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TNS 10-K 2006

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

(Mark One)

 

 

x

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

 

 

SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

OR

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

 

 

SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to

 

Commission file number 1-32033


TNS, INC.
(Exact Name of Registrant as Specified in Its Charter)

DELAWARE

 

36-4430020

(State or Other Jurisdiction

 

(IRS Employer

of Incorporation or Organization)

 

Identification No.)

 

11480 COMMERCE PARK DRIVE, SUITE 600, RESTON, VIRGINIA

 

20191

(Address of Principal Executive Offices)

 

(Zip Code)

 

 

 

 

Registrant’s telephone number, including area code (703) 453-8300

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class

 

 

Name of Each Exchange on Which Registered

 

Common Stock

 

New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o  No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes o  No  x

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 twelve (12) months (or such shorter period that the Registrant was required to file such report) and (2) has been subject to such filing requirements for the past ninety (90) days. Yes x  No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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 x

 

Non-Accelerated Filer o

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes oNo    x

As of December 31, 2005, 23,971,001 shares of the Registrant’s common stock were outstanding. As of June 30, 2005 (the last business day of the Registrant’s most recently completed second fiscal quarter), the aggregate market value of such shares held by non-affiliates of the Registrant was approximately $300,245,584.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement relating to the 2006 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission, are incorporated by reference in Part III, Items 10 - 14 of this Annual Report on Form 10-K as indicated herein.

 




TNS, INC.
2006 FORM 10-K ANNUAL REPORT
INDEX

 

 

 

 

 

 

Page

 

PART I

 

 

 

 

 

 

 

 

 

 

 

Item 1.

 

Business

 

 

3

 

 

 

 

Item 1A.

 

Risk Factors

 

 

18

 

 

 

 

Item 1B.

 

Unresolved Staff Comments

 

 

25

 

 

 

 

Item 2.

 

Properties

 

 

25

 

 

 

 

Item 3.

 

Legal Proceedings

 

 

25

 

 

 

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

 

26

 

 

PART II

 

 

 

 

 

 

 

 

 

 

 

Item 5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

 

27

 

 

 

 

Item 6.

 

Selected Consolidated Financial Data

 

 

27

 

 

 

 

Item 7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

30

 

 

 

 

Item 7A.

 

Qualitative and Quantitative Disclosures About Market Risk

 

 

46

 

 

 

 

Item 8.

 

Financial Statements and Supplementary Data

 

 

48

 

 

 

 

Item 9.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

 

84

 

 

 

 

Item 9A.

 

Controls and Procedures

 

 

84

 

 

 

 

Item 9B.

 

Other Information

 

 

84

 

 

PART III

 

 

 

 

 

 

 

 

 

 

 

Item 10.

 

Directors and Executive Officers of the Registrant

 

 

85

 

 

 

 

Item 11.

 

Executive Compensation

 

 

88

 

 

 

 

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

 

88

 

 

 

 

Item 13.

 

Certain Relationships and Related Transactions

 

 

88

 

 

 

 

Item 14.

 

Principal Accountant Fees and Services

 

 

88

 

 

PART IV

 

 

 

 

 

 

 

 

 

 

 

Item 15.

 

Exhibits and Financial Statement Schedules

 

 

89

 

 

SIGNATURES

 

 

92

 

 

 

2




PART I

Throughout this report, we refer to TNS, Inc., together with its subsidiaries, as “we,” “us,” “our,” “TNS” or “the Company.” TransXpress, LEConnect, CARD*TEL and the TNS logo are our registered trademarks, and Synapse, Trader Voice and Secure Trading Extranet are our service marks. This report contains trade names, trademarks and service marks of other companies. We do not intend our use or display of other parties’ trade names, trademarks or service marks to imply a relationship with, or endorsement or sponsorship of, these other parties.

Forward-Looking Statements

We make forward-looking statements in this report based on the beliefs and assumptions of our management and on information currently available to us. Forward-looking statements include information about our possible or assumed future results of operations in “Business,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the headings “Overview,” “Liquidity and Capital Resources” and other sections throughout this report. The forward-looking statements are based on current expectations, forecasts and assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those set forth in, or implied by, the forward-looking statements. The Company has attempted, whenever possible, to identify these forward-looking statements using words such as “may,” “will,” “should,” “projects,” “estimates,” “expects,” “plans,” “intends,” “anticipates,” “believes,” and variations of these words and similar expressions. Similarly, statements herein that describe the Company’s business strategy, prospects, opportunities, outlook, objectives, plans, intentions or goals are also forward-looking statements.

Forward-looking statements involve risks, uncertainties and assumptions, including risks described below and other risks that we describe from time to time in our periodic filings with the SEC, and our actual results may differ materially from those expressed in our forward-looking statements. We therefore caution you not to rely unduly on any forward-looking statement. The forward-looking statements in this report speak only as of the date of the report, and we undertake no obligation to update or revise any forward-looking statement, whether as a result of new information, future developments or otherwise. The forward-looking statements should not be relied upon as representing the Company’s views as of any date subsequent to the date of this filing. The forward-looking statements in this document are intended to be subject to the safe harbor protection provided by Sections 27A of the Securities Act and 21E of the Securities Exchange Act of 1934, as amended.

Item 1.                        Business

Overview

We are a leading provider of business-critical data communications services to processors of credit card, debit card and ATM transactions. We are also a leading provider of secure data and voice network services to the global financial services industry. We operate one of four unaffiliated Signaling System No. 7 networks in the United States capable of providing services nationwide, and we utilize this network to provide call signaling and database access services to the domestic telecommunications industry. Our data communications services enable secure and reliable transmission of time-sensitive, transaction-related information critical to our customers’ operations. Our customers outsource their data communications requirements to us because of our substantial expertise, comprehensive customer support and cost-effective services. We provide services to customers in the United States and increasingly to international customers in 23 countries, including Canada and countries in Europe, Latin America and the Asia-Pacific region.

We provide services through our multiple data networks, each designed specifically for transaction applications. Our networks support a variety of widely accepted communications protocols and are designed to be scalable and accessible by multiple methods, including dial-up, dedicated, wireless and

3




Internet connections. In the year ended December 31, 2005, we transported approximately 5.8 billion dial transactions for more than 120 point-of-sale/point-of-service, or POS, processing customers in the United States and Canada, including nine of the ten largest payment processors in the United States, making us, on the basis of total transactions transmitted, a leading provider of data communications services to processors of credit card, debit card and ATM transactions. In addition, as of December 31, 2005, we provided network services to more than 450 financial services companies. Based on the total number of connections these companies have to our networks and the total messages transmitted among them using our services, we are a leading service provider to the financial services industry. Our revenues are generally recurring in nature, as we typically enter into multi-year service contracts that require minimum transaction or revenue commitments from our customers.

Our business began operations in 1991 to address the needs of the POS industry in the United States. Although we reported a net loss in 1999 through 2003, and have an accumulated deficit of $31.6 million as of December 31, 2005, we were profitable for 2004 and 2005. The strong operating cash flows generated by our POS business have enabled us to invest in and deploy data networks designed to make our data communications services more rapid, secure, reliable and cost efficient. We have leveraged these investments and used our continued strong operating cash flows to expand our service offerings to related market opportunities in the telecommunications and financial services industries in the United States and abroad. By implementing and executing this strategy, we have grown our revenues every year, from $285,000 for the year ended December 31, 1991, to $258.9 million for the year ended December 31, 2005.

Business Overview

POS opportunity

Transaction services at the point-of-sale continue to expand, thus creating expanding opportunities for TNS. Our traditional business of providing dial service to POS and off-premise ATMs continues to be the mainstay of the division. In the past year, TNS has leveraged existing network infrastructure to provide the additional services of counter-top integration and broadband connectivity. These new services make TNS a total solutions provider for merchants in a variety of categories including convenience stores and petroleum, quick service restaurants and general retail services. During 2005, TNS also introduced GPRS and CDMA services to provide additional growth opportunities in the wireless POS and ATM markets.

POS and off-premise ATM (an automated teller machine at a location other than a branch office of a financial institution) transactions require the two-way transfer of information over a secure, reliable data network. Typically, at any POS or off-premise ATM location where a credit, debit or ATM card is accepted, the customer’s account information and transaction amount must be electronically transmitted to a payment processor. The payment processor then electronically communicates with the financial institution that issued the card to determine whether to authorize the transaction. After this determination is made, the processor returns an authorization or rejection response to the POS or ATM terminal.

Financial institutions in the United States and Canada increasingly outsource the processing of credit and debit card accounts to payment processors who are able to leverage technical expertise and capitalize on economies of scale. Payment processors, in turn, typically have outsourced to third party service providers such as TNS the data networking services used to transport transaction data between the processor’s host computers and the POS or ATM terminal.

POS or off-premise ATM terminals access data network connections to payment processors through a variety of methods, the most common of which are dial-up and dedicated, or leased line, services and increasingly include wireless and broadband connections. Dial-up access services allow merchants and off-premise ATMs to connect to payment processors by dialing a telephone number each time a transaction is initiated. Wireless access provides the same capability as dial-up via GPRS or CDMA quality at a competitive price and at very high speed. A leased line is a dedicated connection provided to a merchant or ATM location for the exclusive purpose of connecting the POS terminal or ATM to the payment

4




processor. Dial-up services and wireless services are less expensive than leased line services because leased line services impose greater fixed monthly communication service charges, making a leased line economically viable only in high-volume merchant or off-premise ATM locations.

In addition to the payment processing industry, other industries, such as pre-paid card providers, vending operators, kiosk services and loyalty cards providers are expanding their use of electronic transaction processing in an attempt to reduce costs, increase sales through the acceptance of credit/debit cards and increase the reliability and efficiency of data transmission. We believe we will be able to increase the number of transactions we transport as these and other industries look to outsource the data communications requirements necessary to transmit transactions electronically.

Our POS services

Our POS division markets our data communications services directly to payment processors in the United States and Canada. The following chart illustrates the route of a typical POS transaction using our data communications services. The route of a typical off-premise ATM transaction is similar except that the card associations are not involved.

POS Credit Card Transaction

GRAPHIC

We also market our POS communications services to entities responsible for the transmission of state lottery transactions, federal and state electronic benefits transfer and healthcare transactions.

Our private, secure data networks were designed specifically to address the data communications requirements of the payment processing industry. Our data communications services provide customized routing technology, built-in redundancy and geographic diversity and are configured to provide fast and reliable call connection and efficient network utilization. Our data networks connect a merchant’s POS terminal or an off-premise ATM to the payment processor’s host computer.

We provide multiple means for the POS terminal or ATM to access our data networks. Merchant POS terminals and off-premise ATMs can connect directly to our network using our TransXpress dial-up service, which utilizes telephone services obtained from interexchange carriers and local exchange carriers. To complement our TransXpress service, we offer TNS Connect, a leased line service that utilizes our secure IP network. Leased line services are attractive to operators of off-premise ATMs and merchants that either manage their own in-house networks or transmit large volumes of transactions. While our customers primarily choose to access our networks using our dial-up and leased line services, we also provide alternative methods of connecting to our networks, including wireless and Internet. Our wireless platform, which we refer to as Synapse, enables merchants and vending machine operators to process credit, debit and other card transactions without the inconvenience and cost of having to connect to a telephone line.

We configure and provide modems that enable off-premise ATM operators to convert leased line ATMs to ATMs that use dial-up connections or wireless service. This allows the ATM operators to avoid the incurrence of additional costs associated with the need to replace or refit the ATM. Because our

5




modems allow the ATM and the payment processor’s system to operate as if they are connected by a leased line, off-premise ATM operators retain the functionality and speed of existing leased line ATMs while reducing monthly recurring telecommunications expenses.

Our new FusionPoint by TNS product allows merchants to consolidate various in-store data applications, including secure payment, enterprise applications and IP services, like voice over IP, controlled internet access, digital music, distance learning and video surveillance, over a single managed data access point, thereby reducing the merchant’s costs and need to manage multiple data communications connections.

We generally enter into multi-year contracts that require minimum transaction or revenue commitments from our POS customers. For dial-up access services, we typically charge our customers a fixed fee per transaction plus a variable time-based charge for transactions that exceed a specified period of time. Generally, our contracts provide for a reduction in the fixed fee per transaction as our customers achieve higher monthly transaction volumes. We typically charge our customers fixed monthly fees for leased line services. We also generate POS revenue from usage charges, circuit charges, charges for access to real-time transaction monitoring and charges for ancillary services. For the year ended December 31, 2005, we transmitted approximately 5.8 billion dial POS transactions in North America and generated $86.6 million of revenue in the POS division, which represented 33.4% of our total revenues.

International opportunity

Internationally there is a growing need for fast, reliable data communications services for transaction-oriented businesses. In markets outside of the United States, financial institutions have historically performed their own processing services for ATM and credit and debit card transactions. Financial institutions in Europe, however, have begun to outsource the processing of credit and debit card transactions to payment processors in an effort to leverage technical expertise, reduce costs and capitalize on economies of scale. As part of this trend, several of the largest domestic payment processors are increasing their  international presence. As they expand into additional international markets, these payment processors will require providers of outsourced data communications services.

While credit and debit card payments are growing significantly in the United States, the international market for these payment methods is expanding at a greater rate. According to The Nilson Report, in 2004 the international transaction volume for combined general purpose cards, such as American Express, MasterCard and Visa, grew 14.7%, compared to United States transaction volume, which grew by 12.9%. In addition to the credit and debit card industry, various other international industries have developed services that require the rapid, secure and reliable transmission of business-critical transaction data. For example, in many European markets wireless telephone operators process transactions in which customers increase the value of their prepaid wireless telephone account balances. According to the ©EMC World Cellular Database 2003, at the end of September 2003, there were approximately 215 million prepaid wireless accounts in Western Europe, including 35 million in the United Kingdom.

The growth, automation and globalization of financial markets has led to increased demand for outsourced, secure, reliable data communications services. Commercial banks, mutual funds, pension funds, broker-dealers, alternative trading systems, electronic communications networks, securities and commodities exchanges and other market participants increasingly use data communications services to exchange trading information, distribute research and review trading positions. According to the United States Treasury Department, foreign gross trading activity in United States securities has increased from $2.5 trillion in 1990 to an estimated $29.7 trillion at the end of 2004. In addition, the Federation of European Stock Exchanges has reported that since 2000 the value of electronic transactions on Europe exchanges has increased from 43.0% to 53.9% of total equity value traded.

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Our international services

Our international services division has operations and provides services to customers located in Australia, France, Germany, Ireland, Italy, Japan, the Netherlands, New Zealand, Poland, Romania, South Korea, Spain, Sweden and the United Kingdom through subsidiaries located in these countries. Additionally, through these international subsidiaries, we also provide services to customers located in Austria, Belgium, Finland, Gibraltar, Hong Kong, Mexico, Norway, Singapore and Thailand. We also have subsidiaries in Bermuda, Brazil, Colombia and India. The network technology and services we have developed to serve our customers in the United States are applicable to the data communications needs of payment processing and financial services industries in other countries. Internationally, we also provide data communications services to payment processors that are not used by payment processors in the United States, including offline polling services which enable merchants to store transaction data until the payment processor retrieves the data after business hours.

We consider a number of factors when evaluating opportunities in international markets, including the regulatory environment of the telecommunications market, consumer use of credit and debit cards and the competitive landscape. We typically provide our services internationally through a subsidiary located in the country identified for expansion. In some instances, we have elected to enter new markets through strategic acquisitions. Continued expansion into international markets is an important part of our operating strategy.

We plan to expand into additional targeted countries in Central Europe, Latin America and the Asia-Pacific.

Our international services revenues are currently generated primarily through the sale of our POS services. We generate the majority of our international revenues in the United Kingdom, where we are one of the leading providers of data communications services to the POS industry. We provide services to substantially all of the financial institutions in the United Kingdom which acquire and process credit and debit transactions in the United Kingdom. We also provide services to financial institutions operating ATMs and have entered into an agreement with one of the largest wireless service providers to provide data networking and processing services for prepaid wireless and telephone card purchases. In addition, we provide our financial data transmission services to more than 45 financial services companies in the United Kingdom.

For the year ended December 31, 2005, we generated $94.5 million of revenue in the international services division, which represented 36.5% of our total revenues. Our operations in the United Kingdom, France and Australia comprised 79.5% of our international revenues in 2005. Although we generate revenues in 12 of the 14 countries in which our international services division has operations, we have yet to generate positive operating cash flows in six of these 14 countries.

For financial information about geographic areas where we do business, please refer to Note 9 of the consolidated financial statements and related notes included in Item 8 of this annual report.

