**United StatesSecurities and Exchange Commission**

**Washington, D.C.  20549**

 

**FORM 10-Q**

** **
| **ý****  Quarterly Report Pursuant to Section 13  or 15(d) of the Securities Exchange Act of 1934 for the Period Ended July 31,  2004.**                                                                                                                                                                                                                                                                                                                                                                                                                     |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| **o****  Transition Report Pursuant to Section 13  or 15(d) of the Securities Exchange Act of 1934 for the Transition Period  from                                    to                                  .** |

** **

**Commissionfile number      0-24201**

** **

**Carreker Corporation**

(Exact name of registrant as specified in its charter)

 
| **Delaware**                                                                        | ** ** | **75-1622836**                    |
|-------------------------------------------------------------------------------------|------------|-----------------------------------|
| (State or other jurisdiction of  incorporation or organization)                     |       | (IRS Employer Identification No.) |
|                                                                                |       |                              |
| **4055 Valley View Lane, #1000  Dallas, Texas**                                     | ** ** | **75244**                         |
| (Address of principal executive office)                                             |       | (Zip Code)                        |
|                                                                                |
| **(972) 458-1981**                                                                  |
| (Registrant’s telephone number, including area code)                           |
|                                                                                |
|                                                                                |
| (Former name, former address and former fiscal year, if changed since  last report) |

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter periods that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days.  Yes   ý   No   o

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).Yes   ý   No   o

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practical date.

 

Common Stock, $.01 par value--- 24,814,324 shares as of August 31, 2004.

 

 

----

 

**CARREKER CORPORATION**

 

**Index**

 
| **PART 1:**    | **FINANCIAL INFORMATION**                                                                                            | ** ** |
|----------------|----------------------------------------------------------------------------------------------------------------------|------------|
| ** **     | ** **                                                                                                           | ** ** |
| **Item 1.**    | **Financial Statements (unaudited)**                                                                                 | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| ** **     | **Condensed Consolidated Balance Sheets at  July 31, 2004 and January 31, 2004**                                     | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| ** **     | **Condensed Consolidated Statements of  Operations for the three and six months ended July 31, 2004 and 2003**       | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| ** **     | **Condensed Consolidated Statements of  Stockholders’ Equity for the three and six months ended July 31, 2004** | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| ** **     | **Condensed Consolidated Statements of Cash  Flows for the three and six months ended July 31, 2004 and 2003**       | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| ** **     | **Notes to Condensed Consolidated Unaudited  Financial Statements**                                                  | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| **Item 2.**    | **Management’s Discussion and Analysis of  Financial Condition and Results of Operations**                      | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| **Item 3.**    | **Quantitative and Qualitative Disclosures  about Market Risk**                                                      | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| **Item 4.**    | **Controls and Procedures**                                                                                          | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| **PART II:**   | **OTHER INFORMATION**                                                                                                | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| **Item 1.**    | **Legal Proceedings**                                                                                                | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| **Item 2.**    | **Unregistered Sales of Equity Securities and  Use of Proceeds**                                                     | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| **Item 3.**    | **Defaults Upon Senior Securities**                                                                                  | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| **Item 4.**    | **Submission of Matters to a Vote of Security  Holders**                                                             | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| **Item 5.**    | **Other Information**                                                                                                | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| **Item  6.**   | **Exhibits**                                                                                                         | ** ** |
| ** **     | ** **                                                                                                           | ** ** |
| **SIGNATURES** | ** **                                                                                                           |

 

2

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**PARTI:  FINANCIALINFORMATION**

 

**Item 1. Financial Statements**

 

**CARREKER CORPORATION**

**CondensedConsolidated Balance Sheets**

**(Unaudited)**

**(In thousands, except per share amounts)**

 

