. As of June 30, 2014, our Senior Secured Leverage Ratio, as defined in the Senior Secured Credit Facilities, was 3.58 to 1.00 compared to the allowed maximum of 3.75 to 1.00. As of June 30, 2014, our Consolidated Interest Coverage Ratio, as defined in the Senior Secured Credit Facilities, was 1.38 to 1.00 compared to the allowed minimum of 1.25 to 1.00. If we do not generate sufficient cash flow from operations to satisfy our debt obligations, including interest payments and the payment of principal at maturity, we may have to undertake alternative financing plans, such as refinancing or restructuring our debt, selling assets, reducing or delaying capital investments or seeking to raise additional capital. We cannot be sure that any refinancing or sale of assets would be possible on commercially reasonable terms or at all. In addition, any refinancing of our debt could be at higher interest rates and may require us to comply with more burdensome covenants, which could further restrict our business operations. In addition, the 15.00%/15.00% Notes also include a leverage ratio test with which we must comply or pay additional interest. If Holdings' leverage ratio exceeds 7.25 to 1.00 as of the most recent quarter end prior to an interest payment date, then for the interest period ending on such date, the interest rate will be retroactively increased by 2.00% in the form of PIK interest. For the quarter ended June 30, 2014 we determined that Holdings' leverage ratio was 8.66 to 1.00 as of the most recent quarter end prior to such subsequent interest payment date and we will be required to pay 2.00% additional PIK interest on November 15, 2014. For further information on the 15.00%/15.00% Notes, see Note 5 to our consolidated financial statements. Operating activities Net cash provided by operating activities was $12.0 million for iPayment and its consolidated subsidiaries during the six months ended June 30, 2014. For iPayment and its consolidated subsidiaries, net cash provided by operating activities consisted of net loss of $11.9 million adjusted by depreciation and amortization of $20.1 million, share-based compensation of $0.7 million, non-cash interest expense and other of $1.0 million, loss on disposal of property and equipment of $0.2 million, and a net favorable change in operating assets and liabilities of $1.7 million. The net favorable change in operating assets and liabilities is due to increases in accounts and income taxes payable, deferred tax liabilities and other liabilities of $1.2 million, $2.2 million and $0.3 million, respectively, and decreases in accounts receivable and prepaid expenses and other current assets of $1.2 million and $0.5 million, respectively, offset by decreases in accrued liabilities and interest of $2.8 million and increases in other assets of $0.8 million. For Holdings and its consolidated subsidiaries, net cash provided by operating activities of $6.2 million consisted of a net loss of $25.9 million adjusted by depreciation and amortization of $20.1 million, share based compensation of $0.7 million, non-cash interest expense and other of $9.1 million, loss on disposal of property and equipment of $0.2 million, and a net favorable change in operating assets and liabilities of $1.9 million. The net favorable change in operating assets and liabilities is due to increases in accounts payable, deferred tax liabilities, accrued interest and other liabilities of $0.7 million, $2.2 million, $0.1 million and $0.3 million, respectively, and decreases in accounts receivable, income taxes receivable and prepaid and other current assets of $1.2 million, $0.4 million and $0.5 million, respectively, offset by a decrease in accrued liabilities and other of $2.7 million and an increase in other assets of $0.8 million. Net cash provided by operating activities was $18.6 million for iPayment and its consolidated subsidiaries during the six months ended June 30, 2013. Net cash provided by operating activities consisted of net loss of $25.2 million adjusted by depreciation and amortization of $25.0 million, share-based compensation of $4.8 million, non-cash interest income and other of $3.4 million, loss on disposal of property and equipment of $0.5 million, and a net favorable change in operating assets and liabilities of $16.9 million. The net favorable change in operating assets and liabilities is primarily due to decreases in accounts receivable and other assets, increases in deferred tax liabilities and accrued liabilities, offset by increases in prepaid expenses and other current assets and decreases in accounts payable and accrued interest. For Holdings and its consolidated subsidiaries, net cash provided by operating activities was $13.2 million during the six months ended June 30, 2013. Net cash provided by operating activities consisted of a net loss of $39.1 million adjusted by depreciation and amortization of $25.0 million, share based compensation of $4.8 million, non-cash interest expense and other of $3.5 million, loss on disposal of property and equipment of $0.5 million, and a net favorable change in operating assets and liabilities of $18.6 million. The net favorable change in operating assets and liabilities is primarily due to decreases in accounts receivable and other assets, increases in deferred tax liabilities, accrued liabilities and accrued interest, offset by increases in prepaid expenses and other current assets and decreases in accounts payable. 35