Telecommunications opportunity

Every wireless or wireline telephone call consists of the content of the call, such as the voice, data or video communication, and the signaling information necessary to establish and close the transmission path over which the call is carried. Substantially all telecommunications carriers in the United States and Canada use Signaling System No. 7, or SS7, as the signaling protocol to identify the network route to be used to connect individual telephone calls. SS7 networks are data networks that transport call signaling information separate from the public switched telecommunication network over which the call content is communicated. Telecommunications carriers require access to an SS7 network connected to the signaling networks of other carriers to be able to provide telecommunication services to their customers.

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SS7 networks also are used to retrieve information from centralized databases maintained by telecommunication services providers and other third parties. By accessing this information, telecommunication services providers are able to offer services that enable intelligent network services such as local number portability, line information database, caller identification and toll-free number services, and credit card, calling card, third-party billing and collect calling. Wireless carriers also use SS7 networks to exchange and maintain subscription and location data on subscribers to support wireless roaming services. Competitive pressures are also encouraging telecommunication services providers to develop and offer additional services that utilize the signaling services provided by an SS7 network. For example, wireless carriers offer content delivery such as video and ring tones, short message service and Internet browsing and commerce capabilities.

The deployment, operation and maintenance of a nationwide SS7 network connected to all of the major signaling networks and database providers require significant capital and specific technical expertise. For these reasons, many telecommunication services providers have chosen not to build the networks necessary to satisfy all of their SS7 signaling requirements. Rather, they are increasingly turning to outsourced telecommunication services providers such as TNS to obtain the call signaling and database access services critical to their business, yet remain competitive on a cost-effective basis.

Our telecommunication services

We operate one of four unaffiliated SS7 networks in the United States capable of providing call signaling and database access services nationwide. Our SS7 network is connected with the signaling networks of all of the incumbent local exchange carriers and a significant number of wireless carriers, competitive local exchange carriers and interexchange carriers. We believe that our independence and neutrality enhance our attractiveness as a provider of outsourced SS7 services.

We offer the following data communications services to wireless and wireline telecommunication services providers:

·       SS7 network services. We provide telecommunication services providers with SS7 connectivity, switching and transport services throughout the United States. Our SS7 network is connected to the SS7 networks of local exchange and wireless carriers through more than 25 mated pairs of signal transfer points deployed throughout the country. By connecting to our SS7 network, our customers eliminate their need to implement, operate and maintain numerous, complex connections linking their SS7 switches to the signaling networks of other telecommunications carriers. We believe that our SS7 network enables us to offer our data communications services more cost-effectively and reliably than our competitors.

·       Database access services. We offer our customers access to databases maintained internally and those operated by telecommunications carriers and other third parties. These databases are used to provide subscribers intelligent network services such as local number portability, line information database, caller identification and toll-free number services. Our SS7 network provides access in the United States to the following types of databases:

·        Local number portability databases. Wireline telecommunications carriers are required to provide local number portability, a service that enables a subscriber to change wireline service providers within a particular location and keep the same phone number. The Federal Communications Commission (FCC) mandated that wireless local number portability be provided in certain markets within the United States beginning in November 2003. Our SS7 network provides access to internally managed databases that host all wireline and wireless number portability data.

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·        Line information databases. Telecommunications carriers develop and maintain databases that store subscriber information, including names and addresses. This information is necessary to provide enhanced services such as validating subscriber and billing information.

·        Toll-free databases. Each time a subscriber calls a toll-free number, the telecommunication services provider must access a national database of toll-free numbers in order to route the call.

·        Calling name delivery databases. A telecommunication services provider must access a database containing the name and other information about the subscriber for the telephone number placing the call in order to offer caller identification services.

·        Validation and fraud control services. Our CARD*TEL validation and fraud control services combine our access to line information databases with our proprietary fraud control technology to provide interexchange carriers, operator services providers and payphone service providers real-time telephone call billing validation and fraud control services for calling card, credit card, third-party billing and collect calls. Our services assist our customers in determining whether telephone company calling cards, credit cards, travel and entertainment cards and telephone numbers constitute valid accounts and billable telephone numbers.

·        ID Plus. ID Plus gives users access to a telephone name and address database, which will increase service providers’ ability to either discern the identity of a caller or to direct bill for services.

·       Other telecommunication services. Our LEConnect data services provide telecommunication services providers with a fast and reliable method of transmitting billing and collection data to and from local exchange carrier data centers over our secure IP networks. Our LEConnect data service minimizes the data transmission errors and time lags associated with a traditional billing and collection system, which requires numerous interexchange carriers and information service providers to send billing data on magnetic data tapes to local exchange carriers. We also offer short message service offload services, which allow telecommunication services providers to avoid the incurrence of additional costs, relieve message congestion and preserve network capacity by offloading short message traffic from SS7 signaling networks to our IP networks.

We generally enter into multi-year contracts with our telecommunication services customers, many of whom agree to minimum volume commitments. We charge fixed monthly fees for SS7 network services and LEConnect services and per-query fees for our database access and validation services. For the year ended December 31, 2005, we generated $46.6 million of revenue in the telecommunication services division, which represented 18.0% of our total revenues.

Financial services opportunity

The securities trading and investment management industry is increasingly requiring high-speed, reliable, secure data communications services to communicate information among industry participants, including commercial banks, mutual funds, pension funds, broker-dealers, alternative trading systems (ATS), electronic communications networks (ECN) and securities and commodities exchanges. Transaction volume in the United States equity markets has increased rapidly over the past decade. For example, average daily shares traded of New York Stock Exchange, AMEX and Nasdaq securities has increased at an 18.7% compound annual rate, from approximately 302 million in 1990 to 3.3 billion in 2004. During the same period, the emergence of new electronic trading venues such as ECN and ATS and regulatory requirements such as the shift to decimalization have placed increasing emphasis on trading and cost efficiencies. To meet these needs, market participants use outsourced data communications services that provide industry participants with access to other participants through a single, managed access point

9




on the service provider’s network. These services allow participants to cost-effectively connect to each other to conduct time-sensitive transactions and communicate real-time information.

Our financial services

Our fast, private, secure and reliable IP data networks were designed specifically to address the data and voice communications requirements of the financial services industry. Our IP network services allow our customers to access multiple financial services companies through a single network connection, thereby eliminating the need for costly dedicated institution-to-institution leased line connections. Additionally, these services facilitate secure and reliable communications between financial services companies by supporting multiple communications standards and protocols, including the Financial Information eXchange (FIX) protocol.

Our primary financial service offerings are:

·       Secure Trading Extranet. Our Secure Trading Extranet service links more than 450 financial services companies through our IP network. Through a single network connection, a customer can communicate with any other entity connected to our IP network. Given the large number of industry participants connected to our network, including commercial banks, mutual funds, pension funds, broker-dealers, alternative trading systems, electronic communications networks and securities and commodities exchanges, a single customer can use its connection to our IP network to conduct seamless, real-time electronic trading and access a variety of content, including news, research and market data.

·       Trader Voice. Our specialized voice services provide secure, customized voice telecommunications between brokers, investment banking firms and securities and commodities exchanges. These services permit calls that originate over traditional phone lines to be connected over our secure, private IP network. The primary applications of our voice services are: a dedicated, always available voice link between specific domestic-to-domestic or domestic-to-international locations, which financial industry participants refer to as “hoot & holler”; an instant voice connection between two locations that is established as soon as a telephone receiver at either location is lifted, which financial industry participants refer to as “automatic ring down”; and a direct voice connection between two locations which requires a manual signal, usually the push of a button, from the telephone at either location to initiate the call, which financial industry participants refer to as “manual ring down.”

As of December 31, 2005, we provided our financial services to more than 450 financial services companies. Our financial services customers may have one or more access points to our IP network, depending on the location of their offices and other factors. We generate financial services revenue primarily from monthly recurring fees based on the number of customer connections to and through our IP network. For the year ended December 31, 2005, we generated $31.3 million of revenue in the financial services division, which represented 12.1% of our total revenues.

Our Strengths

We believe our competitive strengths include:

Recurring revenues and strong operating cash flows. Our established customer base enables us to generate high levels of recurring revenues and strong operating cash flows. We principally operate a transaction-based business model and typically enter into multi-year service contracts that require minimum transaction or revenue commitments from our customers. We believe that our recurring revenues and strong operating cash flows will enable us to continue to invest in the development of new services and international expansion.

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Established customer base. We have an established customer base of leading industry participants in each division and have experienced limited customer turnover. For the year ended December 31, 2005, we provided our POS services to more than 120 customers, including nine of the ten largest payment processors in the United States. In addition, for the year ended December 31, 2005, we provided services to more than 120 telecommunication services providers and more than 450 financial services companies. Our international services division has operations in 14 countries and through these operations provides services to some of the largest financial institutions and wireless and other telecommunication services providers in these countries and neighboring countries. Through our established customer relationships, we have developed an extensive knowledge of each of our customer’s industries. We believe that our knowledge and experience enhance our ability to deliver new and timely data communications services and solutions.

Well positioned to continue international expansion. The network technology and data communications services we have developed to serve customers in the United States are applicable to the data communications needs of the payment processing and financial services industries in other countries. We believe that our domestic data communications services and technologies, our technical expertise and our customer relationships with the largest domestic payment processors and global institutions strategically position us to take advantage of the substantial international opportunities. We have grown our international revenues from $33.1 million for the year ended December 31, 2002 to $94.5 million for the year ended December 31, 2005.

Highly customized data networks. We operate highly-customized networks designed and configured for the transmission of transaction-related, time-sensitive data. Our networks support multiple communications protocols and access methods and, as a result, are able to support a wide variety of transaction applications. The flexibility and scalability of our networks and our technical expertise allow us to rapidly add new data communications services to our existing offerings in response to emerging technologies with limited service disruptions or capital expenditures. We also believe our ability to leverage our fixed cost base provides us with significant economies of scale, resulting in a significant competitive advantage.

Proven acquisition strategy. Our management team has augmented the growth of our business by successfully identifying and integrating strategic acquisitions. We acquired AT&T’s Transaction Access Service business in September 1998 and Sprint’s TranXact POS network services business in 2002. Our ability to close these transactions and transition the acquired businesses to our networks enabled us to significantly grow the revenues generated by our POS division. In addition, we have made a number of smaller acquisitions that have accelerated the growth of each of our other service divisions.

Substantial experience in our target markets. In 1990, our business was founded by John J. McDonnell, Jr., our Chairman and Chief Executive Officer. The 12 members of our executive management team have on a combined basis more than 200 years experience in the transaction services and telecommunications industry, and on average have been employees of the company for more than eight years. We have focused on creating transaction-oriented data communications services for then developing and now established markets. We believe this gives us an understanding of the unique needs and risks of our target markets and provides us a competitive advantage over larger service providers that have a broader market perspective. We also believe our extensive experience provides us a competitive advantage over service providers of similar or smaller size.

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Our Strategy

Our objective is to continue to grow our business and enhance our position as a leading provider of outsourced business-critical data communications services enabling secure and reliable transmission of time-sensitive transaction-related information for transaction processing, telecommunications and financial services. Key elements of our strategy include:

Continue to expand our customer base. We believe our experience, existing customer relationships and secure and reliable data communications services will enable us to expand our customer base, particularly in the international and financial services markets. For example, in our financial services division, we intend to increase the scope of services and leverage our existing customer base of over 450 financial services companies to acquire new customers. We intend to leverage our customer relationships and technical expertise to provide our POS and financial services offerings internationally.

Develop new service offerings. We will continue to expand our service offerings to address new markets for secure and reliable transmission of time-sensitive information. For example, we have begun to offer our data communications services to wireless service providers so that they may deploy wireless broadband local access network services without incurring the capital expenses of building a network and for cashless payment transactions such as vending.

Increase sales to existing customers. We will continue our efforts to further expand our existing customer relationships to increase business domestically and abroad. For example, we intend to encourage our POS customers to transmit a greater percentage of their transaction volume with us, our telecommunication services customers to increase the number of signaling routes they establish through our SS7 network and our financial services customers to connect more endpoints to our data network. Our longstanding relationships with our domestic customers provide us a significant opportunity to increase the sales we make to these customers as they and we expand internationally. Within each of our divisions, we intend to continue our efforts to cross-sell our full range of services to our customers. For example, we believe we have a significant opportunity to sell other components of our suite of telecommunication services, such as our LEConnect service, short messaging services and database access services, to customers already using our SS7 network services. We also intend to work closely with our customers to increase our knowledge of their business and technical requirements so that we may identify opportunities to provide them with additional services.

Pursue strategic acquisitions. We will continue to seek opportunities to acquire businesses that expand our range of services, provide opportunities to increase our customer base and enter into new domestic and international markets. We will need to use operating cash flows or additional financing to pursue our strategy.

Our Networks

We operate multiple, highly-customized data networks specifically designed and configured for the transmission of transaction-related, time-sensitive data. Our diverse data network architecture supports a variety of widely-accepted communications protocols and is accessible through a variety of methods, including dial-up, leased line, wireless and Internet connections. Our data networks also are designed to be scalable and to allow easy adoption of new access technologies. The hardware utilized in our networks is installed at 94 points of presence worldwide, 39 of which are in North America. We connect these points of presence with digital circuits leased from multiple telecommunication services providers. In addition, our network control centers allow us to administer our network and enable us to monitor our customers’ transactions in real time.

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We believe that our networks provide the following important benefits to our customers:

Our networks are designed specifically to address the data communications needs of our diverse customer base. Our data networks support multiple communications protocols and include customized hardware, software and value-added features developed by us or by vendors to our specifications. The following is a description of the data networks we operate:

·       X.25. X.25 is a communications protocol used to transmit packets of data. Our domestic and international X.25 networks transport our customers’ POS transactions and are used to provide the validation services offered by our telecommunication services division. These networks are designed to provide fast call connection times, a high level of system redundancy, dynamic rerouting, wide geographic coverage and value-added features, at a low cost per transaction. Customers may access our X.25 networks using various methods, including dial-up services, leased line services, wireless services, satellite services and Internet connections.

·       IP. Internet protocol is a communications technology that routes outgoing data messages and recognizes incoming data messages. Our domestic and international IP networks provide the services offered by our financial services division, the leased line services offered by our POS division and the LEConnect data services offered by our telecommunication services division. We also use our IP networks for our internal processes, such as accounting functions and network monitoring and management. We have designed and implemented these networks with a high level of system redundancy, dynamic routing and sophisticated security and authorization technologies.

·       SS7. SS7 is a communications protocol used to transmit signaling information to establish and close the transmission path over which a telephone call is routed. Our domestic SS7 data network sets up, routes and terminates the transactions transmitted through the services offered by our POS division. It also provides the call signaling services and database access services offered by our telecommunication services division. Our SS7 network is accessed using dedicated SS7 links provided by local exchange carriers and interexchange carriers.

Our networks are reliable, redundant and secure. We believe we have configured the major components of our networks to eliminate any single point of failure. The reliability of our data networks is enhanced significantly because we have deployed our networks with redundant hardware installed at geographically diverse facilities connected by multiple telecommunications carriers. Our facilities are deployed with battery back-up and emergency generator power systems. We coordinate the physical routing of the digital circuits connecting our facilities with multiple telecommunication service providers to ensure the availability of diverse paths for routing any transaction or data, thereby enhancing network reliability. Due to such physical diversity, minor outages or failures typically do not require the immediate intervention of our technicians. We are able to respond quickly to service problems because the network monitoring, management and troubleshooting systems we use permit our network control centers to correct problems remotely. Our data networks contain industry standard firewalls and protections, and their security is further enhanced by limiting access.

Our X.25 and IP networks incorporate several customized, value-added features that distinguish our services and performance from our competitors. We believe that various value-added features we have developed permit our POS customers accessing our data networks through dial-up services to process a greater volume of transactions than other dial-up service providers. These features include:

·       the use of equipment that supports and converts transaction data delivered to our data networks in multiple protocols and message formats into the protocols employed by our data networks, thereby eliminating the need for our customers to incur the high costs associated with reprogramming POS terminals and host computers and performing continuous network enhancements and software upgrades,

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·       real-time call tracking, which enables us to quickly resolve host, terminal or network problems experienced by our customers and to recommend to our customers ways to improve their systems, and

·       an Internet-based transaction monitoring system, which permits our customers to monitor the status of their transactions in real-time using the Internet.

Our networks can accommodate growth in our business. Our networks are deployed with sufficient capacity to accommodate significant growth in transaction volumes without incurring delays relating to the provisioning and deployment of additional hardware and telecommunications circuits. We have also designed the networks so that we may easily increase capacity as necessary.