**ASSETS**

 
| ** **                                                                                                                                          | ** ** | **July 31,  2004** | ** ** | **January 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
|                                                                                                                                                |       |               |       |                  |       |
| Current assets                                                                                                                                      |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                                           |       | $                  | 28,449     |                  | $          | 28,605 |   |
| Accounts receivable, net of allowance of  $986 and $1,512 at July 31, 2004 and January 31, 2004, respectively                                       |       | 15,246             |       | 21,751                |       |
| Prepaid expenses and other current assets                                                                                                           |       | 3,288              |       | 3,331                 |       |
| Total current assets                                                                                                                                |       | 46,983             |       | 53,687                |       |
|                                                                                                                                                |       |               |       |                  |       |
| Property and equipment, net of accumulated  depreciation of $18,768 and $17,140  at  July 31, 2004 and January 31, 2004, respectively          |       | 6,398              |       | 6,690                 |       |
| Capitalized software costs, net of  accumulated amortization of $11,529 and   $11,050 at July 31, 2004 and January 31, 2004, respectively      |       | 3,158              |       | 2,028                 |       |
| Acquired developed technology, net of  accumulated amortization of $13,463 and   $11,153 at July 31, 2004 and January 31, 2004, respectively   |       | 12,237             |       | 14,547                |       |
| Goodwill, net of accumulated amortization  of $3,405 at July 31, 2004 and January 31, 2004                                                          |       | 20,806             |       | 21,193                |       |
| Customer relationships, net of accumulated  amortization of $4,433 and $3,733  at  July 31, 2004 and January 31, 2004, respectively            |       | 3,967              |       | 4,667                 |       |
| Deferred loan costs, net of accumulated  amortization of $1,164 and $1,028 at July 31, 2004 and January 31, 2004,  respectively                     |       | 543                |       | 680                   |       |
| Other assets                                                                                                                                        |       | 952                |       | 1,087                 |       |
| Total assets                                                                                                                                        |       | $                  | 95,044     |                  | $          | 104,579 |   |
|                                                                                                                                                |       |               |       |                  |       |
| Current liabilities                                                                                                                                 |       |               |       |                  |       |
| Accounts payable                                                                                                                                    |       | $                  | 899        |                  | $          | 913 |   |
| Accrued compensation and benefits                                                                                                                   |       | 6,926              |       | 9,219                 |       |
| Other accrued expenses                                                                                                                              |       | 4,309              |       | 4,520                 |       |
| Income tax payable                                                                                                                                  |       | 135                |       | 181                   |       |
| Deferred revenue                                                                                                                                    |       | 24,725             |       | 25,231                |       |
| Accrued merger and restructuring costs                                                                                                              |       | 536                |       | 1,898                 |       |
| Total current liabilities                                                                                                                           |       | 37,530             |       | 41,962                |       |
| Long-term debt                                                                                                                                      |       | —             |       | 6,250                 |       |
| Other long-term liabilities                                                                                                                         |       | 309                |       | 49                    |       |
| Total liabilities                                                                                                                                   |       | 37,839             |       | 48,261                |       |
|                                                                                                                                                |       |               |       |                  |       |
| Commitments and Contingencies                                                                                                                       |       |               |       |                  |       |
|                                                                                                                                                |       |               |       |                  |       |
| Stockholders’ equity                                                                                                                           |       |               |       |                  |       |
| Preferred stock, $.01 par value:  2,000 shares authorized; no shares issued  or outstanding                                                    |       | —             |       | —                |       |
| Common stock, $.01 par value:  100,000 shares authorized; 24,802 and  24,357 shares issued at July 31, 2004 and January 31, 2004, respectively |       | 248                |       | 244                   |       |
| Additional paid-in capital                                                                                                                          |       | 110,253            |       | 108,757               |       |
| Accumulated deficit                                                                                                                                 |       | (53,293            | )          | (52,680               | )          |
| Less treasury stock, at cost:  1 common share at July 31, 2004 and January  31, 2004                                                           |       | (3                 | )          | (3                    | )          |
| Total stockholders’ equity                                                                                                                     |       | 57,205             |       | 56,318                |       |
| Total liabilities and stockholders’ equity                                                                                                     |       | $                  | 95,044     |                  | $          | 104,579 |   |

 

See accompanying notes.

 

3

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**CARREKER CORPORATION**

**Condensed Consolidated Statements of Ope****rations**

**(Unaudited)**

**(In thousands, except per share amounts)**

 
| ** **                                                  | ** ** | **Three Months Ended  July 31,** | ** ** | **Six Months Ended  July 31,** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                  | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| **Revenues:**                                               |       |                             |       |                           |       |   |   |   |   |
| Consulting fees                                             |       | $                                | 10,514     |                           | $          | 8,202 |   | $ | 19,571 |   | $ | 14,953 |   |
| Software license fees                                       |       | 4,577                            |       | 8,351                          |       | 10,433 |   | 14,929 |   |
| Software maintenance fees                                   |       | 10,232                           |       | 14,284                         |       | 21,316 |   | 22,994 |   |
| Software implementation fees                                |       | 3,642                            |       | 4,508                          |       | 6,521 |   | 9,402 |   |
| Outsourcing service fees                                    |       | 10                               |       | —                         |       | 10 |   | — |   |
| Out-of-pocket expense reimbursements                        |       | 662                              |       | 816                            |       | 1,552 |   | 2,139 |   |
| Total revenues                                              |       | 29,637                           |       | 36,161                         |       | 59,403 |   | 64,417 |   |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| **Cost of revenues:**                                       |       |                             |       |                           |       |   |   |   |   |
| Consulting fees                                             |       | 5,082                            |       | 5,288                          |       | 9,611 |   | 10,257 |   |
| Software license fees                                       |       | 1,670                            |       | 1,905                          |       | 3,268 |   | 3,626 |   |
| Software maintenance fees                                   |       | 3,386                            |       | 3,133                          |       | 7,184 |   | 6,310 |   |
| Software implementation fees                                |       | 3,810                            |       | 5,058                          |       | 7,179 |   | 9,913 |   |
| Outsourcing service fees                                    |       | 14                               |       | —                         |       | 14 |   | — |   |
| Out-of-pocket expenses                                      |       | 652                              |       | 1,038                          |       | 1,595 |   | 2,291 |   |
| Total cost of revenues                                      |       | 14,614                           |       | 16,422                         |       | 28,851 |   | 32,397 |   |
| Gross profit                                                |       | 15,023                           |       | 19,739                         |       | 30,552 |   | 32,020 |   |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| **Operating costs and expenses:**                           |       |                             |       |                           |       |   |   |   |   |
| Selling, general and administrative                         |       | 11,971                           |       | 12,538                         |       | 24,163 |   | 24,470 |   |
| Research and development                                    |       | 1,874                            |       | 1,779                          |       | 3,582 |   | 3,645 |   |
| Amortization of customer relationships                      |       | 350                              |       | 350                            |       | 700 |   | 700 |   |
| Restructuring and other charges                             |       | 197                              |       | 778                            |       | 2,712 |   | 1,462 |   |
| Total operating costs and expenses                          |       | 14,392                           |       | 15,445                         |       | 31,157 |   | 30,277 |   |
| Income (loss) from operations                               |       | 631                              |       | 4,294                          |       | (605 | ) | 1,743 |   |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| **Other income (expense):**                                 |       |                             |       |                           |       |   |   |   |   |
| Interest income                                             |       | 66                               |       | 73                             |       | 115 |   | 154 |   |
| Interest expense                                            |       | (121                             | )          | (339                           | )          | (230 | ) | (757 | ) |
| Other income (expense)                                      |       | (27                              | )          | 36                             |       | 457 |   | 50 |   |
| Total other income (expense)                                |       | (82                              | )          | (230                           | )          | 342 |   | (553 | ) |
| Income (loss) before provision for income  taxes            |       | 549                              |       | 4,064                          |       | (263 | ) | 1,190 |   |
| Provision for income taxes                                  |       | 350                              |       | 133                            |       | 350 |   | 226 |   |
| Net income (loss)                                           |       | $                                | 199        |                           | $          | 3,931 |   | $ | (613 | ) | $ | 964 |   |
| Basic earnings (loss) per share                             |       | $                                | 0.01       |                           | $          | 0.17 |   | $ | (0.03 | ) | $ | 0.04 |   |
| Diluted earnings (loss) per share                           |       | $                                | 0.01       |                           | $          | 0.17 |   | $ | (0.03 | ) | $ | 0.04 |   |
| Shares used in computing basic earnings  (loss) per share   |       | 24,671                           |       | 23,547                         |       | 24,524 |   | 23,547 |   |
| Shares used in computing diluted earnings  (loss) per share |       | 25,481                           |       | 23,723                         |       | 24,524 |   | 23,631 |   |