--------------------------------------------------------------------------------

Table of Contents

Investing activities Net cash used in investing activities for both iPayment and its consolidated subsidiaries and Holdings and its consolidated subsidiaries was $4.5 million during the six months ended June 30, 2014, consisting primarily of capital expenditures of $2.0 million, acquisitions of $3.0 million and payments received on notes receivable of $0.5 million. Net cash used in investing activities for iPayment and its consolidated subsidiaries and Holdings and its consolidated subsidiaries was $11.7 million during the six months ended June 30, 2013, consisting primarily of $1.9 million of property and equipment expenditures and $9.8 million of acquisitions of businesses and portfolios and payments for prepaid residual expenses. Financing activities Net cash used in financing activities for iPayment and its consolidated subsidiaries was $14.8 million during the six months ended June 30, 2014, consisting of $9.0 million in net repayments on the revolving facility under the Senior Secured Credit Facilities and dividends to Holdings of $5.8 million for the payment of interest on the 15.00%/15.00% Notes and certain expenses of Holdings. Net cash used in financing activities for Holdings and its consolidated subsidiaries was $9.0 million during the six months ended June 30, 2014, consisting of $9.0 million in net repayments on the revolving facility under the Senior Secured Credit Facilities. Net cash used in financing activities for iPayment and its consolidated subsidiaries was $11.3 million during the six months ended June 30, 2013, consisting of $5.0 million of repayments on the term loan under the Senior Secured Credit Facilities and $1.0 million of net repayments on the revolving facility thereunder and a $5.3 million dividend to Holdings which was used for the payment of interest on the 15.00%/15.00% Notes and certain expenses of Holdings. Net cash used in financing activities for Holdings and its consolidated subsidiaries was $6.0 million during the six months ended June 30, 2013, consisting of $5.0 million of repayments on the term loan under the Senior Secured Credit Facilities and $1.0 million of borrowings on the revolving facility thereunder. See Note 5 to the consolidated financial statements for further detail regarding the Company's long-term debt. Contractual Obligations The following table of our material contractual obligations as of June 30, 2014, summarizes the aggregate effect that these obligations are expected to have on our cash flows in the periods indicated. Payments due by



period

(Dollars in thousands) Total Less than 1 year 1-3 years 3-5 years More than 5 years Contractual Obligations of iPayment Senior Secured Credit Facilities 377,500 - 377,500 - - 10.25% Notes 400,000 - - 400,000 - Interest, net of discount and amortization (1) 229,489 66,860 127,947 34,682 - Operating lease obligations 20,649 2,673 5,383 5,529 7,064 Purchase obligations and other (2) 3,017 1,528 1,489 - - Total contractual obligations 1,030,655 71,061 512,319 440,211 7,064

Contractual Obligations of Holdings 15.00%/15.00% Notes(3) 132,288 - - 132,288 - Interest(1)(3) 86,362 10,157 43,546 32,659 - Total contractual obligations 218,650 10,157 43,546 164,947 -



(1) Future interest obligations are calculated using current interest rates on

existing debt balances as of June 30, 2014, and assume no principal reduction

other than mandatory principal repayments in accordance with the terms of the

debt instruments as discussed in Note 5 to the consolidated financial statements. 36



--------------------------------------------------------------------------------

Table of Contents

(2) Purchase obligations represent minimum monthly management charges due under a

fractional ownership arrangement and certain office equipment leases.

(3) Assumes that (i) for all interest periods through and including May 15, 2015,

Holdings will pay interest on 50% of the outstanding principal amount of its

15.00%/15.00% Notes in cash and 50% in kind and (ii) after May 15, 2015,

Holdings will make all interest payments on the 15.00%/15.00% Notes entirely

in cash.

We expect to be able to fund our operations, capital expenditures and the contractual obligations above (other than the repayment at maturity of the aggregate principal amount of (i) term loans under the Senior Secured Credit Facilities and (ii) the Notes) using our cash from operations. We intend to use our revolving facility primarily to fund temporary working capital needs and acquisition opportunities as they arise. To the extent we are unable to fund our operations, capital expenditures and the contractual obligations above using cash from operations, we intend to use borrowings under our revolving facility or future debt or equity financings. In addition, we may seek to sell additional equity or arrange debt financing to give us financial flexibility to pursue attractive opportunities that may arise in the future. If we raise additional funds through the sale of equity or convertible debt securities, these transactions may dilute the value of our outstanding common stock. We may also decide to issue securities, including debt securities, which have rights, preferences and privileges senior to our common stock. If future financing is not available or is not available on acceptable terms, we may not be able to fund our future needs, which may prevent us from increasing our market share, capitalizing on new business opportunities or remaining competitive in our industry. New Accounting Standards In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The standard is effective for annual periods beginning after December 15, 2016, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). We are currently evaluating the impact of our pending adoption of ASU 2014-09 on our consolidated financial statements and have not yet determined the method by which we will adopt the standard in 2017. Effects of Inflation Our monetary assets, consisting primarily of cash and receivables, are not significantly affected by inflation. Our non-monetary assets, consisting primarily of intangible assets and goodwill, are not affected by inflation. We believe that replacement costs of equipment, furniture and leasehold improvements will not materially affect our operations. However, the rate of inflation affects our expenses, such as those for employee compensation and other operating expenses, which may not be readily recoverable in the price of services offered by us. The rate of inflation can also affect our revenues by affecting our merchant charge volume and corresponding changes to processing revenue. 37



--------------------------------------------------------------------------------

Table of Contents


For more stories on investments and markets, please see HispanicBusiness' Finance Channel



Source: Edgar Glimpses


Story Tools






HispanicBusiness.com Facebook Linkedin Twitter RSS Feed Email Alerts & Newsletters