Our network operations centers continuously monitor and manage our networks. We provide 24-hour, seven days a week network control coverage domestically through our network control center located in Reston, Virginia and internationally through our network control center located in Sheffield, England. Each of these network control centers serves as the backup network control center for the other control center. Our network control centers are staffed with skilled technicians experienced with the services we offer. Our network control centers remotely monitor the components of our data networks and manage our networks using sophisticated network management tools we have either developed internally or licensed from others.

Customers

As of December 31, 2005, we provided our POS services to more than 120 customers, including nine of the ten largest payment processors in the United States. In addition, as of December 31, 2005, we provided services to more than 120 telecommunication services providers and more than 450 financial services companies. Historically we have experienced limited customer turnover. We believe this is a result of our strong relationships with our customers and is one of our strengths. Maintaining these relationships is critical to our long-term success.

For the year ended December 31, 2005, we derived approximately 20.9% of our total revenues from our five largest customers. No customer accounted for more than 10% of our total revenues for the year ended December 31, 2005. We typically enter into multi-year service contracts with our customers with minimum commitments. Under some of our contracts, once the customer has met its minimum commitment on an annual or contract term basis, the customer is no longer obligated to purchase services from us. The contracts with our five largest customers contain minimum transaction or revenue commitments on an annual or contract term basis. The contracts with our five largest customers expire from 2006 to 2009.

Sales and Marketing

We sell our services directly to customers through geographically dispersed sales teams. In the United States and Canada, we have a specialized sales team for each of our POS, telecommunication services and financial services divisions. In our international services division, our sales teams are organized geographically with each team responsible for selling our services in the country in which the team is based and, in some cases, proximate countries. Our international services division sales teams are based in Austria, Australia, Bermuda, France, Germany, Ireland, India, Italy, Japan, the Netherlands, Romania, Spain, Sweden, Thailand and the United Kingdom. Generally, each sales team includes a general manager or managing director, account representatives, business development personnel, sales engineers and customer service representatives experienced in the industries of our customers and the services we offer.

Our sales teams work to establish and maintain relationships with customers by identifying a customer’s need for our services and promoting our secure, reliable, efficient, competitively priced services. We also pursue opportunities to customize our solutions to meet requirements of large customers.

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When a customer initially purchases services from us, the customer typically purchases some, but not all, of the services we offer. Our sales teams strive to increase the services purchased by existing customers and to expand the range of services we provide to our customers. Our sales teams consult with customers in an attempt to identify new outsourced business-critical services we may provide our customers.

Suppliers

The operation of our networks depends upon the capacity, reliability and security of services provided to us by a limited number of telecommunication services providers. We have no control over the operation, quality or maintenance of those services or whether the vendors will improve their services or continue to provide services that are essential to our business. In addition, telecommunication services providers may increase the prices at which they provide services.

In addition, some key components we use in our networks are available only from a limited number of suppliers. The number of available suppliers of components for our X.25 networks is particularly limited. We do not have long-term supply contracts with these or any other limited source vendors, and we purchase data network equipment on a purchase order basis.

Competition

POS division. Our POS division competes on the basis of industry expertise, network service quality and reliability, transaction speed, value-added features, customer support and cost-efficiency. The primary competitors of our POS division are interexchange carriers such as MCI, Inc. and AT&T Corp. These carriers typically do not aggressively pursue transaction-oriented business as a stand-alone service, but rather offer it in conjunction with other products and services.

Telecommunication services division. Our telecommunication services division competes on the basis of industry expertise, network service quality and reliability, transaction speed, customer support, cost-efficiency and value-added services. The primary competitors of our telecommunication services division include Southern New England Telephone, Syniverse Technologies, Inc., Verisign, Inc. and regional Bell operating companies.

Financial services division. Our financial services division competes on the basis of access to multiple financial services companies, security, support services, cost-efficiency and discrete service offerings. The primary competitors of our financial services division are other private communications networks, such as interexchange carriers including AT&T, providers of quote terminals and market data services such as Bloomberg, Reuters and Thomson Financial and other network service providers such as SAVVIS and Radianz.

International services division. Our international services division competes on a similar basis as our POS and financial services divisions. Primary competitors of our international services division are incumbent telephone companies, including British Telecom in the United Kingdom, France Telecom in France, Telefonica in Spain and Telstra in Australia.

Government Regulation

Although the FCC retains general regulatory jurisdiction over the sale of interstate services, other than one of our subsidiaries, we, as a provider of enhanced or information services, are not required to maintain a certificate of public convenience and necessity with the FCC or to file tariffs with the FCC covering our services. One of our wholly-owned subsidiaries, TNS Transline, LLC, is subject to regulatory oversight by the FCC due to its provision of interstate telecommunications services. TNS Transline complies with all regulatory registration and payment obligations mandated by the FCC. TNS Transline provides exclusively interstate telecommunications services, thus it is not subject to state regulation of its services. State regulators may regulate purely intrastate enhanced services and may regulate mixed

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intrastate/interstate enhanced services to the extent their regulation does not impede federal policies. Regulators at the state and federal levels are examining the treatment of information services and their decisions may alter our regulatory obligations. We do not believe that we currently are subject to state regulations for our existing services, and we believe that, even if we were subjected to state regulation, we could obtain all necessary approvals.

Federal and state regulations can affect the costs of business for us and our competitors by changing the rate structure for access services purchased from local exchange carriers to originate and terminate calls. Under the Telecommunications Act of 1996, the FCC implemented rules and regulations known as Access Charge Reform to reform the system of interstate access charges. The FCC’s implementation of these rules increased some components of our costs for access while decreasing others. The FCC is currently considering additional rulemaking proceedings concerning this intercarrier compensation scheme, and we currently cannot predict whether any rule changes will be adopted or the impact these rule changes might have on our access charges if they are adopted. Recent and pending decisions of the FCC and state regulatory commissions may limit the availability and increase pricing used by our suppliers to provide telecommunication services to us. We cannot predict whether the rule changes will increase the cost or availability of services we purchase from our suppliers.

In connection with some of our services, we are required to pay Federal Universal Service Fund surcharges. The monies generated by Federal Universal Service Fund surcharges are used to help
provide affordable telecommunication services throughout the country, including to consumers in
high-cost areas, low-income consumers, eligible schools and libraries and rural healthcare providers. Our telecommunications service suppliers are obligated to contribute directly to the Federal Universal Service Fund. Our telecommunications service suppliers, in turn, recover the cost of their contribution obligations by imposing surcharges on us and our competitors based upon a percentage of their interstate and international end-user telecommunications revenues. The United States Congress and the FCC is considering modifying the way in which Federal Universal Service Fund charges are calculated, including considering whether to assess universal service charges on a flat-fee basis, such as a per-line, per-telephone number or per-account charge. We currently cannot predict whether Congress will mandate or the FCC will adopt changes in the calculation of Federal Universal Service Fund contributions or whether these changes, if adopted, would increase our Federal Universal Service Fund surcharges. If the FCC implements any legislation, adopts any proposal or takes any administrative action that increases our Federal Universal Service Fund surcharges, our network operating costs will increase. In addition, if the FCC implements any legislation, adopts any proposal, or takes any administrative action that increases our supplier’s Universal Service Fund obligations, these telecommunications service suppliers may seek to pass through cost-recovery charges to us, which would result in an increase in our cost of network services.

The 1996 Telecommunications Act (“the Act”) also removed some restrictions on the ability of the incumbent local exchange carriers to provide long distance enhanced services, specifically including data communications services that may be used to transport credit card, debit card and ATM transactions, between local access and transport areas. Pursuant to the Act, the incumbent local exchange carriers will be permitted to provide long distance telecommunications between local access  and transport areas, with out-of-region services immediately permitted and in-region service permitted after they satisfy network unbundling and related requirements. The incumbent local exchange carriers have met the legislative and regulatory requirements to be able to offer these services in nearly every state. To date, no incumbent local exchange carrier has elected to offer these services nationwide, but if they choose to do so, we would face additional competition.

Intellectual Property

Our success is dependent in part upon our proprietary technology. We rely principally upon trade secret and copyright law to protect our technology, including our software and network design. We enter

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into confidentiality or license agreements with our employees, distributors, customers and potential customers and limit access to and distribution of our software, documentation and other proprietary information. We believe, however, that because of the rapid pace of technological change in the data communications industry, the legal protections for our services are less significant factors in our success than the knowledge, ability and experience of our employees and the timeliness and quality of services provided by us.

Employees

As of December 31, 2005, we employed 568 persons worldwide, of whom 391 were engaged in systems operation, development and engineering, 63 of whom were engaged in sales and marketing,  85 of whom were engaged in finance and administration and 29 comprised executive management. Of our total employees as of December 31, 2005, 326 were employed domestically and the balance were in other countries, including 164 in the United Kingdom. None of our employees are currently represented by a labor union. We have not experienced any work stoppages and consider our relationship with our employees to be good.

Internet Address and Company SEC Filings

Our internet address is www.tnsi.com. On the investor relations portion of our web site, we provide a link to our electronic SEC filings, including our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and any amendments to these reports. All such filings are available free of charge and are available as soon as reasonably practicable after filing.

Executive Officers of the Registrant

See Item 10 on page 85 of this report for information about our executive officers.

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Item 1A.                Risk Factors

We are subject to various risks that could have a negative effect on the Company and its financial condition. You should understand that these risks could cause results to differ materially from those expressed in forward-looking statements contained in this report and in other Company communications. Because there is no way to determine in advance whether, or to what extent, any present uncertainty will ultimately impact our business, you should give equal weight to each of the following.

We derive a substantial portion of our revenue from a small number of customers. If one or more of our top five customers were to cease doing business with us, or to substantially reduce its dealings with us, our revenues and earnings could decline.

For the year ended December 31, 2005, we derived approximately 20.9% of our total revenues from our five largest customers. We expect to continue to depend upon a relatively small number of customers for a significant percentage of our revenues. The loss of any of our largest customers or a decision by one of them to purchase our services at a reduced level could harm our revenues and earnings.

The contracts with our five largest customers contain minimum transaction or revenue commitments on an annual or contract term basis. Upon meeting these commitments, the customers are no longer obligated to purchase services from us and may elect not to make further use of our services. In addition, our customers may elect not to renew their contracts when they expire. Even if contracts are renewed, the renewal terms may be less favorable to us than under the current contracts. The contracts with our five largest customers expire from 2006-2009.

We face significant pressure on the prices for our services from our competitors and customers. Our failure to sustain pricing could impair our ability to maintain profitability or positive cash flow.

Our competitors and customers have caused and may continue to cause us to reduce the prices we charge for services. We may not be able to offset the effects of these price reductions by increasing the number of transactions we transport using our networks or by reducing our costs. The primary sources of pricing pressure include:

·       Competitors offering our customers services at reduced prices. For example, telecommunications carriers may reduce the overall cost of their services by bundling their data networking services with other services such as voice communications.

·       POS and telecommunication services customers seeking greater pricing discounts during contract negotiations in exchange for maintaining or increasing their minimum transaction or revenue commitments.

·       Consolidation of existing customers resulting in pricing reductions. For example, one of our customers with relatively lower contract prices may acquire another of our customers, enabling the acquired customer’s transactions to receive the benefit of the lower prices. In addition, if an existing customer acquires another customer, the combined transaction volume may qualify for reduced pricing under our contract.

Our POS business is highly dependent upon our customers’ transaction volumes and our ability to expand into new markets.

We already serve the largest payment processors in the United States. Accordingly, our POS division is highly dependent on the number of domestic transactions transmitted by our existing customers through our networks. Factors which may reduce the number of credit and debit card and ATM transactions include future economic downturns, acts of war or terrorism and other events that reduce consumer spending. Revenues from our POS division, which represented our largest business segment prior to the

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year ended December 31, 2005, have decreased as a result of a decline in transaction volumes primarily from a major customer and to a lesser extent a decrease in revenue per transaction as a result of negotiated price reductions upon renewal of certain contracts.

We may be unable to increase our business from state lottery operators, electronic benefits programs and healthcare industry participants that we have identified as potential sources of future growth for our POS business. Factors that may interfere with our ability to expand further into these areas include:

·       market participants’ adoption of alternative technologies,

·       our potential inability to enter into commercial relationships with additional market participants, and

·       implementation of federal and state regulations.

Our strategy to expand internationally may fail, which may impede our growth and harm our operating results.

As of December 31, 2005, we have yet to generate positive operating cash flows in six out of the 14 countries in which we have operations and provide services outside the United States and Canada. In addition, we are planning expansion in our existing international markets and into additional international markets.

Key challenges we will face in pursuing our international strategy include the need to:

·       secure commercial relationships to help establish our presence in international markets,

·       obtain telecommunications services from incumbent telecommunication service providers that may compete with us,

·       adapt our services to support varying telecommunications protocols that differ from those markets where we have established operations,

·       hire and train personnel capable of marketing, installing and integrating our data communications services, supporting customers and managing operations in foreign countries,

·       localize our products to target the specific needs and preferences of foreign customers, which may differ from our traditional customer base in the United States,

·       build our brand name and awareness of our services among foreign customers, and

·       implement new systems, procedures and controls to monitor our operations in new markets.

In addition, we are subject to risks associated with operating in foreign countries, including:

·       multiple, changing and often inconsistent enforcement of telecommunications and other laws and regulations,

·       competition with existing market participants which have a longer history in and greater familiarity with the foreign markets we enter,

·       laws and business practices that favor local competitors,

·       fluctuations in currency exchange rates,

·       imposition of limitations on conversion of foreign currencies into U.S. dollars or remittance of dividends and other payments by foreign subsidiaries, and

·       changes in a specific country’s or region’s political or economic conditions.

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If we fail to address the challenges and risks associated with international expansion, we may encounter difficulties implementing our strategy, which could impede our growth or harm our operating results.

Our customers may develop in-house networks and divert part or all of their data communications from our networks to their networks.

As a payment processor’s business grows larger and generates a greater number of credit card and debit card transactions, it could become economically advantageous for the processor to develop its own network for transmitting transaction data, including credit card and debit card transactions. Currently, some of the largest processors in the United States and some very large merchants, such as supermarkets, department stores and major discount stores, operate their own networks to transmit some or all of their transactions. Also, as the number of outsourced providers of network services has decreased, payment processors and large merchants have developed, and may continue to seek to develop, their own networks in order to maintain multiple sources of supply. In addition, our telecommunication services division customers may elect to connect their call signaling networks directly to the call signaling networks of other telecommunications carriers. As a result of any of these events, we could experience lower revenues.

Our reliance on a limited number of telecommunication services providers exposes us to a number of risks over which we have no control, including risks with respect to increased prices and termination of essential services.

The operation of our networks depends upon the capacity, reliability and security of services provided to us by a limited number of telecommunication services providers. We have no control over the operation, quality or maintenance of those services or whether the vendors will improve their services or continue to provide services that are essential to our business. In addition, telecommunication services providers may increase the prices at which they provide services, which would increase our costs. If one or more of our telecommunication services providers were to cease to provide essential services or to significantly increase their prices, we could be required to find alternative vendors for these services. With a limited number of vendors, we could experience significant delays in obtaining new or replacement services, which could lead to slowdowns or failures of our networks. This could harm our reputation and could cause us to lose customers and revenues.

A slowdown or failure of our networks could cause us to lose customers and revenue.

Our business is based upon our ability to rapidly and reliably receive and transmit data through our networks. One or more of our networks could slow down significantly or fail for a variety of reasons, including:

·       undetected defects or errors in our software programs, especially when first integrated into a network,

·       unexpected problems encountered when integrating changes, enhancements or upgrades of third party equipment or software with our systems,

·       computer viruses,

·       natural or man-made disasters disrupting power or telecommunications systems generally, and

·       damage to, or failure of, our systems due to human error or intentional disruption.

We may not have sufficient redundant systems or backup telecommunications facilities to allow us to receive and transmit data in the event of significant system failures. Any significant degradation or failure of one or more of our networks could cause our customers to suffer delays in transaction processing, which could damage our reputation, increase our service costs, or cause us to lose customers and revenues.

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We depend on a limited number of network equipment suppliers and do not have supply contracts. Our inability to obtain necessary network equipment or technical support could harm our business.

Some key components we use in our networks are available only from a limited number of suppliers. The number of available suppliers of components and technical support for our X.25 networks are particularly limited. We do not have long-term supply contracts with these or any other limited source vendors, and we purchase data network equipment on a purchase order basis. If we are unable to obtain sufficient quantities of limited source equipment and required technical support, or to develop alternate sources as required in the future, our ability to deploy equipment in our networks could be delayed or reduced, or we may be forced to pay higher prices for our network components. Delays or reductions in supplies could lead to slowdowns or failures of our networks.