 

See accompanying notes.

 

4

----

 

**CARREKER CORPORATION**

**Condensed Consolidated Statements of Sto****ckholders’ Equity**

**(Unaudited)**

**(In thousands, except per share amounts)**

 
| ** **                                                         | ** ** | **Common Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Treasury Stock** | ** ** | **Total  Stockholders’   Equity** | ** ** |
|--------------------------------------------------------------------|------------|------------------|------------|----------------------------------|------------|--------------------------|------------|--------------------|------------|----------------------------------------|------------|
| ** **                                                         | ** ** | **Shares**       | ** ** | **Amount**                       | ** ** | ** **               | ** ** | **Shares**         | ** ** | **Amount**                             | ** ** | ** ** |
| Balance at January 31, 2004                                        |       | 24,357           |       | $                                | 244        |                     | $          | 108,757            |       | $                                      | (52,680    | ) | 1 |   | $ | (3 | ) | $ | 56,318 |   |
|                                                               |       |             |       |                             |       |                     |       |               |       |                                   |       |   |   |   |   |
| Cancellation of restricted stock                                   |       | (20              | )          | —                           |       | —                   |       | —             |       | —                                 |       | — |   | — |   |
| Compensation expense related to issuance of  restricted stock      |       | —           |       | —                           |       | 35                       |       | —             |       | —                                 |       | — |   | 35 |   |
| Issuance of shares of common stock upon  exercise of stock options |       | 74               |       | —                           |       | 375                      |       | —             |       | —                                 |       | — |   | 375 |   |
| Net loss                                                           |       | —           |       | —                           |       | —                   |       | (812               | )          | —                                 |       | — |   | (812 | ) |
| Balance at April 30, 2004                                          |       | 24,411           |       | 244                              |       | 109,167                  |       | (53,492            | )          | 1                                      |       | (3 | ) | 55,916 |   |
|                                                               |       |             |       |                             |       |                     |       |               |       |                                   |       |   |   |   |   |
| Cancellation of restricted stock                                   |       | (7               | )          | —                           |       | —                   |       | —             |       | —                                 |       | — |   | — |   |
| Compensation expense related to issuance of  restricted stock      |       | 251              |       | 2                                |       | 139                      |       | —             |       | —                                 |       | — |   | 141 |   |
| Issuance of shares of common stock upon  exercise of stock options |       | 147              |       | 2                                |       | 947                      |       | —             |       | —                                 |       | — |   | 949 |   |
| Net income                                                         |       | —           |       | —                           |       | —                   |       | 199                |       | —                                 |       | — |   | 199 |   |
| Balance at July 31, 2004                                           |       | 24,802           |       | $                                | 248        |                     | $          | 110,253            |       | $                                      | (53,293    | ) | 1 |   | $ | (3 | ) | $ | 57,205 |   |

 

See accompanying notes.

 

5

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**CARREKER CORPORATION**

**Condensed Consolidated Statements of Cas****h Flows**

**(Unaudited)**

**(In thousands)**

 
| ** **                                                                                | ** ** | **Three Months Ended  July 31,** | ** ** | **Six Months Ended  July 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Operating Activities:**                                                                 |       |                             |       |                           |       |   |   |   |   |
| Net income (loss)                                                                         |       | $                                | 199        |                           | $          | 3,931 |   | $ | (613 | ) | $ | 964 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities: |       |                             |       |                           |       |   |   |   |   |
| Depreciation and amortization of property  and equipment                                  |       | 835                              |       | 832                            |       | 1,657 |   | 1,706 |   |
| Amortization of capitalized software costs  and acquired developed technology             |       | 1,394                            |       | 1,270                          |       | 2,789 |   | 2,606 |   |
| Amortization of customer relationships                                                    |       | 350                              |       | 350                            |       | 700 |   | 700 |   |
| Compensation expense related to issuance of  restricted stock                             |       | 141                              |       | 35                             |       | 176 |   | 35 |   |
| Minority share of loss in Carretek LLC                                                    |       | (134                             | )          | —                         |       | (220 | ) | — |   |
| Gain on sale of Cash Services Australia  Pty. Limited                                     |       | —                           |       | —                         |       | (539 | ) | — |   |
| EPG litigation loss provision                                                             |       | 14                               |       | —                         |       | 1,700 |   | — |   |
| Payment of EPG litigation settlement                                                      |       | (1,700                           | )          | —                         |       | (1,700 | ) | — |   |
| Provision for (recovery of) doubtful  accounts                                            |       | (212                             | )          | 25                             |       | (392 | ) | (27 | ) |
| Amortization of deferred loan costs                                                       |       | 69                               |       | 108                            |       | 136 |   | 216 |   |
| Non cash reduction in merger cost accrual                                                 |       | (1,215                           | )          | —                         |       | (1,215 | ) | — |   |
| Changes in operating assets and  liabilities:                                             |       |                             |       |                           |       |   |   |   |   |
| Accounts receivable                                                                       |       | 124                              |       | (1,001                         | )          | 6,897 |   | 5,721 |   |
| Prepaid expenses and other assets                                                         |       | 636                              |       | 1,005                          |       | 937 |   | 864 |   |
| Accounts payable and accrued expenses                                                     |       | 995                              |       | (1,380                         | )          | (2,278 | ) | (3,082 | ) |
| Income taxes payable/receivable                                                           |       | (13                              | )          | 100                            |       | (46 | ) | 100 |   |
| Deferred revenue                                                                          |       | (3,750                           | )          | (3,487                         | )          | (506 | ) | 4,197 |   |
| Net cash provided by (used in) operating  activities                                      |       | (2,267                           | )          | 1,788                          |       | 7,483 |   | 14,000 |   |
| **Investing Activities:**                                                                 |       |                             |       |                           |       |   |   |   |   |
| Purchases of property and equipment                                                       |       | (1,134                           | )          | (259                           | )          | (1,365 | ) | (570 | ) |
| Computer software costs capitalized                                                       |       | (698                             | )          | —                         |       | (1,608 | ) | — |   |
| Net cash used in investing activities                                                     |       | (1,832                           | )          | (259                           | )          | (2,973 | ) | (570 | ) |
| **Financing Activities:**                                                                 |       |                             |       |                           |       |   |   |   |   |
| Payments on long-term debt                                                                |       | —                           |       | (2,500                         | )          | (6,250 | ) | (12,500 | ) |
| Payments of deferred loan costs                                                           |       | —                           |       | (456                           | )          | — |   | (456 | ) |
| Proceeds from exercises of stock options                                                  |       | 949                              |       | —                         |       | 1,324 |   | — |   |
| Minority interest and minority shareholder  loan to Carretek LLC                          |       | 113                              |       | —                         |       | 260 |   | — |   |
| Net cash provided by (used in) financing  activities                                      |       | 1,062                            |       | (2,956                         | )          | (4,666 | ) | (12,956 | ) |
| Net increase (decrease) in cash and cash  equivalents                                     |       | (3,037                           | )          | (1,427                         | )          | (156 | ) | 474 |   |
| Cash and cash equivalents at beginning of  period                                         |       | 31,486                           |       | 28,887                         |       | 28,605 |   | 26,986 |   |
| Cash and cash equivalents at end of period                                                |       | $                                | 28,449     |                           | $          | 27,460 |   | $ | 28,449 |   | $ | 27,460 |   |
|                                                                                      |       |                             |       |                           |       |   |   |   |   |
| Supplemental disclosures of cash flow  information:                                       |       |                             |       |                           |       |   |   |   |   |
| Cash paid for interest                                                                    |       | $                                | 38         |                           | $          | 322 |   | $ | 109 |   | $ | 669 |   |
| Cash paid for income taxes, net                                                           |       | $                                | 349        |                           | $          | 36 |   | $ | 382 |   | $ | 130 |   |

 

See accompanying notes.

 

6

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**Carreker Corporation**

**Notes toCondensed Consolidated Unaudite****d FinancialStatementsFor the Three and Six Months Ended July 31, 2004 and 2003**

 

**1.****              Description ofBusiness**

 

Carreker Corporation (“the Company,” “Carreker,” “our,” “we”) providespayments-related software and consulting solutions to financial institutionsand financial service providers.  Thesesolutions help the Company’s customers set winning strategies in their paymentbusinesses; improve operational efficiency in how payments are processed;enhance revenue and profitability from payments-oriented products and services;reduce losses associated with fraudulent payment transactions; and/or improvethe alignment of product offerings with customer needs.

 

**2.****              Summary of SignificantAccounting Procedures**

 

**Principles of Consolidation and Presentation**

 

The condensed consolidated unaudited financial statements include theaccounts of the Company and its wholly owned subsidiaries. All significantintercompany balances and transactions have been eliminated in consolidation.

 

The accompanying condensed consolidated unaudited financial statementsand notes have been prepared in accordance with the rules and regulations ofthe Securities and Exchange Commission for Form 10-Q and include all of theinformation and disclosures required by generally accepted accountingprinciples for interim financial reporting. The accompanying financial statements reflect all adjustments,(consisting of normal recurring entries) which in the opinion of management arenecessary for a fair presentation of the results for the interim periodspresented.  The results of operations,for the three and six months ended July 31, 2004, are not necessarilyindicative of full-year results.