We may experience fluctuations in quarterly results because of the seasonal nature of our business and other factors outside of our control, which could cause the market price of our common stock to decline.

Credit card and debit card transactions account for a major percentage of the transaction volume processed by our customers. The volume of these transactions on our networks generally is greater in the fourth quarter holiday season than during the rest of the year. Consequently, revenues and earnings from credit card and debit card transactions in the first quarter generally are lower than revenues and earnings from credit card and debit card transactions in the fourth quarter of the immediately preceding year. We expect that our operating results in the foreseeable future will be significantly affected by seasonal trends in the credit card and debit card transaction market.

In addition, a variety of other factors may cause our results to fluctuate from one quarter to the next, including:

·       varying costs incurred for network expansion,

·       the impact of quarterly variations in general economic conditions,

·       acquisitions made or customers acquired or lost during the quarter, and

·       changes in pricing policy by us, our competitors and our third party supplier and service providers during a particular quarter.

We may not be able to adapt to changing technology and our customers’ technology needs.

We face rapidly changing technology and frequent new service offerings by competitors that can render existing services obsolete or unmarketable. Our future success depends on our ability to enhance existing services and to develop, introduce and market, on a timely and cost effective basis, new services that keep pace with technological developments and customer requirements.

We may be unable to protect our proprietary technology, which would allow competitors to duplicate our services. This would make it more difficult for us to compete with them.

We may not be able to protect sufficiently our proprietary technology, which could make it easier for competitors to develop services that compete with our services. We rely principally on copyright and trade secret laws and contractual provisions to protect our proprietary technology. The laws of some countries in which we sell our services and products may not protect software and intellectual property rights to the same extent as the laws of the United States. If these measures do not adequately prevent misappropriation of our technology, competitors may be able to use and adapt our technology. Our failure to protect our technology could diminish our competitive advantage and cause us to lose customers to competitors.

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We may face claims of infringement of proprietary rights, which could harm our business and operating results.

Third parties may assert claims that we are infringing their proprietary rights. If infringement claims are asserted against us, we could incur significant costs in defending those claims. We may be required to discontinue using and selling any infringing technology and services, to expend resources to develop non-infringing technology or to purchase licenses or pay royalties for other technology. We may be unable to acquire licenses for the other technology on reasonable commercial terms or at all. As a result, we may find that we are unable to continue to offer the services and products upon which our business depends.

Future acquisitions and investments could negatively affect our operating results and could dilute the interests of existing stockholders.

We expect to continue to seek selective acquisitions and investments as an element of our growth strategy. Future acquisitions and investments could subject us to risks including:

·       If we are not able to successfully integrate acquired businesses in a timely manner, our operating results may decline, particularly in the fiscal quarters immediately following the completion of such transactions while the operations of the acquired entities are being integrated into our operations. We also may incur substantial costs, delays or other operational or financial problems during the integration process.

·       Acquisitions could result in large, immediate write-offs and assumption of contingent liabilities, either of which could harm our operating results.

·       Acquisitions and investments may divert the attention of senior management from our existing business.

·       If we issue additional equity to finance our acquisitions or investments, it could result in dilution for our existing stockholders.

·       If we incur additional indebtedness to finance acquisitions or investments, our interest expense could increase and new debt agreements might involve new restrictive covenants that could reduce our flexibility in managing our business.

·       If we invest in companies before they are profitable, we may incur losses on these investments up to the amount invested. As of December 31, 2005, we have $6.0 million of long-term investments in unconsolidated affiliates, and we expect to incur losses on these investments in 2006 and may continue to incur losses thereafter.

We may not have adequate resources to meet demands resulting from growth.

Growth may strain our management systems and resources. We may need to make additional investments in the following areas:

·       recruitment and training,

·       communications and information systems,

·       sales and marketing,

·       facilities and other infrastructure,

·       treasury and accounting functions,

·       licensing and acquisition of technology and rights, and

·       employee and customer relations and management.

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If we fail to develop systems, procedures and controls to handle current and future growth on a timely basis, we may be less efficient in the management of our business or encounter difficulties implementing our strategy, either of which could harm our results of operations.

We may lack the capital required to maintain our competitive position or to sustain our growth.

We have historically relied on cash flow from operations and proceeds from equity and debt to fund our operations, capital expenditures and expansion. If we are unable to obtain sufficient capital in the future, we may face the following risks:

·       We may not be able to continue to meet customer demand for service quality, availability and competitive pricing.

·       We may not be able to expand rapidly internationally or to acquire complementary businesses.

·       We may not be able to develop new services or otherwise respond to changing business conditions or unanticipated competitive pressures.

Our substantial debt could adversely affect our financial health.

As of December 31, 2005, we had $113.4 million in debt outstanding. You should be aware that this level of debt could have important consequences to you. Below, we have identified some of the material potential consequences resulting from this debt:

·       A significant portion of our cash flow from operations must be dedicated to the repayment or servicing of indebtedness, thereby reducing the amount of cash we have available for other purposes, including reinvestment in the company.

·       We may be unable to obtain additional financing for working capital, capital expenditures, acquisitions and general corporate purposes.

·       Our ability to adjust to changing market conditions may be hampered.

·       We may be at a competitive disadvantage compared to our less leveraged competitors.

·       We may be vulnerable to the impact of adverse economic and industry conditions and, to the extent of our outstanding debt under our amended and restated senior secured credit facility, the impact of increases in interest rates.

We cannot assure you that we will continue to generate sufficient cash flow or that we will be able to borrow funds under our amended and restated senior secured credit facility in amounts sufficient to enable us to service our debt, or meet our working capital and capital expenditure requirements. We must satisfy borrowing base restrictions in order to borrow additional amounts under our amended and restated senior secured credit facility. If we are not able to generate sufficient cash flow from operations or to borrow sufficient funds to service our debt, due to borrowing base restrictions or otherwise, we may be required to sell assets, reduce capital expenditures, refinance all or a portion of our existing debt, or obtain additional financing. We cannot assure you that we will be able to refinance our debt, sell assets or borrow more money on terms acceptable to us, if at all.

If we do not compete effectively, we may lose market share to competitors and suffer a decline in revenues.

Many of our competitors have greater financial, technical, marketing and other resources than us. As a result, they may be able to support lower pricing and margins and to devote greater resources to marketing their current and new products and services.

23




We face competition in each of our four divisions as follows:

·       The primary competitors of our POS division are MCI, Inc. and AT&T Corp.

·       The primary competitors of our telecommunication services division include Southern New England Telephone Company, Syniverse Technologies, Inc. and Verisign, Inc.

·       The primary competitors of our financial services division include SAVVIS Communications Corporation, Radianz Inc., AT&T Corp., Bloomberg L.P., Reuters Group PLC and The Thomson Corporation (Thomson Financial).

·       The primary competitors of our international services division include British Telecom in the United Kingdom, France Telecom in France, Telefonica S.A. in Spain and Telstra Corporation Limited in Australia.

We depend on key personnel.

Our success depends largely on the ability and experience of a number of key employees, including John J. McDonnell, Jr., our Chairman and Chief Executive Officer, Brian J. Bates, our President and Chief Operating Officer, and Henry H. Graham, Jr., our Executive Vice President and Chief Financial Officer. If we lose the services of any of our key employees, our business may be adversely affected.

Regulatory changes may increase our costs or impair our growth.

Federal and state regulations can affect the costs of business for us and our competitors by changing the rate structure for access services purchased from local exchange carriers to originate and terminate calls, by restricting access to dedicated connections available from local exchange carriers, by changing the basis for computation of other charges, such as universal service charges, or by revising the basis for taxing the services we purchase or provide. The Federal Communications Commission (“FCC”) is currently considering changes to the rate structure for services provided by local exchange carriers, including the rate structure for access services, and we currently cannot predict whether these rule changes will be adopted or the impact these rule changes may have on our charges for access and other services if they are adopted.

Recent and pending decisions of the FCC may limit the availability and increase pricing of network elements used by our suppliers to provide telecommunications services to us. We cannot predict whether these rule changes will increase the cost of services we purchase from our suppliers. Further, the United States Congress and the FCC is considering modifying the way in which Federal Universal Service Fund charges are calculated, including considering whether to assess universal service charges on a flat-fee basis, such as a per-line, per-telephone number or per-account charge. We currently cannot predict whether Congress will mandate or the FCC will adopt changes in the calculation of Federal Universal Service Fund contributions or whether these changes, if adopted, would increase our Federal Universal Service Fund surcharges. If the FCC implements any legislation, adopts any proposal or takes any administrative action that increases our Federal Universal Service Fund surcharges, our network operating costs will increase. In addition, if the FCC implements any legislation, adopts any proposal, or takes any administrative action that increases our telecommunications service supplier’s Universal Service Fund obligations, these suppliers may seek to pass through cost-recovery charges to us, which would result in an increase in our cost of network services.

The business of our telecommunication services division customers is or may become subject to regulation that indirectly affects our business. Many of our telecommunication services division customers are subject to federal and state regulations applicable to the telecommunications industry. Changes in these regulations could cause our customers to alter or decrease the services they purchase from us.

24




In addition, the payment processing industry in which our POS division operates may become subject to regulation as a result of recent data security breaches that have exposed consumer data to potential fraud. To the extent this occurs, our POS division customers could impose on us additional technical, contractual or other requirements as a condition to continuing to do business with them. These requirements could cause us to incur additional costs, which could be significant, or to lose revenues to the extent we do not comply with these requirements.

We cannot predict when, or upon what terms and conditions, further regulation or deregulation might occur or the effect future regulation or deregulation may have on our business. Our operating costs may be increased because our service providers and several services that we offer may be indirectly affected by federal and state regulations. In addition, future services we may provide could become subject to direct regulation.

Item 1B.               Unresolved Staff Comments

None

Item 2.                        Properties

Our principal executive offices are located in Reston, Virginia and consist of approximately 40,980 square feet of office space under a lease expiring in February 2013. Our primary network control center is also located in Reston, Virginia and consists of approximately 44,500 square feet of separate office space under a lease expiring in February 2008. In addition, we lease the following additional principal facilities:

Use

 

 

 

Location

 

 

 

Approximate
square footage

 

Lease
expiration date

 

European technology and finance center

 

Dublin, Ireland

 

 

14,500

 

 

January 2022

 

United Kingdom headquarters and network
control center

 

Sheffield, England

 

 

16,000

 

 

April 2015

 

 

We also lease and occupy regional sales offices in various cities. We house our remote network switching equipment in facilities owned and maintained by some of our digital telecommunications circuit providers and also in leased telecommunications point-of-presence facilities located in various cities. These leases total approximately 28,000 square feet and expire on dates ranging from January 2007 to October 2014. We believe that our existing facilities are adequate to meet current requirements and that suitable additional space will be available as needed to accommodate the expansion of our operations and development.

Item 3.                        Legal Proceedings

On August 26, 2002, an action was filed in the Superior Court of the State of Delaware by persons alleging that we breached an agreement to purchase an unrelated entity. On February 28, 2005, the court denied our motion for summary judgment filed in June 2004. After considering the defense costs, potential damages should the plaintiffs prevail, and continued diversion of management resources, we determined in March 2005 that a settlement was warranted. In April 2005, we settled the matter by making payment of $3.3 million in cash to the plaintiffs and received the dismissal of all claims, with prejudice, by the plaintiffs.

Certain states in which we operate assess sales taxes on certain services provided by us. Our customer contracts generally contain terms that stipulate the customer is responsible for any sales tax liability. In jurisdictions where the customer may be liable for sales taxes, we either include sales tax on our invoice or have obtained an exemption certificate from the customer. Certain states have audited us from 1996 to early 2001 and originally proposed $6.7 million in assessments on the basis that sales taxes were owed. In March 2005, we received verbal notification from a state sales tax auditor that one of the states was likely

25




to reduce its proposed assessment by an amount in excess of $4 million. In April 2005, we received written confirmation from that state’s Department of Revenue that the state’s assessment would be reduced by $4.3 million. In July 2005, we entered into an agreement with that state’s Department of Revenue to settle the remaining outstanding liability of approximately $1.5 million for $0.8 million and concurrently entered into an agreement with a customer to reimburse us for $0.5 million of the settlement amount. We and our customers involved are vigorously defending the remaining proposed assessments. In the opinion of management, resolution of these matters will not have a material adverse effect upon our financial position or future operating results.

We are from time to time a party to other legal proceedings, which arise in the normal course of business. Although we have been involved in past litigation, we are not currently involved in any material litigation the outcome of which could, in management’s judgment based on information currently available, have a material adverse effect on our results of operations or financial condition. Management is not aware of any material litigation threatened against us.

Item 4.                        Submission of Matters to a Vote of Security Holders

No matter was submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders.

26




PART II

Item 5.                        Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Our common stock trades on The New York Stock Exchange (“NYSE”) under the symbol “TNS”. The following table reflects the range of high and low sale prices for the period indicated as reported by the NYSE.

Fiscal Year Ended December 31, 2005

 

 

 

HIGH

 

LOW

 

First quarter ended March 31, 2005

 

$

22.70

 

$

16.72

 

Second quarter ended June 30, 2005

 

$

23.59

 

$

17.67

 

Third quarter ended September 30, 2005

 

$

25.88

 

$

21.55

 

Fourth quarter ended December 31, 2005

 

$

24.45

 

$

17.26

 

 

As of March 9, 2006, there were 40 stockholders of record of our common stock, excluding shares held in street name by various brokerage firms. We estimate that there are approximately 2,000 beneficial owners of our common stock.

We have never declared or paid any cash dividends on our common stock. We currently intend to retain our earnings for future growth and, therefore, do not anticipate paying any cash dividends in the foreseeable future. Under our amended and restated senior secure credit agreement, we are subject to restrictions on paying dividends.

During the period covered by this report, we did not sell any equity securities without registration under the Securities Act.

We repurchased 221 shares for total consideration of approximately $5,000 during the fourth quarter of the fiscal year covered by this report. Neither we nor any affiliated purchaser (as that term is defined in Securities Exchange Act Rule 10b-18(a)(3)) made any other repurchases of our shares during the fourth quarter of the fiscal year covered by this report.

Item 6.                        Selected Consolidated Financial Data

The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this report. The consolidated statement of operations data for the years ended December 31, 2003, 2004 and 2005 and the consolidated balance sheet data as of December 31, 2004 and 2005 are derived from our consolidated financial statements, which are included elsewhere in this report. The consolidated statement of operations data for the period from April 3, 2001 through December 31, 2001 and the year ended December 31, 2002 and the balance sheet data as of December 31, 2001, 2002, and 2003 are derived from our consolidated financial statements, which are not included in this report.

The consolidated statement of operations data for our predecessor, Transaction Network Services, Inc., formerly PSINet Transaction Solutions, Inc., for the period from January 1, 2001 through April 2, 2001 is derived from the consolidated financial statements of Transaction Network Services, Inc., formerly PSINet Transaction Solutions, Inc. and are not included in this report.

The historical results are not necessarily indicative of the results to be expected for any future period.