 

Certain prior year amounts have been reclassified to conform to thecurrent year presentation.  For the threemonths ended July 31, 2003, selling, general and administrative expenses havebeen reduced by $157,000, while cost of sales-software maintenance fees, costof sales-software implementation fees and research and development expensesincreased $63,000, $31,000 and $63,000, respectively.  Additionally, for the six months ended July31, 2003, selling, general and administrative expenses have been reduced by$310,000, while cost of sales-software maintenance fees, cost of sales-softwareimplementation fees and research and development expenses increased $124,000,62,000 and $124,000, respectively.  Thesereclassifications were made to conform to the presentation of certaininformation technology costs in the three and six months ended July 31, 2004.

 

The Company has been engaged in several legal actions, more fullydescribed in Note 8, that have been deemed to be outside the normal course ofbusiness.  Accordingly, these legal feesand settlement amounts have been classified, and prior periods reclassified, asrestructuring and other charges in the accompanying statements ofoperations.  In the six months ended July31, 2004, $462,000 of legal costs related to these specific legal actionsincurred during the three months ended April 30, 2004 were reclassified fromselling, general and administrative expense to this separate financialstatement caption.

 

In the three and six months ended July 31, 2004, the consolidatedfinancial statements also contain Carretek LLC which is a 51% ownedsubsidiary.  The minority interest andminority interest in income (loss) of Carretek LLC represents the 49% minoritystockholders’ investment and share of the loss of this consolidated subsidiary.

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States requires the use ofestimates and assumptions that affect the amounts reported in the financialstatements and accompanying notes.  Asdiscussed below, the Company makes significant estimates and assumptions in theareas of accounts receivable, impairment of intangibles and revenuerecognition.  Although the Companybelieves that the estimates and assumptions are reasonable, actual results maydiffer, and such differences could be significant to the Company’s financialresults.

 

**Cash and Cash Equivalents**

 

The Company considers all highly liquid investments with maturities ofthree months or less when purchased to be cash equivalents. Cash and cashequivalents consist primarily of demand deposit accounts and shares in a demandmoney market account comprised of domestic and foreign commercial paper,certificates of deposit and U.S. government obligations which are maintainedwith nationally recognized financial institutions.

 

7

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**Foreign Currency Translation**

 

The Company considers the U.S. Dollar to be the functional currency forits international subsidiaries.  Allremeasurement adjustments are recorded in the consolidated statement ofoperations.

 

**Accounts Receivable****and Concentration of Credit Risk**

 

Financial instruments, which potentially subject the Company toconcentration of credit risk consist principally of temporary cash investmentsand accounts receivable.  The Companyplaces temporary cash investments with financial institutions and limits itsexposure with any one financial institution.

 

A significant portion of the Company’s business consists of providingconsulting services and licensing software to major domestic and internationalbanks, which gives rise to a concentration of credit risk in receivables.  Because the Company’s accounts receivable aretypically unsecured, the Company periodically evaluates the collectibility ofits accounts based on a combination of factors, including a particularcustomer’s ability to pay as well as the age of receivables.  In cases where the evidence suggests acustomer may not be able to satisfy its obligation to the Company or if thecollection of the receivable becomes doubtful due to a dispute that arisessubsequent to the delivery of the Company’s products and services, the Companysets up a reserve in an amount determined appropriate for the perceivedrisk.  Most of the Company’s contractsinclude multiple payment milestones, some of which occur in advance of revenuerecognition, which mitigates the risk both in terms of collectibility andadjustments to recorded revenue. Write-offs of receivables during the threemonths ended July 31, 2004 and 2003 were $135,000 and $26,000,respectively.  Write-offs of receivablesduring the six months ended July 31, 2004 and 2003 were $134,000 and $105,000,respectively.

 

The fair value of accounts receivable approximates the carrying amountof accounts receivable.

 

Accounts receivable, net of related deferred revenue and allowances,consist of the following (in thousands):

 
| ** **                           | ** ** | **July 31,  2004** | ** ** | **January 31,  2004** | ** ** |
|--------------------------------------|------------|--------------------|------------|-----------------------|------------|
|                                 |       |               |       |                  |       |
| Gross accounts receivable            |       | $                  | 48,288     |                  | $          | 65,109 |   |
| Less related deferred revenue        |       | (32,056            | )          | (41,846               | )          |
| Less allowance for doubtful accounts |       | (986               | )          | (1,512                | )          |
| Net accounts receivable              |       | $                  | 15,246     |                  | $          | 21,751 |   |

 

**Property and Equipment**

 

Property and equipment are stated at cost. Depreciation is calculatedusing the straight-line method over the estimated useful lives of therespective assets, generally from three to five years. Leasehold improvementsare amortized using the straight-line method over the shorter of the terms ofthe related leases or the respective useful lives of the assets.   The components of property and equipment areas follows (in thousands):

 
| ** **                                      | ** ** | **July 31,  2004** | ** ** | **January 31,  2004** | ** ** |
|-------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
|                                            |       |               |       |                  |       |
| Furniture                                       |       | $                  | 5,092      |                  | $          | 5,070 |   |
| Equipment and software                          |       | 18,991             |       | 17,686                |       |
| Leasehold improvements                          |       | 1,083              |       | 1,074                 |       |
| Total cost                                      |       | 25,166             |       | 23,830                |       |
|                                            |       |               |       |                  |       |
| Less accumulated depreciation and  amortization |       | (18,768            | )          | (17,140               | )          |
| Net property and equipment                      |       | $                  | 6,398      |                  | $          | 6,690 |   |

 

The Company accounts for the costs of computer software developed orobtained for internal use in accordance with Statement of Position 98-1, *“Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use”.*  The Company capitalizes costs of consultants,and payroll and payroll-related costs for employees incurred in developinginternal-use computer software.  Thesecosts are included in “Equipment and Software”. Costs incurred during preliminary project and post-implementation stagesare charged to expense.

 

8

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**Long Lived Assets**

 

The Company accounts for goodwill and other intangible assets inaccordance with Statement of Financial Accounting Standards No. 142, *“Goodwill and Other Intangible Assets,”*(SFAS 142).  Under the provisions of SFAS142, an annual assessment of goodwill impairment is performed.  This assessment involves the use of estimatesrelated to fair market values of the Company’s reporting units with which thegoodwill is associated.  The assessmentof goodwill impairment in the future will be impacted if future operating cashflows of the Company’s reporting units decline, which would result in decreasesin the related estimate of fair market value. The Company performs its annual impairment analysis as of November 1stof each year and whenever facts and circumstances indicate impairment mayexist.  Intangible assets not subject toamortization are tested annually for impairment, and are tested for impairmentmore frequently if events and circumstances indicate that an asset might beimpaired.  An impairment loss is recognizedto the extent that the carrying amount exceeds the asset’s fair value.

 

The Company accounts for long lived assets in accordance with Statementof Financial Accounting Standards No. 144, *“Accountingfor the Impairment or Disposal of Long-Lived Assets,”* (SFAS144).  Under the provisions of SFAS 144,long-lived assets, such as property, plant and equipment and purchasedintangibles subject to amortization, are tested for recoverability wheneverevents or changes in circumstances indicate that the carrying amount of anasset may not be recoverable. Recoverability of assets to be held and used is measured by a comparisonof the carrying amount of an asset to estimated undiscounted future cash flowsexpected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cashflows, an impairment charge is recognized by the amount by which the carryingamount of the assets exceeds the fair value of the asset.

 

**Deferred Loan Costs**

 

Deferred loan costs consist of loan closing costs and otheradministrative expenses associated with the Revolving Credit Agreement.  On July 31, 2003, the Revolving CreditAgreement was amended as described in Note 4. In connection with this amendment, the Company incurred approximately$456,000 of deferred loan costs.  Thesecosts, along with the net book value of the original deferred loan costs, arebeing amortized to interest expense over the 36 month life of the RevolvingCredit Agreement.

 

**Capitalized Software Costs and AcquiredDeveloped Technology**

 

The Company capitalizes the development costs of software, other thaninternal-use software, in accordance with Statement of Financial AccountingStandards No. 86, *“Accounting for Costs ofComputer Software to be Sold, Leased or Otherwise Marketed”* (“SFAS86”).  The Company’s policy is tocapitalize software development costs incurred in developing a product oncetechnological feasibility of the product has been established. Technologicalfeasibility of the product is determined after completion of a detailed programdesign and a determination has been made that any uncertainties related tohigh-risk development issues have been resolved. If the process of developingthe product does not include a detail program design, technological feasibilityis determined only after completion of a working model. All softwaredevelopment costs capitalized are amortized using an amount determined as thegreater of: (1) the ratio that current gross revenues for a capitalizedsoftware project bears to the total of current and estimated future grossrevenues for that project or (2) the straight-line method over the remainingeconomic life of the product (generally three to six years). The Companycapitalized $698,000 and $0 of software development costs in the three monthsended July 31, 2004 and 2003, respectively. The Company capitalized $1.6 million and $0 of software developmentcosts in the six months ended July 31, 2004 and 2003, respectively.  The Company is currently developing softwarefor sending and receiving check images, distributing capture of checks andcheck images and extending the functionality of the anti-money launderingsoftware discussed below.  The productsreached technological feasibility in the latter half of fiscal 2003 andaccordingly certain costs subsequently incurred were capitalized under SFAS 86.

 

The Company recorded amortization relating to software developmentcosts capitalized of $239,000 in the three months ended July 31, 2004 and 2003,respectively.  The Company recordedamortization relating to software development costs capitalized of $479,000 and$546,000 in the six months ended July 31, 2004 and 2003, respectively.  Amortization expense is recorded as acomponent of cost of software license fees in the accompanying consolidated statementof operations.

 

9

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In October 2003, the Company purchased an anti-money launderingsoftware solution designed to help banks protect both their customers and theircorporate reputations from the growing risk of financial fraud and to complywith a growing number of laws and regulations. The $1.5 million purchase price was recorded in acquired developedtechnology in the accompanying condensed consolidated balance sheets and isbeing amortized over a 3-year period.

 

Acquired developed technology includes purchased technology intangibleassets associated with acquisitions. These purchased technology intangibles are initially recorded based onthe fair value ascribed at the time of acquisition.

 

Acquired developed technology with a useful life of 3-6 years isamortized on a straight-line basis, resulting in amortization expense of $1.2million and $1.0 million for the three months ended July 31, 2004 and 2003,respectively, and $2.3 million and $2.1 million for the six months ended July31, 2004 and 2003.  Amortization expenseis recorded as a component of cost of software license fees in the accompanyingconsolidated statements of operations.