27




Selected Consolidated Financial Data
(In thousands, except per share and transaction data)

 

 

Transaction Network
Services, Inc.
(Formerly PSINet
Transaction
Solutions, Inc.)
(Predecessor)

 

The Company

 

 

 

January 1, 2001-
April 2, 2001

 

April 3, 2001-
December 31,
2001

 

Year ended
December 31,
2002

 

Year ended
December 31,
2003

 

Year ended
December 31,
2004

 

Year ended
December 31,
2005

 

Consolidated Statements of Operations Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

 

$

46,755

 

 

 

$

144,994

 

 

 

$

202,180

 

 

 

$

223,353

 

 

 

$

249,112

 

 

 

$

258,940

 

 

Cost of network services

 

 

26,506

 

 

 

73,650

 

 

 

108,392

 

 

 

119,990

 

 

 

120,356

 

 

 

121,682

 

 

Engineering and development

 

 

2,857

 

 

 

6,560

 

 

 

10,638

 

 

 

11,560

 

 

 

14,688

 

 

 

15,521

 

 

Selling, general and administrative 

 

 

11,032

 

 

 

18,795

 

 

 

33,063

 

 

 

37,284

 

 

 

49,264

 

 

 

55,245

 

 

Depreciation and amortization of property and equipment

 

 

3,749

 

 

 

8,376

 

 

 

16,480

 

 

 

20,220

 

 

 

20,205

 

 

 

18,972

 

 

Amortization of intangible
 assets
(1)

 

 

11,520

 

 

 

15,601

 

 

 

23,150

 

 

 

25,769

 

 

 

28,573

 

 

 

22,773

 

 

Impairment of goodwill and other intangible assets

 

 

322,153

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Costs of terminated initial public offering

 

 

 

 

 

 

 

 

1,473

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

 

377,817

 

 

 

122,982

 

 

 

193,196

 

 

 

214,823

 

 

 

233,086

 

 

 

234,193

 

 

Income (loss) from operations before taxes, equity in net loss of unconsolidated affiliates, and minority interest in net loss of consolidated subsidiary

 

 

(331,062

)

 

 

22,012

 

 

 

8,984

 

 

 

8,530

 

 

 

16,026

 

 

 

24,747

 

 

Interest expense

 

 

(151

)

 

 

(12,091

)

 

 

(11,917

)

 

 

(11,272

)

 

 

(7,341

)

 

 

(9,052

)

 

Interest and other income (expense), net

 

 

250

 

 

 

555

 

 

 

915

 

 

 

2,544

 

 

 

1,601

 

 

 

(25

)

 

Income tax benefit (provision)

 

 

1,125

 

 

 

(4,562

)

 

 

(45

)

 

 

(838

)

 

 

(4,263

)

 

 

(7,218

)

 

Equity in net loss of unconsolidated affiliates

 

 

 

 

 

 

 

 

(364

)

 

 

(64

)

 

 

(1,039

)

 

 

(2,686

)

 

Minority interest in net loss of consolidated subsidiary

 

 

156

 

 

 

348

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)(1)

 

 

(329,682

)

 

 

6,262

 

 

 

(2,427

)

 

 

(1,100

)

 

 

4,984

 

 

 

5,766

 

 

Dividends on preferred stock

 

 

 

 

 

(11,934

)

 

 

(14,630

)

 

 

(15,060

)

 

 

(3,428

)

 

 

 

 

Loss on early extinguishment of related party debt, net of tax benefit of $1,428

 

 

 

 

 

(2,238

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) attributable to common stockholders

 

 

$

(329,682

)

 

 

$

(7,910

)

 

 

$

(17,057

)

 

 

$

(16,160

)

 

 

$

1,556

 

 

 

$

5,766

 

 

Per Share Information:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic net income (loss) per common share

 

 

 

 

 

 

$

(0.64

)

 

 

$

(1.38

)

 

 

$

(1.31

)

 

 

$

0.06

 

 

 

$

0.24

 

 

Diluted net income (loss) per common share

 

 

 

 

 

 

$

(0.64

)

 

 

$

(1.38

)

 

 

$

(1.31

)

 

 

$

0.06

 

 

 

$

0.23

 

 

Basic weighted average common shares outstanding

 

 

 

 

 

 

12,371

 

 

 

12,372

 

 

 

12,373

 

 

 

24,114

 

 

 

24,519

 

 

Diluted weighted average common shares outstanding

 

 

 

 

 

 

12,371

 

 

 

12,372

 

 

 

12,373

 

 

 

24,449

 

 

 

24,767

 

 

 

 

28




 

 

 

As of December 31,

 

 

 

2001

 

2002

 

2003

 

2004

 

2005

 

Consolidated Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

8,091

 

$

5,984

 

$

11,074

 

$

19,788

 

$

26,628

 

Working capital

 

(5,080

)

(12,923

)

(18,102

)

10,086

 

33,114

 

Total assets

 

320,768

 

362,811

 

342,359

 

356,412

 

352,184

 

Total debt, including current portion

 

134,184

 

169,347

 

150,395

 

51,000

 

113,448

 

Class A redeemable convertible preferred stock

 

146,780

 

161,410

 

176,470

 

 

 

Total stockholders’ equity (deficit)

 

(4,445

)

(21,896

)

(37,512

)

242,498

 

177,846

 


(1)              On January 1, 2002, we adopted Statement of Financial Accounting Standards, No. 142, “Goodwill and Other Intangible Assets” which requires that goodwill no longer be amortized. If SFAS No. 142 had been effective for the period from April 3, 2001 through December 31, 2001, net income would have increased by approximately $0.5 million resulting in a net loss attributable to common stockholder of approximately $7.5 million. For the period from January 1, 2001 to April 2, 2001, amortization of intangible assets includes amortization of goodwill.

29




Item 7.                        Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the related notes included elsewhere in this report.

Overview

We are a leading provider of business-critical data communications services to processors of credit card, debit card and ATM transactions. We are also a leading provider of secure data and voice network services to the global financial services industry. We operate one of four unaffiliated Signaling System No. 7 networks in the United States capable of providing services nationwide, and we utilize this network to provide call signaling and database access services to the domestic telecommunications industry. Our data communications services enable secure and reliable transmission of time-sensitive, transaction-related information critical to our customers’ operations. Our customers outsource their data communications requirements to us because of our substantial expertise, comprehensive customer support and cost-effective services. We provide services to customers in the United States and increasingly to international customers in 23 countries, including Canada and countries in Europe, Latin America and the Asia-Pacific region.

We provide services through our multiple data networks, each designed specifically for transaction applications. Our networks support a variety of widely accepted communications protocols and are designed to be scalable and accessible by multiple methods, including dial-up, dedicated, wireless and Internet connections.

We generate revenues through four business divisions:

·       POS services. We provide fast, secure and reliable data communications services primarily to payment processors in the United States and Canada. POS services revenue is derived primarily from per transaction fees paid by our customers for the transmission of transaction data through our networks between payment processors and POS or ATM terminals.

·       International services. We are one of the leading providers of data communications services to the POS industry in the United Kingdom. Our international services division also provides services in Australia, France, Germany, Ireland, Italy, Japan, the Netherlands, New Zealand, Poland, Romania, South Korea, Spain and Sweden through subsidiaries located in these countries. Additionally, through these international subsidiaries, we also provide services to customers located in Belgium, Finland, Gibraltar, Hong Kong, Mexico, Norway, Singapore and Thailand. Our international services division generates revenues primarily from our POS and financial services offerings abroad.

·       Telecommunication services. We provide call signaling services that enable telecommunications carriers to establish and terminate telephone calls placed by their subscribers. We also provide database access services that enable our customers to provide intelligent network services, such as caller identification and local number portability, and credit card, calling card, third-party billing and collect calling. Our telecommunication services division generates revenues primarily from fixed monthly fees charged for our call signaling services and per-query fees charged for our database access and validation services.

·       Financial services. We provide fast, secure and reliable private data networking services that enable seamless communications and facilitate electronic trading among commercial banks, mutual funds, pension funds, broker-dealers, alternative trading systems, electronic communications networks, securities and commodities exchanges and other market participants. Our networks support multiple communications protocols including the Financial Information eXchange, or FIX,

30




protocol. Our financial services division generates revenues from monthly recurring fees based on the number of customer connections to and through our networks.

Our most significant expense is cost of network services, which is comprised primarily of telecommunications charges, including data transmission and database access, leased digital capacity charges, circuit installation charges and activation charges. The cost of data transmission is based on a contract or tariff rate per minute of usage in addition to a prescribed rate per transaction for some vendors.

The costs of database access, circuits, installation charges and activation charges are based on fixed fee contracts with local exchange carriers and interexchange carriers. The cost of network services also includes salaries, equipment maintenance and other costs related to the ongoing operation of our data networks. Depreciation expense on our network equipment and amortization of developed technology are excluded from our cost of network services and included in depreciation and amortization of property and equipment and amortization of intangible assets in our consolidated statements of operations.

Our engineering and development expenses include salaries and other costs related to product development, engineering, hardware maintenance and materials. The majority of these costs are expensed as incurred, including costs related to the development of internal use software in the preliminary project, the post-implementation and operation stages. Development costs we incur during the software application development stage are capitalized and amortized over the estimated useful life of the developed software.

Our selling, general and administrative expenses include costs related to sales, marketing, administrative and management personnel, as well as external legal, accounting and consulting services.

In March 2004, we completed our initial public offering (IPO) of common stock issuing 4,420,000 common shares at $18.00 per share, which generated proceeds, net of offering costs, of approximately $71.5 million. The net proceeds of the IPO were used to repay a portion of the outstanding debt under our 2001 senior secured credit facility. Concurrent with the closing of the IPO, we entered into a new 2004 senior secured credit facility and used the net proceeds from borrowings to repay the remaining debt outstanding under our 2001 senior secured credit facility. In connection with the termination of our 2001 senior secured credit facility, we recognized a charge of approximately $2.0 million related to the write-off of unamortized deferred financing costs. Such write-off was included in interest expense in the accompanying  consolidated statement of operations for the year ended December 31, 2004.

Upon the completion of the IPO, all of the outstanding shares of our Class A redeemable convertible preferred stock, including accrued and unpaid dividends, converted at $18.00 per share into 9,984,712 shares of common stock.

On October 1, 2004, we completed a follow-on offering of common stock issuing 1,084,744 common shares at $20.00 per share, which generated proceeds, net of offering costs, of approximately $19.9 million.

On November 1, 2004, in connection with the follow-on offering, the underwriters exercised a portion of their over-allotment option and we issued an additional 118,232 common shares at $20.00 per share, which generated proceeds, net of offering costs of approximately $2.3 million. The net proceeds from the follow-on offering were used to repay a portion of our long-term debt outstanding under our 2004 senior secured credit facility.

In connection with the completion of our tender offer, as described below, on May 4, 2005, we entered into an amended and restated senior secured credit facility, which consists of two amended and restated facilities: a senior term loan facility in an aggregate principal amount of $165 million and a senior revolving credit facility in an aggregate principal amount of $30 million. Pursuant to the amended and restated senior secured credit facility, certain term lenders holding loans under our 2004 senior secured credit

31




facility exchanged $48 million of old term loans for term loans under the amended term facility and $117 million of additional term loans were made to us to finance the purchase of shares of our common stock, including fees and expenses incurred therewith, in connection with the tender offer. The amended and restated senior secured credit facility may also be used for general corporate purposes.

On May 5, 2005, we completed a modified Dutch auction tender offer, purchasing and retiring 6,263,435 shares of our outstanding common stock at a price of $18.50 per share net to each seller in cash, for an aggregate purchase price of $116.9 million. The 6,263,435 shares tendered include 6,000,000 shares tendered by our then controlling stockholder, GTCR.

On September 21, 2005, we completed a follow-on offering of common stock issuing 1,200,000 common shares at $23.25 per share, which generated proceeds, net of offering costs, of approximately $26.1 million. On September 21, 2005, in connection with the follow-on offering, the underwriters exercised their over-allotment option and we issued an additional 900,000 shares of common stock at $23.25 per share, which generated proceeds, net of offering costs, of approximately $20.0 million. The net proceeds from the follow-on offering were used to repay a portion of our long-term debt outstanding under our amended and restated senior secured credit facility.

Acquisitions

On December 4, 2002, we completed the acquisition of a 50.1% interest in Openet S.r.l., an Italian provider of POS services, for a purchase price of $1.8 million, plus transaction costs of $0.4 million. On January 24, 2003, we acquired the remaining 49.9% interest in Openet for $2.0 million in cash. We accounted for this acquisition under the purchase method with the total consideration allocated to the fair value of assets acquired and liabilities assumed, including identified intangibles of $3.4 million and goodwill of $0.5 million. Our consolidated statements of operations include the operating results of Openet.

On November 18, 2003, we acquired certain tangible and intangible assets of Transpoll Offline for a purchase price of $2.5 million including direct acquisition costs of $0.4 million. The assets acquired included the right to provide POS services in the United Kingdom under customer contracts, certain fixed assets and a non-compete agreement. We accounted for this acquisition under the purchase method with the total consideration allocated to the fair value of assets acquired and liabilities assumed, including identified intangibles of $1.3 million. Our consolidated statements of operations include the operating results of Transpoll Offline from November 18, 2003.

On May 21, 2004, we completed the acquisition of two groups of tangible and intangible assets from the bankrupt U.S. Wireless Data, Inc. (USWD). Pursuant to two separate asset purchase agreements, the Company, with the approval of the bankruptcy court, (a) paid approximately $6.1 million, including direct acquisition costs of approximately $0.1 million, for certain assets related to USWD’s Synapse platform, which enables wireless POS terminals to initiate transactions for mobile and other merchants and (b) paid approximately $3.7 million, including direct acquisition costs of approximately $47,000, for USWD’s vending assets, which support cashless transactions at vending machines. We purchased these assets to advance our wireless capability to service existing customers as well as to penetrate new vertical markets. We accounted for the acquisitions of the Synapse and vending assets under the purchase method with the total consideration allocated to the fair value of the assets acquired and liabilities assumed, including identifiable intangibles of $5.9 million related to the Synapse assets and $3.7 million related to the vending assets. Our consolidated results of operations include the operating results of these acquisitions from May 21, 2004.

In November 2004, we acquired the right to provide telecommunications services under customer contracts from ICG Telecom Group, Inc for a purchase price of $1.7 million plus an agreement to provide telecommunications services valued at $0.7 million. We accounted for this acquisition under the purchase

32




method with the total consideration allocated to the fair value of assets acquired and liabilities assumed, including identified intangibles of $2.4 million. Our consolidated statements of operations include the operating results of ICG Telecom Group, Inc. from November 9, 2004.

On May 12, 2005, we acquired certain tangible and intangible assets of FusionPoint Technology Solutions from Techlan, Inc. for a purchase price of $3.5 million, including direct acquisition costs of $0.1 million. FusionPoint designs and installs turn-key solutions that integrate legacy data communication devices found in convenience stores and service stations onto an IP network. We accounted for the acquisition of the FusionPoint assets under the purchase method with the total consideration allocated to the fair value of the assets acquired and liabilities assumed, including identifiable intangibles of $3.5 million. Our consolidated results of operations include the operating results of this acquisition from May 12, 2005.

On August 2, 2005, we acquired certain intangible assets of Process Logistics Limited for a purchase price of $0.5 million, including direct acquisition costs of approximately $27,000. The assets acquired include the right to provide POS services in the United Kingdom and a non-compete agreement. We accounted for the acquisition of the Process Logistics assets under the purchase method with the total consideration allocated, on a preliminary basis, to the fair value of the assets acquired, including identifiable intangibles of $0.5 million. Our consolidated results of operations include the operating results of this acquisition from August 2, 2005.

On December 13, 2005, we completed the acquisition of an Romanian company, SC Connet-Ro SRL (Connet-Ro) for a purchase price of $1.4 million, including direct acquisition costs of approximately $0.1 million. We accounted for this acquisition under the purchase method with the total consideration allocated to the fair value of assets acquired and liabilities assumed, including identified intangibles of $1.2 million. The purchase agreement allows for additional consideration of up to $0.4 million to be paid, based upon the results of operations of Connet-Ro for the year ended December 31, 2005. Our consolidated results of operations include the operating results of this acquisition from December 13, 2005.

On December 31, 2005, we acquired certain tangible and intangible assets of Arval UK Limited for a purchase price of approximately $0.9 million including direct acquisition costs of $52,000. The assets acquired included the right to provide POS services in the United Kingdom under customer contracts, certain fixed assets and a non-compete agreement. We accounted for this acquisition under the purchase method with the total consideration allocated to the fair value of assets acquired and liabilities assumed, including identified intangibles of $0.6 million.

On January 6, 2006, we completed the acquisition of two companies in the United Kingdom, CommsXL Services and CommsXL Limited (collectively CommsXL). Pursuant to two separate purchase agreements, the Company paid approximately $12.0 million, including direct acquisition costs of approximately $0.2 million for certain assets of CommsXL. We purchased these companies to advance our end-to-end POS service offerings in the United Kingdom as well as to penetrate new vertical markets.

On February 28, 2006, we acquired certain tangible and intangible assets of InfiniRoute Networks, Inc. for a purchase price of approximately $2.5 million. The assets acquired include the right to provide TSD services under customer contracts, certain fixed assets and a non-compete agreement. We purchased these assets to advance our TSD service offerings to enable traditional telecommunications carriers and next-generation service providers to interconnect directly over Internet Protocol (IP) packet networks, reducing the cost and complexity associated with these interconnections.

International Operations

Although we generate revenues in 12 of the 14 countries that we operate in our international services division, as of December 31, 2005 we have yet to generate positive operating cash flows in six of these 14

33




countries. When establishing operations in a country, we typically incur personnel and capital expenditures for an average of two to three years prior to establishing a customer base, recording revenues and generating positive operating cash flows. On a consolidated basis as of December 31, 2005, our international services division generated positive operating cash flows.

Results of Operations

The following tables set forth, for the periods indicated, the selected statements of operations data (in thousands):

 

 

Year ended December 31,

 

 

 

2003

 

2004

 

2005

 

Statements of Operations Data:

 

 

 

 

 

 

 

Revenues

 

$

223,353

 

$

249,112

 

$

258,940

 

Cost of network services

 

119,990

 

120,356

 

121,682

 

Engineering and development

 

11,560

 

14,688

 

15,521

 

Selling, general and administrative

 

37,284

 

49,264

 

55,245

 

Depreciation and amortization of property and equipment

 

20,220

 

20,205

 

18,972

 

Amortization of intangible assets

 

25,769

 

28,573

 

22,773

 

Total operating expenses

 

214,823

 

233,086

 

234,193

 

Income from operations before income tax provision and equity in net loss of unconsolidated affiliates

 

8,530

 

16,026

 

24,747

 

Interest expense

 

(11,272

)

(7,341

)

(9,052

)

Interest and other income (expense), net

 

2,544

 

1,601

 

(25

)

Income tax provision

 

(838

)

(4,263

)

(7,218

)

Equity in net loss of unconsolidated affiliates

 

(64

)

(1,039

)

(2,686

)

Net (loss) income

 

$

(1,100

)

$

4,984

 

$

5,766

 

 

Year ended December 31, 2005 compared to the year ended December 31, 2004

Revenues. Total revenues increased $9.8 million, or 3.9%, to $258.9 million for the year ended December 31, 2005, from $249.1 million for the year ended December 31, 2004. We generate revenues through four operating divisions.

POS division. Revenues from the POS division decreased $25.4 million, or 22.7%, to $86.6 million for the year ended December 31, 2005, from $112.0 million for the year ended December 31, 2004. The $25.4 million decrease in POS revenues resulted primarily from a decline in transaction volumes, primarily from a major customer, and to a lesser extent a decrease in revenue per transaction as a result of negotiated price reductions upon renewal of certain contracts. POS transaction volumes decreased 19.8% to 5.8 billion transactions for the year ended December 31, 2005, from 7.2 billion transactions for the year ended December 31, 2004. We have negotiated contract renewals with some of our POS customers, and in several instances we agreed to pricing discounts in exchange for maintaining or increasing their minimum transaction or revenue commitments. As a result, it is likely our revenue per transaction will decrease and, depending upon the number of transactions we transport, our POS revenues may continue to decrease. In addition, during 2005 we amended our contract with a major customer to extend the term of the agreement for two years. The amended contract does not contain any minimum transaction commitments. Based on the amended contract, we believe that revenues and related transaction volumes from this customer may decline in 2006 and thereafter.

International services division. Revenues from the international services division increased $16.9 million, or 21.9%, to $94.5 million for the year ended December 31, 2005, from $77.5 million for the year ended December 31, 2004. The increase was primarily due to additional revenues generated from our POS and

34




FSD customers in the United Kingdom, Australia, France, Germany, Ireland and Italy. Revenues from our United Kingdom subsidiary increased $8.3 million, or 15.0%, to $55.5 million for the year ended December 31, 2005, from $47.1 million for the year ended December 31, 2004.

Telecommunication services division. Revenues from the telecommunication services division increased $12.4 million, or 36.3%, to $46.6 million for the year ended December 31, 2005, from $34.1 million for the year ended December 31, 2004. The growth in revenues was primarily due to increased usage of our call signaling and database access services from new and existing customers.

Financial services division. Revenues from the financial services division increased $5.9 million, or 23.1%, to $31.3 million for the year ended December 31, 2005, from $25.5 million for the year ended December 31, 2004. The increase in revenues was due to the growth in the number of customer connections to and through our networks.

Cost of network services. Cost of network services increased $1.3 million, or 1.1%, to $121.7 million for the year ended December 31, 2005, from $120.4 million for the year ended December 31, 2004. Cost of network services were 47.0% of revenues for the year ended December 31, 2005, compared to 48.3% of revenues for the year ended December 31, 2004. The increase in cost of network services resulted primarily from higher usage charges from our TSD, FSD and ISD services, offset primarily by lower usage charges from decreased POS transactions and to a lesser extent, a decrease in usage-based vendor telecommunications charges in our POS division. Gross profit represented 53.0% of total revenues for the year ended December 31, 2005, compared to 51.7% for the year ended December 31, 2004. The increase in gross profit as a percentage of total revenues resulted primarily from increased contribution of our international services division and financial services division, our highest gross margin divisions, and to a lesser extent the decrease in usage-based vendor telecommunications charges. These increases were partially offset by the decline in margin of our POS business as we transported fewer transactions over our fixed cost network, as well as from increased contribution from our telecommunications services division, our lowest gross margin division.

Future cost of network services depends on a number of factors including total transaction and query volume, the relative growth and contribution to total transaction volume of each of our customers, the success of our new service offerings, the timing and extent of our network expansion and the timing and extent of any network cost reductions. In addition, any significant loss or significant reduction in transaction volumes could lead to a decline in gross margin since significant portions of our network costs are fixed costs.

Engineering and development expense. Engineering and development expense increased $0.8 million, or 5.7%, to $15.5 million for the year ended December 31, 2005, from $14.7 million for the year ended December 31, 2004. Engineering and development expense represented 6.0% of revenues for the year ended December 31, 2005 and 5.9% of revenues for the year ended December 31, 2004. Engineering and development expense increased primarily from an increase in engineering expenses required to support our international expansion and new product offerings in our POS division.

Selling, general and administrative expense. Selling, general and administrative expense increased $6.0 million, or 12.1%, to $55.2 million for the year ended December 31, 2005, from $49.3 million for the year ended December 31, 2004. Selling, general and administrative expense represented 21.3% of revenues for the year ended December 31, 2005, compared to 19.8% of revenues for the year ended December 31, 2004. Selling, general and administrative expense increased primarily from the incremental costs necessary to operate as a public company and to a lesser extent, the expenses required to support our revenue growth, mainly within the international services division. Included in selling, general and administrative expense for the year ended December 31, 2005 is a pre-tax benefit to earnings of $2.3 million, comprised of $6.5 million of benefits from settlements of state sales tax liabilities, a $3.3 million charge related to a legal

35




settlement and a $0.9 million charge related to severance. Excluding this $2.3 million pre-tax benefit, selling, general and administrative expense was $57.5 million for the year ended December 31, 2005.

Depreciation and amortization of property and equipment. Depreciation and amortization of property and equipment decreased $1.2 million, or 6.1%, to $19.0 million for the year ended December 31, 2005, from $20.2 million for the year ended December 31, 2004. Depreciation expense decreased primarily from certain assets becoming fully depreciated during the year. Depreciation and amortization of property and equipment represented 7.3% of revenues for the year ended December 31, 2005, compared to 8.1% of revenues for the year ended December 31, 2004.

Amortization of intangible assets. Amortization of intangible assets decreased $5.8 million, or 20.3%, to $22.8 million for the year ended December 31, 2005, from $28.6 million for the year ended December 31, 2004. The amortization of intangible assets for the year ended December 31, 2005 and 2004 relates solely to the intangible assets resulting from acquisitions. Included in amortization of intangible assets for the years ended December 31, 2005 and 2004 is approximately $3.8 million and $3.4 million, respectively, of accelerated amortization on a portion of our customer relationship intangible assets in connection with the loss of certain customers during those years.  Excluding these items, amortization of intangible assets decreased due to certain of our intangible assets becoming fully amortized during 2005. For purposes of measuring and recognizing impairment of long-lived assets including intangibles, we assess whether separate cash flows can be attributed to the individual asset. For our customer relationship intangible assets, we recognize and measure impairment upon the significant loss of revenue from a customer. Based upon our contract with one of our major customers, we believe that revenues and related transaction volumes from this customer will continue to decline in 2006 and may decline further thereafter. The intangible asset value attributable to this customer relationship is approximately $23.8 million as of December 31, 2005. We assessed the recoverability of this customer relationship asset based upon undiscounted anticipated future cash flows, and concluded no impairment existed as of December 31, 2005.

Interest expense. Interest expense increased $1.7 million to $9.1 million for the year ended December 31, 2005, from $7.3 million for the year ended December 31, 2004. Included in interest expense for the year ended December 31, 2005 is approximately $1.1 million of deferred financing costs in connection with the termination of our 2004 senior secured credit facility. Included in interest expense for the year ended December 31, 2004 is approximately $2.0 million of deferred financing costs in connection with the termination of our 2001 senior secured credit facility. Excluding these items, interest expense increased primarily due to the additional borrowings under our amended and restated senior secured credit facility to finance the stock repurchase in May 2005.

Interest and other income (expense), net. Interest and other income (expense), net was approximately $25,000 of expense for the year ended December 31, 2005 compared to $1.6 million of income for the year ended December 31, 2004. Included in other income (expense), net for the year ended December 31, 2005 is a loss on foreign currency translation of $0.8 million due to fluctuations in the value of the U.S. dollar as compared with foreign currencies, predominately, the euro, the British pound and the Australian dollar, versus a gain on foreign currency translation of $1.1 million for the year ended December 31, 2004. Also included in interest  and other income (expense), net is $0.7 million and $0.3 million of interest income for the years ended December 31, 2005 and 2004, respectively. Also included in other income (expense), net for the year ended December 31, 2005 is a $0.1 million loss on the sale of property and equipment, versus a gain of $0.2 million for the year ended December 31, 2004.

Income tax provision. For the year ended December 31, 2005, our income tax provision was $7.2 million compared to $4.3 million for the year ended December 31, 2004. Our effective tax rate for the year ended December 31, 2005 is 46.1% versus the U.S. federal statutory tax rate of 34.0%, due primarily to the fact that we have losses from certain of our international subsidiaries that cannot be used to offset income in other jurisdictions.

36




Equity in net loss of unconsolidated affiliates. For the year ended December 31, 2005, our equity in net loss of unconsolidated affiliates was $2.7 million compared to $1.0 million for the year ended December 31, 2004. The increase was due to additional losses recorded on our equity method investments, primarily relating to our investments in WAY Systems, Inc. and IP Commerce, Inc. As of December 31, 2005, we have $5.1 million of long-term investments in unconsolidated affiliates, and we expect to incur losses on these investments in 2006 and we may continue to incur losses thereafter.

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

Revenues. Total revenues increased $25.7 million, or 11.5%, to $249.1 million for the year ended December 31, 2004, from $223.4 million for the year ended December 31, 2003. We generate revenues through four operating divisions.

POS division. Revenues from the POS division decreased $10.9 million, or 8.9%, to $112.0 million for the year ended December 31, 2004, from $122.9 million for the year ended December 31, 2003. The $10.9 million decrease in POS revenues resulted from a decline in transaction volumes primarily from our largest customer and to a lesser extent a decrease in revenue per transaction as a result of negotiated price reductions upon renewal of certain contracts. POS transaction volumes decreased 8.4% to 7.2 billion transactions for the year ended December 31, 2004, from 7.9 billion transactions for the year ended December 31, 2003. In 2004, we negotiated contract renewals with some of our POS customers, and in several instances we agreed to pricing discounts in exchange for maintaining or increasing their minimum transaction or revenue commitments.

International services division. Revenues from the international services division increased $29.0 million, or 60.0%, to $77.5 million for the year ended December 31, 2004, from $48.5 million for the year ended December 31, 2003. The increase was primarily due to additional revenues generated from our POS customers in the United Kingdom, Australia, France, Spain and Italy and to a lesser extent we benefited from favorable foreign exchange rates. Revenues from our United Kingdom subsidiary increased $13.8 million, or 41.4%, to $47.1 million for the year ended December 31, 2004, from $33.3 million for the year ended December 31, 2003.

Telecommunication services division. Revenues from the telecommunication services division increased $2.9 million, or 9.4%, to $34.1 million for the year ended December 31, 2004, from $31.2 million for the year ended December 31, 2003. The growth in revenues was primarily due to increased usage of our call signaling services.

Financial services division. Revenues from the financial services division increased $4.7 million, or 22.5%, to $25.5 million for the year ended December 31, 2004, from $20.8 million for the year ended December 31, 2003. The increase in revenues was due to the growth in the number of customer connections to and through our networks.

Cost of network services. Cost of network services increased $0.4 million, or 0.3%, to $120.4 million for the year ended December 31, 2004, from $120.0 million for the year ended December 31, 2003. Cost of network services were 48.3% of revenues for the year ended December 31, 2004, compared to 53.7% of revenues for the year ended December 31, 2003. The increase in cost of network services resulted primarily from higher usage charges from our TSD, FSD and ISD services, offset primarily by a decrease in usage-based vendor telecommunications charges in our POS division, and to a lesser extent, lower usage charges from decreased POS transactions. Gross profit represented 51.7% of total revenues for the year ended December 31, 2004, compared to 46.3% for the year ended December 31, 2003. The increase in gross profit as a percentage of total revenues resulted primarily from increased contribution of our financial services division and international services division, and to a lesser extent the decrease in usage-based vendor telecommunications charges.

37




Engineering and development expense. Engineering and development expense increased $3.1 million, or 27.1%, to $14.7 million for the year ended December 31, 2004, from $11.6 million for the year ended December 31, 2003. Engineering and development expense represented 5.9% of revenues for the year ended December 31, 2004 and 5.2% of revenues for the year ended December 31, 2003. Engineering and development expense increased primarily from an increase in engineering expenses required to support our international expansion.

Selling, general and administrative expense. Selling, general and administrative expense increased $12.0 million, or 32.1%, to $49.3 million for the year ended December 31, 2004, from $37.3 million for the year ended December 31, 2003. Selling, general and administrative expense represented 19.8% of revenues for the year ended December 31, 2004, compared to 16.7% of revenues for the year ended December 31, 2003. Selling, general and administrative expense increased primarily from the expenses required to support our revenue growth, mainly within the international services division, and to a lesser extent, the incremental costs necessary to operate as a public company.

Depreciation and amortization of property and equipment. Depreciation and amortization of property and equipment decreased $15,000 to $20.2 million for the year ended December 31, 2004, from $20.2 million for the year ended December 31, 2003. Depreciation and amortization of property and equipment represented 8.1% of revenues for the year ended December 31, 2004, compared to 9.1% of revenues for the year ended December 31, 2003.

Amortization of intangible assets. Amortization of intangible assets increased $2.8 million, or 10.9%, to $28.6 million for the year ended December 31, 2004, from $25.8 million for the year ended December 31, 2003. The amortization of intangible assets for the year ended December 31, 2004 and 2003 relates solely to the intangible assets resulting from acquisitions. The increase was attributable to $3.4 million of accelerated amortization on a portion of our customer relationship intangible assets in connection with the loss of certain customers in 2004. For purposes of measuring and recognizing impairment of long-lived assets including intangibles, we assess whether separate cash flows can be attributed to the individual asset. For our customer relationship intangible assets, we recognize and measure impairment upon the termination or loss of a customer that results in a loss of revenue. We will continue to assess the recoverability of our customer relationship assets based upon undiscounted anticipated future cash flows.

Interest expense. Interest expense decreased $4.0 million to $7.3 million for the year ended December 31, 2004, from $11.3 million for the year ended December 31, 2003. This decrease was primarily due to the repayment of a portion of our term debt with the net proceeds from our initial public offering in March 2004 and our follow-on offering in October 2004, partially offset by the write-off on March 19, 2004 of $2.0 million of deferred financing costs in connection with the termination of our 2001 senior secured credit facility.

Interest and other income (expense), net. Interest and other income (expense), net was $1.6 million for the year ended December 31, 2004 compared to $2.5 million for the year ended December 31, 2003. Included in other income (expense), net for the year ended December 31, 2004 is a gain on foreign currency translation of $1.1 million due to fluctuations in the value of the U.S. dollar as compared with foreign currencies, predominately, the euro, the British pound and the Australian dollar, versus a gain on foreign currency translation of $1.7 million for the year ended December 31, 2003. Also included in interest and other income (expense), net for the year ended December 31, 2004 is a $0.2 million gain on the sale of property and equipment, versus a loss of $29,000 for the year ended December 31, 2003. Included in interest and other income, net for the year ended December 31, 2003 was a gain of $0.6 million on the sale of our equity method investment in a related entity.

Income tax provision. For the year ended December 31, 2004, our income tax provision was $4.3 million compared to $0.8 million for the year ended December 31, 2003. Our effective tax rate for the year ended December 31, 2004 was 41.4% versus the U.S. federal statutory tax rate of 34.0%, due primarily to the fact

38




that we have losses from certain of our international subsidiaries that cannot be used to offset income in other jurisdictions.