 

The following table sets forth the estimated amortization expense ofcapitalized software costs and acquired developed technology for the six monthsremaining in fiscal year ended January 31, 2005 and for the remaining futurefiscal years ending January 31 (in thousands):

 
| **Period**                         | ** ** | **Capitalized  Software Costs** | ** ** | **Acquired  Developed  Technology** | ** ** |
|------------------------------------|------------|---------------------------------|------------|-------------------------------------|------------|
|                               |       |                            |       |                                |       |
| August 1, 2004 - January 31, 2005  |       | $                               | 358        |                                | $          | 2,310 |   |
| Fiscal year ended January 31, 2006 |       | 148                             |       | 4,620                               |       |
| Fiscal year ended January 31, 2007 |       | —                          |       | 4,107                               |       |
| Fiscal year ended January 31, 2008 |       | —                          |       | 1,200                               |       |
|                                    |            |                                 |            |                                     |            |  |  |

 

The table does not include the estimated amortization expense for $2.7million of capitalized software products that are currently being developed,and for which amortization has not commenced.

 

10

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**Revenue Recognition**

 

The Company’s revenue recognition policies are in accordance withStatement of Position (“SOP”) 97-2, *“Software RevenueRecognition,”* as amended by SOP 98-9, “*Modificationof SOP 97-2,**Software RevenueRecognition with Respect to Certain Transactions,”* Staff AccountingBulletin (“SAB”) No. 104,**RevenueRecognition and Emerging Issues Task Force (“EITF”) No. 00-21,*“Revenue Arrangements with Multiple Deliverables.”* In the case of software arrangements thatrequire significant production, modification, or customization of software, orthe license agreement requires the Company to provide implementation servicesthat are determined to be essential to other elements of the arrangement, theCompany follows the guidance in SOP 81-1, *“Accounting forPerformance of Construction – Type and Certain Production – Type Contracts.”*

 

*Consulting Fees.*  The Company employs three primary pricingmethods in connection with its delivery of consulting services. First, theCompany may price its delivery of consulting services on the basis of time andmaterials, in which case the customer is charged agreed-upon daily rates forservices performed and out-of-pocket expenses. In this case, the Company isgenerally paid fees and related amounts usually on a monthly basis, and theCompany recognizes revenues as the services are performed. Second, the Companymay deliver consulting services on a fixed-price basis. In this case, theCompany is paid on a monthly basis or pursuant to an agreed upon paymentschedule, and the Company recognizes revenues on a percentage-of-completion basis.  The Company believes that this method isappropriate because of its ability to determine performance milestones anddetermine dependable estimates of its costs applicable to each phase of acontract.  Because financial reporting ofthese contracts depends on estimates, which are assessed continually during theterm of the contract, costs are subject to revisions as the contractprogresses.  Anticipated losses onfixed-price contracts are recognized when estimatable.  Third, the Company may deliver consultingservices pursuant to a value-priced contract with the customer. In this case,the Company is paid, on an agreed upon basis with the customer, either aspecified percentage of (1) the projected increased revenues and/ordecreased costs that are expected to be derived by the customer generally overa period of up to twelve months following implementation of its solution or (2)the actual increased revenues and/or decreased costs experienced by thecustomer generally over a period of up to twelve months followingimplementation of its solution, subject in either case to a maximum, if any isagreed to, on the total amount of payments to be made to the Company.  The Company must first commit time andresources to develop projections associated with value-pricing contracts beforea customer will commit to purchase its solutions, and the Company thereforeassumes the risk of making these commitments with no assurance that thecustomer will purchase the solution. Costs associated with these value-pricing contracts are expensed asincurred.  These contracts typicallyinclude payments to be made to the Company pursuant to an agreed upon scheduleranging from one to twelve months in length. The Company recognizes revenues generated from consulting services inconnection with value-priced contracts based upon projected results only uponcompletion of all services and agreement upon the actual fee to be paid (eventhough billings for these services may be delayed by mutual agreement forperiods not to exceed twelve months). In an effort to allow customers to moreclosely match expected benefits from services with payments to the Company, theCompany on occasion, may offer payment terms which extend beyond 12months.  When the Company enters into anagreement which has a significant component of the total amount payable underthe agreement due beyond 12 months or if it is determined payments are notfixed and determinable at the date the agreement was entered into, revenueunder the arrangement will be recognized as payments become due andpayable.  When fees are to be paid basedon a percentage of actual revenues and/or savings to customers, the Companyrecognizes revenues only upon completion of all services and as the amounts ofactual revenues or savings are confirmed by the customer with a fixed paymentdate.

 

Costs associated with time and materials, fixed-priced and value-pricedconsulting fee arrangements are expensed as incurred and are included as acomponent of the cost of consulting fees.

 

The Company expects that value-pricing contracts will continue toaccount for a significant portion of its revenues in the future. As aconsequence of the use of value-pricing contracts and due to the revenuerecognition policy associated with those contracts, the Company’s results ofoperations will likely fluctuate significantly from period to period.

 

Regardless of the pricing method employed by the Company in a givencontract, the Company is typically reimbursed on a monthly basis forout-of-pocket expenses incurred on behalf of its customers.

 

*Software License Fees.*  A software license is sold either togetherwith implementation services or on a stand-alone basis.  The Company is usually paid software licensefees in one or more installments, as provided in the customer’s contract butnot to exceed twelve months.  The Companyrecognizes software license revenue upon execution of a contract and deliveryof the software, provided that the license fee is fixed and determinable, nosignificant production, modification or customization of the software isrequired and collection is considered probable by management.  When the software license arrangementrequires the Company to provide implementation services that are essential tothe functionality of the software or significant production, customization ormodification of the software is required, both the product license revenue andimplementation fees are recognized as services are performed.