Seasonality

Credit card and debit card transactions account for a major percentage of the transaction volume processed by our customers. The volume of these transactions on our networks generally is greater in the third and fourth quarter vacation and holiday seasons than during the rest of the year. Consequently, revenues and earnings from credit card and debit card transactions in the first and second quarter generally are lower than revenues and earnings from credit card and debit card transactions in the third and fourth quarters of the immediately preceding year. We expect that our operating results in the foreseeable future will be significantly affected by seasonal trends in the credit card and debit card transaction market.

Liquidity and Capital Resources

Our primary liquidity and capital resource needs are to finance the costs of our operations, to make capital expenditures and to service our debt. The borrowings under our amended and restated senior secured credit facility were used to finance the stock repurchase on May 5, 2005, as well as to repay the amounts outstanding under our 2004 senior secured credit facility. The proceeds from our initial public offering in March 2004, along with the proceeds from borrowings under our 2004 senior secured credit facility, were used to repay the amounts outstanding under our 2001 senior secured credit facility. Based upon our current level of operations, we expect that our cash flow from operations, together with the amounts we are able to borrow under our amended and restated senior secured credit facility, will be adequate to meet our anticipated needs for the foreseeable future. Although we have no specific plans to do so, to the extent we decide to pursue one or more significant strategic acquisitions, we will likely need to incur additional debt or sell additional equity to finance those acquisitions.

Our operations provided us cash of $51.3 million for the year ended December 31, 2005, which was attributable to net income of $5.8 million, depreciation, amortization and other non-cash charges of $51.0 million and a decrease in working capital of $5.5 million. Our operations provided us cash of $54.9 million for the year ended December 31, 2004, which was attributable to net income of $5.0 million, depreciation, amortization and other non-cash charges of $50.2 million and a decrease in working capital of $0.3 million. Our operations provided us cash of $48.1 million for the year ended December 31, 2003, which was attributable to a net loss of $1.1 million, depreciation, amortization and other non-cash charges of $46.8 million and a decrease in working capital of $2.4 million.

We used cash of $33.4 million in investing activities for the year ended December 31, 2005, which includes capital expenditures of $21.6 million. In addition, we made investments of $2.6 million in WAY Systems and $2.9 million in IP Commerce. We also purchased certain assets of FusionPoint for $3.5 million, Process Logistics for $0.6 million and Arval for $0.9 million. We also acquired Connet-Ro for $1.3 million. We used cash of $38.5 million in investing activities for the year ended December 31, 2004, which includes capital expenditures of $23.4 million. In addition, we spent $6.1 million and $3.7 million, respectively, to purchase the Synapse and vending assets from USWD to facilitate our objective to enhance our POS services. We also spent $1.7 million to purchase certain assets from ICG Telecom Group, Inc. to facilitate our objective to expand our telecommunications services. We also made investments of $2.5 million in WAY Systems, Inc. and $1.0 million in AK Jensen Group, Limited. We used cash of $21.7 million in investing activities for the year ended December 31, 2003, which consisted primarily of capital expenditures of $17.1 million. In addition, we spent $2.0 million in January 2003 to purchase the remaining 49.9% interest of Openet and $2.5 million to purchase Transpoll Offline in November 2003 to facilitate our objective to expand our international services division. Significant portions of our capital expenditures in each period were for network equipment, third-party software and capitalized software

39




development costs we incurred to expand our network platforms and service our customer requirements. Our remaining capital expenditures were for office equipment and leasehold improvements and for general corporate purposes. We currently have no significant capital spending or purchase commitments but expect to continue to engage in capital spending in the ordinary course of business.

We used cash of $10.1 million for financing activities for the year ended December 31, 2005, which includes borrowings under our amended and restated senior secured credit facility, net of financing costs, of $165.2 million that were used to finance the purchase and retirement of 6,263,435 shares of our common stock at a price of $18.50 per share plus expenses for approximately $116.9 million and to repay $48.0 million of long-term debt under our 2004 senior secured credit facility. We used the net proceeds from our follow-on offering in September 2005 of approximately $46.1 million to repay long-term debt under our amended and restated senior secured credit facility. In addition, we made long-term debt repayments of $8.4 million on our amended and restated senior secured credit facility, a portion of which was applied to the current maturity in 2006 and an additional $3.0 million on our 2004 senior secured credit facility. We also received proceeds from the exercise of employee stock options of approximately $1.5 million. We used cash of $7.5 million for financing activities for the year ended December 31, 2004, which included $35.4 million of long-term debt repayments on our 2004 senior secured credit facility and $150.4 million of long-term debt repayments under our 2001 senior secured credit facility with the net proceeds generated from our IPO in March 2004 of $71.5 million, net proceeds from our follow-on offering in the fourth quarter 2004 of $22.2 million and borrowings under our 2004 credit facility, net of financing costs, of $79.0 million. We also borrowed $5.5 million in May 2004 under our 2004 credit facility, the proceeds of which were used to fund the acquisition of the Synapse assets from USWD. We used cash of $19.5 million for financing activities for the year ended December 31, 2003, which consisted primarily of $19.0 million of long-term debt repayments. We paid an additional $0.6 million of financing fees in April 2003 to secure an amendment to our 2001 senior secured credit facility.

Amended and Restated Senior Secured Credit Facility

On May 4, 2005, we entered into an amended and restated senior secured credit facility to finance the stock repurchase and to replace our 2004 senior secured credit facility. The amended and restated senior secured credit facility consists of a $165.0 million term loan and a revolving credit facility of $30.0 million, under which there were no borrowings as of December 31, 2005. The amended and restated senior secured credit facility matures May 4, 2012. Payments on the term loan are due in quarterly installments over the seven-year term, beginning on June 1, 2005, with the remainder payable on May 4, 2012. Voluntary prepayments on the term loan are first applied pro-rata to the scheduled quarterly installments due within the next succeeding twelve month period until paid in full and then applied to the term loan in inverse order of maturity. As of December 31, 2005 total remaining payments on the term loan are as follows (in thousands):

2006

 

$

 

2007

 

1,650

 

2008

 

1,650

 

2009

 

1,650

 

2010

 

1,650

 

Thereafter

 

106,848

 

 

 

$

113,448

 

 

For the period through December 31, 2005, borrowings on the revolving credit facility and the term loan bore interest at a rate of 2.00 percent over the LIBOR rate (6.48 percent as of December 31, 2005). Thereafter, if we achieve a leverage ratio of less than 1.75, the borrowings on the revolving credit facility

40




and the term loan generally will bear interest at a rate, at our option, of either 0.75 percent over the lender’s base rate or 1.75 percent over the LIBOR rate. Our leverage ratio as of December 31, 2005 was 1.74 to 1.0. The revolving credit facility is subject to an annual non-use commitment fee in an amount equal to 0.375 percent or 0.5 percent per annum, depending on our leverage ratio, multiplied by the amount of funds available for borrowing under the revolving credit facility. Interest payments on the amended and restated senior secured credit facility are due monthly, bimonthly, or quarterly at our option.

The terms of the amended and restated senior secured credit facility require us to comply with financial and nonfinancial covenants, including maintaining certain leverage, interest and fixed charge coverage ratios at the end of each fiscal quarter. As of December 31, 2005, we were required to maintain a leverage ratio of less than 2.85 to 1.0, an interest coverage ratio of greater than 4.0 to 1.0 and a fixed charge ratio of greater than 2.5 to 1.0. Certain of the financial covenants will become more restrictive over the term of the amended and restated senior secured credit facility. The amended and restated senior secured credit facility also contains nonfinancial covenants that restrict some of our corporate activities, including our ability to dispose of assets, incur additional debt, pay dividends, create liens, make investments, make capital expenditures and engage in specified transactions with affiliates. Our future results of operations and our ability to comply with the covenants could be adversely impacted by increases in the general level of interest rates since the interest on a majority of our debt is variable. Noncompliance with any of the financial or nonfinancial covenants without cure or waiver would constitute an event of default under the amended and restated senior secured credit facility. An event of default resulting from a breach of a financial or nonfinancial covenant may result, at the option of the lenders, in an acceleration of the principal and interest outstanding, and a termination of the amended and restated senior secured revolving credit facility. The amended and restated senior secured credit facility also contains other customary events of default (subject to specified grace periods), including defaults based on events of bankruptcy and insolvency, nonpayment of principal, interest or fees when due, breach of specified covenants, change in control and material inaccuracy of representations and warranties. We were in compliance with the financial and nonfinancial covenants of the amended and restated senior secured credit facility as of December 31, 2005.

Preferred stock

On April 3, 2001, we issued 134,846 shares of Class A redeemable convertible preferred stock for $134.8 million. The preferred stock accrued dividends at 11.5% for the first year and 9.0% for each year thereafter. Dividends were cumulative and compounded quarterly. The preferred stock had a liquidation preference equal to its purchase price, plus accrued and unpaid dividends. The preferred stock plus accrued and unpaid dividends was converted into 9,984,712 shares of our common stock upon the closing of our initial public offering in March 2004.

Related Party Transactions

Long-term investments

In April 2003, we made an investment in LinkSpot Networks, Inc., a company that provides wireless Internet access to recreational vehicle parks. We purchased 3.2 percent of the company’s common shares for $0.1 million and obtained representation on the company’s board of directors. In July 2003, we entered into an agreement to provide services to the company and, as consideration, received stock valued at $0.3 million for an additional 7.9 percent of the company’s common shares. In May 2004, our investment in common shares was converted into 13.1 percent of the company’s Series A preferred shares. In May 2004, we also made an additional $0.1 million investment to purchase 3.7 percent of the company’s Series A preferred shares and the company exercised its right under the existing services agreement to receive additional services from us valued at $0.3 million in exchange for 9.4 percent of the company’s Series A preferred shares. As of December 31, 2004, we owned 26.2 percent of the company’s Series A preferred

41




shares and 20.9 percent of the company’s total outstanding shares. We accounted for this investment under the equity method of accounting. During the year ended December 31, 2004, we wrote-down the remaining investment value to zero. For the years ended December 31, 2003 and 2004, we recognized a net loss in the equity of an unconsolidated affiliate of approximately $0.1 million and $0.7 million, respectively.

In August 2004, we made an investment in WAY Systems, Inc. (WAY), which provides mobile POS transaction infrastructure and solutions for mobile merchants. We purchased 5,952,381 shares or 38.5 percent of WAY’s Series B convertible preferred stock for $2.5 million and became entitled to representation on WAY’s board of directors. As of December 31, 2004, we owned 18.1 percent of WAY’s total outstanding shares. In March 2005, we made an additional investment of $0.8 million to purchase 1,910,401 shares of WAY’s Series B convertible preferred stock representing an additional 1.9 percent of WAY’s outstanding shares. In July 2005, we made an additional investment of $0.7 million in exchange for a convertible note bearing interest at a rate of 8 percent per annum due January 1, 2009. In September 2005, we exercised our option on the convertible note to convert the outstanding principal and accrued interest of approximately $0.8 million to 1,185,085 shares of WAY’s Series C convertible preferred stock and made an additional investment of $1.1 million to purchase 1,676,429 shares of WAY’s Serices C convertible preferred stock. As of December 31, 2005, we owned 17.0 percent of WAY’s outstanding shares. We are accounting for this investment under the equity method of accounting as the Company has significant influence through its representation on the board of directors. Due to timing of the receipt of WAY’s financial statements, we are accounting for the income or loss in this equity method investment on a one-month lag. For the year ended December 31, 2004 and 2005, we recognized a net loss in the equity of an unconsolidated affiliate of approximately $0.3 million and $1.4 million, respectively.

In September 2004, we made an investment in AK Jensen Group, Limited (AKJ), a company that provides order-routing systems and integrated electronic trading solutions to financial software companies and end-clients. We purchased 94,429 common shares or 8.4% of AKJ’s total outstanding shares for $1.0 million and obtained representation on AKJ’s board of directors. The Company is accounting for its investment under the equity method of accounting as the Company has significant influence through its representation on the board of directors. Due to timing of the receipt of AKJ’s financial statements, we are accounting for the income or loss in this equity method investment on a one-month lag. For the years ended December 31, 2004 and 2005 we recognized a net loss in the equity of an unconsolidated affiliate of approximately $35,000 and $0.1 million, respectively.

In January 2005, we made an investment in IP Commerce, Inc., a company that provides operating software to facilitate the authorization of IP-based retail payment transactions. We purchased 2,368,545 Series A preferred shares or 39.9 percent of IP Commerce’s total outstanding shares for $2.0 million and became entitled to representation on IP Commerce’s board of directors. We are accounting for this investment under the equity method of accounting. Due to timing of the receipt of IP Commerce’s financial statements, we are accounting for the income or loss in this equity method investment on a one-month lag. As of December 31, 2005 we owned 39.7 percent of IP Commerce’s total outstanding shares. For the year ended December 31, 2005, we recognized a net loss in the equity of an unconsolidated affiliate of approximately $1.1 million  In September 2005, we made an additional investment of $0.9 million in exchange for a convertible note bearing interest at a rate of 8 percent per annum which is payable on demand, no earlier than February 1, 2007.

Asset acquisition

During the year ended December 31, 2001, we purchased a partial interest in an aircraft for $1.2 million from a company that is controlled by our Chairman and Chief Executive Officer. We obtained an independent appraisal to ascertain the fair value of the partial interest on the purchase date and purchased it for the appraised fair value. During the year ended December 31, 2003, we sold this fixed asset for $0.9 million, for a net gain of $4,000.

42




Aircraft Usage

During the year ended December 31, 2005, we paid approximately $0.7 million for the use of an aircraft to a company that is controlled by our Chairman and Chief Executive Officer.

Telecommunications services

One of our directors is the Chief Executive Officer and co-founder of TARGUS Information Corp. (TARGUS). We have done business with TARGUS in the past and expect to continue to do business with TARGUS in the future. For the years ended December 31, 2003, 2004 and 2005, we billed approximately $3.1 million, $2.3 million and $2.1 million, respectively, to TARGUS and paid approximately $2.1 million, $2.7 million and $4.6 million, respectively to TARGUS for services received and provided in the ordinary course of business.

Commitments

The following table summarizes our contractual obligations as of December 31, 2005 that require us to make future cash payments (dollars in thousands):

 

 

 

 

Year ending December 31,

 

 

 

 

 

Total

 

2006

 

2007

 

2008

 

2009

 

2010

 

Thereafter

 

Contractual Cash Obligations by Period:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Long-term debt under the senior secured credit facility

 

$

113,448

 

$

 

$

1,650

 

$

1,650

 

$

1,650

 

$

1,650

 

$

106,848

 

Operating lease obligations

 

46,751

 

7,937

 

6,726

 

5,921

 

5,354

 

5,375

 

15,438

 

 

 

$

160,199

 

$

7,937

 

$

8,376

 

$

7,571

 

$

7,004

 

$

7,025

 

$

122,286

 

 

We expect that we will be able to fund our remaining obligations and commitments with cash flow from operations. To the extent we are unable to fund these obligations and commitments with cash flow from operations, we intend to fund these obligations and commitments with proceeds from borrowings under our amended and restated senior secured credit facility or future debt or equity financings.

On September 21, 2005, we entered into a lease to rent office space in the United Kingdom with a company that is majority owned by the President of our international services division. Prior to entering into this lease, we obtained an independent appraisal confirming that the terms of the lease were consistent with market standards. The lease provides for quarterly payments in equal installments of approximately £26,000 and expires on September 20, 2017.

Critical Accounting Policies

Our significant accounting policies are described in Note 2 to our consolidated financial statements. We consider the accounting policies related to revenue and related cost recognition, valuation of goodwill and other intangible assets and accounting for income taxes to be critical to the understanding of our results of operations. Critical accounting policies include the areas where we have made what we consider to be particularly subjective or complex judgments in making estimates and where these estimates can significantly impact our financial results under different assumptions and conditions. We prepare our financial statements in conformity with U.S. generally accepted accounting principles. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. Actual results could be different from these estimates.

43




Revenues and related cost recognition

We recognize revenue when persuasive evidence of an agreement exists, the terms are fixed or determinable, services are performed, and collection is probable. Cash received in advance of revenue recognition is recorded as deferred revenue. POS services revenue is derived primarily from the transmission of transaction data through our networks between payment processors and POS or ATM terminals. Telecommunication services revenue is derived primarily from fixed monthly recurring fees for our call signaling services and per query fees charged for our database access and validation services. Financial services revenue is derived primarily from monthly recurring fees based on the number of customer connections to and through our networks. Customer incentives granted to new customers or upon contract renewals are deferred and recognized ratably as a reduction of revenue over the contract period to the extent that the incentives are recoverable against the customer’s minimum purchase commitments under the contract. In addition, we receive installation fees related to the configuration of the customer’s systems. Revenue from installation fees are deferred and recognized ratably over the customer’s contractual service period, generally three years. We perform periodic evaluations of our customer base and establish allowances for estimated credit losses.

Cost of network services is comprised primarily of telecommunications charges, which include data transmission and database access, leased digital capacity charges, circuit installation charges and activation charges. The cost of data transmission is based on a contract or tariff rate per minute of usage in addition to a prescribed rate per transaction for certain vendors. The costs of database access, circuits, installation charges and activation charges are based on fixed fee contracts with local exchange carriers and interexchange carriers. The cost of network services also includes salaries, equipment maintenance and other costs related to the ongoing operation of our data networks. These costs are expensed as incurred. We record our accrual for telecommunications charges based upon network services utilized at historical invoiced rates.

Goodwill and intangible assets

We account for goodwill and intangible assets in accordance with Statement of Financial Accounting Standard (SFAS) No. 142, Goodwill and Other Intangible Assets. Under this standard, goodwill and intangible assets deemed to have indefinite lives are not amortized and are subject to annual impairment tests. We have elected to perform the impairment test annually as of October 1 of each year. An interim goodwill impairment test is performed if an event occurs or circumstances change between annual tests that would more likely than not reduce the fair value of a reporting unit below its carrying amount. If facts and circumstances indicate goodwill may be impaired, we perform a recoverability evaluation based upon a determination of fair value.

In accordance with SFAS, No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we review our long-lived assets including property and equipment, capitalized software development costs and identifiable intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable. To determine the recoverability of our long-lived assets, we evaluate the probability that future estimated undiscounted net cash flows will be less than the carrying amount of the intangible assets. If we estimate that the assets are impaired, the assets are written down to their fair value.

For purposes of measuring and recognizing impairment of long-lived assets, we assess whether separate cash flows can be attributed to the individual asset. We group our long-lived assets by business unit where separately identifiable cash flows are available. In the event that long-lived assets, including intangibles are abandoned or otherwise disposed of, we recognize an impairment charge upon disposition. For our customer relationship intangible assets, we evaluate impairment upon the significant loss of revenue from a customer.

44




The calculation of fair value in accordance with SFAS Nos. 142 and 144 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. Our estimates of anticipated future income and cash flows used in determining fair value could be reduced significantly in the future due to changes in technologies, regulation, available financing, competition or other circumstances. As a result, the carrying amount of our long-lived assets could be reduced through impairment charges in the future. Additionally, changes in estimated future cash flows could result in a shortening of estimated useful lives for long-lived assets including intangibles.

Income taxes

We account for income taxes pursuant to the provisions of SFAS No. 109, Accounting for Income Taxes. Under this method, deferred tax assets or liabilities are computed based upon the difference between the financial statement and income tax bases of assets and liabilities using the enacted marginal tax rate. We provide a valuation allowance on net deferred tax assets when it is more likely than not that such assets will not be realized. Deferred income tax expense or benefits are based upon the changes in the asset or liability from period to period.

The American Jobs Creation Act of 2004 (the Jobs Act), enacted on October 22, 2004, provides for a temporary 85 percent dividends received deduction on certain foreign earnings repatriated during a one-year period. The deduction would result in an approximate 5.25 percent federal tax rate on the repatriated earnings. To qualify for the deduction, the earnings must be reinvested in the United States pursuant to a domestic reinvestment plan established by a company’s chief executive officer and approved by the company’s board of directors. Certain other criteria in the Jobs Act must be satisfied as well. During the year ended December 31, 2005, we decided to repatriate and ultimately did repatriate, $16.1 million of foreign earnings under the repatriation provisions of the American Jobs Creation Act of 2004. Accordingly, we recorded an additional income tax provision of approximately $0.9 million related to this decision. We intend to reinvest the remaining undistributed foreign earnings indefinitely and, therefore, no provision for U.S. income taxes has been provided against these undistributed earnings.

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123R supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recorded as an expense based on their fair values. Pro forma disclosure is no longer an alternative. Information about the fair value of stock options under the Black-Scholes model and its pro forma impact on its net income (loss) and basic and diluted net income (loss) per common share for the years ended December 31, 2003, 2004 and 2005 (which may differ from the ultimate impact of adopting the new standard) can be found in the notes to our consolidated financial statements, included elsewhere in this report . Under SFAS No. 123(R), we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at the date of adoption. The transition alternatives include the modified prospective or the modified retrospective adoption methods. Under the modified retrospective method, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The modified prospective method requires that compensation expense be recorded for all unvested stock options and share awards at the beginning of the first quarter of adoption of SFAS No. 123(R), while the modified retrospective methods would record compensation expense for all unvested stock options and share awards beginning with the first period restated. We will adopt SFAS No. 123(R) on January 1, 2006 using the modified prospective method. We expect the adoption of SFAS No. 123 (R) to result in additional stock

45




compensation expense, and therefore a reduction of net income for the year ending December 31, 2006, of approximately $1.5 million to $1.7 million.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS No. 154), a replacement of APB Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. Previously, voluntary changes in accounting principles were generally required to be recognized by way of a cumulative effect adjustment within net income during the period of the change. SFAS No. 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the statement does not change the transition provisions of any existing accounting pronouncements. We do not believe adoption of SFAS No. 154 will have a material effect on our financial position, cash flows or results of operations.

In November 2005, the FASB issued FASB Staff Position (FSP) FAS 115-1 (FSP 115-1), The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. FSP 115-1 addresses the determination of when an investment is considered impaired, whether that impairment is other-than-temporary and the measurement of an impairment loss. In addition, FSP 115-1 includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP amends FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities and adds a footnote to APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. FSP 115-1 also nullifies certain requirements of Emerging Issue Task Force No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The effective date for this FSP is reporting periods beginning after December 15, 2005. We have not yet determined if the adoption of FSP 115-1 will have a material effect on our consolidated financial statements.

Effects of Inflation

Our monetary assets, consisting primarily of cash and receivables, and our non-monetary assets, consisting primarily of intangible assets and goodwill, are not affected significantly 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 costs of network services, which may not be readily recoverable in the price of services offered by us.

Item 7A.                Quantitative and Qualitative Disclosures about Market Risk

Interest rates

Our principal exposure to market risk relates to changes in interest rates. As of December 31, 2005, we had $113.4 million outstanding under our amended and restated senior secured credit facility with interest rates tied to changes in the lender’s base rate or the LIBOR rate. Based upon the outstanding borrowings on December 31, 2005 and assuming repayment of the Term Loan in accordance with scheduled maturities, each 1.0% increase in these rates could add an additional $1.1 million to our annual interest expense.

As of December 31, 2005, we did not hold derivative financial or commodity instruments and all of our cash and cash equivalents were held in money market or commercial accounts.

Foreign currency risk

Our earnings are affected by fluctuations in the value of the U.S. dollar as compared with foreign currencies, predominately the euro, the British pound and the Australian dollar due to our operations in Europe and Australia.

46




We have operations in 15 countries outside of the U.S., including the United Kingdom, Australia, Canada, France, Germany, Ireland, Italy, Japan, the Netherlands, New Zealand, Poland, Romania, South Korea, Spain and Sweden. We provide services in these countries using networks deployed in each country. We manage foreign exchange risk through the structure of our business. In the substantial majority of our transactions, we receive payments denominated in the U.S. dollar, British pound, euro or Australian dollar. Therefore, we do not rely on international currency markets to obtain and pay illiquid currencies. The foreign currency exposure that does exist is limited by the fact that the majority of transactions are paid according to our standard payment terms, which are generally short-term in nature. Our policy is not to speculate in foreign currencies, and we promptly buy and sell foreign currencies as necessary to cover our net payables and receivables, which are denominated in foreign currencies. For the year ended December 31, 2005, we recorded a loss on foreign currency translation of approximately $0.8 million.

47




Item 8.                        Financial Statements and Supplementary Data

The following financial information is included on the pages indicated:

REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

49

 

CONSOLIDATED BALANCE SHEETS

51

 

As of December 31, 2004 and 2005

 

 

CONSOLIDATED STATEMENTS OF OPERATIONS

52

 

For the years ended December 31, 2003, 2004 and 2005

 

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ (DEFICIT) EQUITY

53

 

For the years ended December 31, 2003, 2004 and 2005

 

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

54

 

For the years ended December 31, 2003, 2004 and 2005

 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

55

 

FINANCIAL STATEMENT SCHEDULE:

 

 

SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS

91

 

For the years ended December 31, 2003, 2004 and 2005

 

 

 

48




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors of TNS, Inc.:

We have audited the accompanying consolidated balance sheets of TNS, Inc. as of December 31, 2004 and 2005, and the related consolidated statements of operations, shareholders’ (deficit) equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in item 15(b). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of TNS, Inc. at December 31, 2004 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth herein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of TNS, Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2006 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

McLean, Virginia
March 10, 2006

49




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors of TNS, Inc.:

We have audited management’s assessment, included in the accompanying management report located in Item 9A that TNS, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). TNS, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that TNS, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, TNS, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of TNS, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders’ (deficit) equity, and cash flows for each of the three years in the period ended December 31, 2005 of TNS, Inc. and our report dated March 10, 2006 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

McLean, Virginia
March 10, 2006

50




TNS, INC.

CONSOLIDATED BALANCE SHEETS

 

 

December 31,

 

 

 

2004

 

2005

 

 

 

(in thousands, except per
share and share amounts)

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

19,788

 

$

26,628

 

Accounts receivable, net of allowance for doubtful accounts of $4,756 and $5,260, respectively

 

47,896

 

48,773

 

Prepaid expenses

 

3,279

 

4,407

 

Deferred tax assets

 

1,167

 

5,236

 

Other current assets

 

4,903

 

5,813

 

Total current assets

 

77,033

 

90,857

 

Property and equipment, net

 

50,587

 

52,448

 

Identifiable intangible assets, net

 

205,208

 

187,233

 

Goodwill

 

5,386

 

5,160

 

Other assets

 

18,198

 

16,486

 

Total assets

 

$

356,412

 

$

352,184

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Current portion of long-term debt

 

$

9,000

 

$

 

Accounts payable, accrued expenses and other current liabilities

 

43,528

 

46,933

 

Deferred revenue

 

14,419

 

10,810

 

Total current liabilities

 

66,947

 

57,743

 

Long-term debt, net of current portion

 

42,000

 

113,448

 

Other liabilities

 

4,967

 

3,147

 

Total liabilities

 

113,914

 

174,338

 

Commitments and contingencies (see Note 10)

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Common stock, $0.001 par value; 130,000,000 shares authorized; 27,996,053 shares issued and outstanding and 23,998,715 shares issued and 23,971,001 shares outstanding, respectively

 

28

 

24

 

Treasury stock

 

 

(517

)

Additional paid-in capital

 

281,766

 

217,434

 

Accumulated deficit

 

(37,333

)

(31,567

)

Deferred stock compensation

 

(4,766

)

(7,150

)

Accumulated other comprehensive income (loss)

 

2,803

 

(378

)

Total stockholders’ equity

 

242,498

 

177,846

 

Total liabilities and stockholders’ equity

 

$

356,412

 

$

352,184

 

 

See accompanying notes.

51




TNS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

Year ended December 31,

 

 

 

2003

 

2004

 

2005

 

 

 

(in thousands, except per share and share amounts)

 

Revenues

 

$

223,353

 

$

249,112

 

$

258,940

 

Operating expenses:

 

 

 

 

 

 

 

Cost of network services, exclusive of the items shown separately below

 

119,990

 

120,356

 

121,682

 

Engineering and development

 

11,560

 

14,688

 

15,521

 

Selling, general, and administrative

 

37,284

 

49,264

 

55,245

 

Depreciation and amortization of property and equipment

 

20,220

 

20,205

 

18,972

 

Amortization of intangible assets

 

25,769

 

28,573

 

22,773

 

Total operating expenses

 

214,823

 

233,086

 

234,193

 

Income from operations.

 

8,530

 

16,026

 

24,747

 

Interest expense.

 

(11,272

)

(7,341

)

(9,052

)

Interest income

 

154

 

305

 

674

 

Other income (expense), net

 

2,390

 

1,296

 

(699

)

Income (loss) before income tax provision and equity in
net loss of unconsolidated affiliates

 

(198

)

10,286

 

15,670

 

Income tax provision.

 

(838

)

(4,263

)

(7,218

)

Equity in net loss of unconsolidated affiliates

 

(64

)

(1,039

)

(2,686

)

Net income (loss)

 

(1,100

)

4,984

 

5,766

 

Dividends on preferred stock

 

(15,060

)

(3,428

)

 

Net income (loss) attributable to common stockholders

 

$

(16,160

)

$

1,556

 

$

5,766

 

Basic net income (loss) per common share

 

$

(1.31

)

$

0.06

 

$

0.24

 

Diluted net income (loss) per common share

 

$

(1.31

)

$

0.06

 

$

0.23

 

Basic weighted average common shares outstanding

 

12,373,335

 

24,114,348

 

24,518,578

 

Diluted weighted average common shares outstanding

 

12,373,335

 

24,449,283

 

24,766,971

 

 

See accompanying notes.

52




TNS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ (DEFICIT) EQUITY

 

 

 

 

 

 

 

 

 

 

Stockholders’ deficit

 

Accumulated

 

Total

 

 

 

 

 

 

 

 

 

 

 

Additional

 

 

 

Deferred

 

other

 

stockholders’

 

Comprehensive

 

 

 

Common  Stock

 

Treasury

 

paid-in

 

Accumulated

 

stock

 

comprehensive

 

(deficit)

 

income

 

 

 

Shares

 

Amount

 

Stock

 

capital

 

deficit

 

compensation

 

income (loss)

 

equity

 

(loss)

 

 

 

(in thousands, except per share and share amounts)

 

Balance, December 31, 2002

 

12,372,639

 

 

$

12

 

 

 

$

 

 

 

$

2,363

 

 

 

$

(22,729

)

 

 

$

(367

)

 

 

$

(1,175

)

 

 

$

(21,896

)

 

 

 

 

 

Dividends on preferred stock

 

 

 

 

 

 

 

 

 

 

 

 

(15,060

)

 

 

 

 

 

 

 

 

(15,060

)

 

 

 

 

 

Exercise of employee stock options 

 

731

 

 

 

 

 

 

 

 

14

 

 

 

 

 

 

 

 

 

 

 

 

14

 

 

 

 

 

 

Revaluation of options

 

 

 

 

 

 

 

 

 

(100

)

 

 

 

 

 

100

 

 

 

 

 

 

 

 

 

 

 

 

Stock compensation expense

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

94

 

 

 

 

 

 

94

 

 

 

 

 

 

Change in market value and expiration of derivative instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(350

)

 

 

(350

)

 

 

$

(350

)

 

Foreign currency translation

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

786

 

 

 

786

 

 

 

786

 

 

Net loss

 

 

 

 

 

 

 

 

 

 

 

 

(1,100

)

 

 

 

 

 

 

 

 

(1,100

)

 

 

(1,100

)

 

Balance, December 31, 2003

 

12,373,370

 

 

12

 

 

 

 

 

 

2,277

 

 

 

(38,889

)

 

 

(173

)

 

 

(739

)

 

 

(37,512

)

 

 

 

 

 

Total, December 31, 2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

(664

)

 

Issuance of common stock

 

5,622,976

 

 

6

 

 

 

 

 

 

93,700

 

 

 

 

 

 

 

 

 

 

 

 

93,706

 

 

 

 

 

 

Conversion of preferred stock to common stock

 

9,984,712

 

 

10

 

 

 

 

 

 

179,715

 

 

 

 

 

 

 

 

 

 

 

 

179,725

 

 

 

 

 

 

Dividends on preferred stock

 

 

 

 

 

 

 

 

 

 

 

 

(3,428

)

 

 

 

 

 

 

 

 

(3,428

)

 

 

 

 

 

Exercise of employee stock options 

 

14,995

 

 

 

 

 

 

 

 

307

 

 

 

 

 

 

 

 

 

 

 

 

307

 

 

 

 

 

 

Stock compensation expense

 

 

 

 

 

 

 

 

 

5,767

 

 

 

 

 

 

(4,593

)

 

 

 

 

 

1,174

 

 

 

 

 

 

Foreign currency translation