 

11

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In certain instances, especially with recently developed software, theCompany defers software license revenue recognition until the services arecompleted and the project is accepted by the customer.  This practice is followed for the first twoinstallations of a recently developed software product.  After two successful implementations, theproduct is considered generally available (“GA”).

 

Software licenses are often sold as part of a multiple elementarrangement that may include maintenance, implementation or consulting.  The Company determines whether there isvendor specific objective evidence of fair value (“VSOEFV”) for each elementidentified in the arrangement to determine whether the total arrangement feescan be allocated to each element.  IfVSOEFV exists for each element, the total arrangement fee is allocated based onthe relative fair value of each element. In cases where there is not VSOEFV for each element, or if it isdetermined services are essential to the functionality of the software beingdelivered, or if significant production, modification or customization of thesoftware is required, the Company initially defers revenue recognition of thesoftware license fees until VSOEFV is established or the services areperformed.  However, if VSOEFV isdeterminable for all of the undelivered elements, and assuming the undeliveredelements are not essential to the delivered elements, the Company will deferrecognition of the full fair value related to the undelivered elements andrecognize the remaining portion of the arrangement value through application ofthe residual method.  Where VSOEFV hasnot been established for certain undelivered elements, revenue for all elementsis deferred until those elements have been delivered or their fair values havebeen determined.  Evidence of VSOEFV isdetermined for software products based on actual sales prices for the productsold to a similar class of customer and based on pricing strategies set forthin the Company’s price book.  Evidence ofVSOEFV for services (implementation and consulting) is based upon standardbilling rates and the estimated level of effort for individuals expected toperform the related services.  TheCompany establishes VSOEFV for maintenance agreements using the percentage methodsuch that VSOEFV for maintenance is a percentage of the license fee chargedannually for a specific software product, which in most instances is 20% of theportion of arrangement fees allocated to the software license element.

 

Although substantially all of the Company’s current software licensesprovide for a fixed price license fee, some licenses instead provide for thecustomer to pay a monthly license fee based on actual use of the softwareproduct.  The level of license feesearned by the Company under these arrangements will vary based on the actualamount of use by the customer.  Revenueunder these arrangements is recognized on a monthly basis as the usage becomesdeterminable.

 

*Software Maintenance Fees.*  In connection with the sale of a softwarelicense, a customer may elect to purchase software maintenance services. Mostof the customers that purchase software licenses from the Company also purchasesoftware maintenance services, which typically are renewed annually.  The Company charges an annual maintenancefee, which is typically a percentage of the initial software license fee. Theannual maintenance fee generally is paid to the Company at the beginning of themaintenance period, and the Company recognizes these revenues ratably over theterm of the related contract.  If the annualmaintenance fee is not paid at the beginning of the maintenance period, theCompany defers revenue recognition until the time that the maintenance fee ispaid by the customer.  The Companynormally continues to provide maintenance service while awaiting payment fromcustomers.  When the payment is received,revenue is recognized for the period that revenue was previously deferred.  This may result in volatility in software maintenancerevenue from period to period.

 

*Software Implementation Fees.*  In connection with the sale of a softwarelicense, a customer may elect to purchase software implementation services,including software enhancements and other software services. Most of thecustomers that purchase software licenses from the Company also purchasesoftware implementation services.  TheCompany prices its implementation services on a time-and-materials or on afixed-price basis, and the Company recognizes the related revenues as servicesare performed.  Costs associated withthese engagements are expensed as incurred.

 

The Company’s contracts typically do not include right of returnclauses, and as a result, the Company does not record a provision for returns.

 

**Royalties**

 

In connection with software license and maintenance agreements enteredinto with certain banks and purchase agreements with vendors under which theCompany acquired software technology used in products sold to its customers,the Company is required to pay royalties on sales of certain software products.  Under these arrangements, the Company accruesroyalty expense when the associated revenue is recognized.  For current product offerings, the royaltypercentages generally range from 20% to 50% of the associated revenues.  Approximately $433,000 and $592,000 ofroyalty expense was recorded under these agreements in the three months endedJuly 31, 2004 and 2003, respectively, and $688,000 and $1.0 million in the sixmonths ended July 31, 2004 and 2003. Royalty expense is included as a component of the cost of softwarelicense fees and cost of software maintenance fees in the accompanyingcondensed consolidated statements of operations.

 

12

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**Deferred Revenue**

 

Deferred revenue represents amounts paid by customers under termsspecified in consulting, software licensing, and maintenance contracts forwhich completion of contractual terms or delivery of the software has notoccurred.

 

Deferred revenue and advance payments from customers consist of thefollowing (in thousands):

 
| ** **                                         | ** ** | **July 31,  2004** | ** ** | **January 31,  2004** | ** ** |
|----------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
|                                               |       |               |       |                  |       |
| Deferred software maintenance fees                 |       | $                  | 31,675     |                  | $          | 44,117 |   |
| Deferred software implementation and  license fees |       | 25,106             |       | 22,960                |       |
|                                               |       | 56,781             |       | 67,077                |       |
| Less related accounts receivable                   |       | (32,056            | )          | (41,846               | )          |
|                                               |       | $                  | 24,725     |                  | $          | 25,231 |   |

 

**Research and Development Costs**

 

Research and development costs, which are not subject to capitalizationunder Statement of Financial Accounting Standards (SFAS) 86, *“Accounting for the Cost of Computer Software to beSold, Leased, or Otherwise Marketed,”* are expensed as incurred andrelate mainly to the development of new products (prior to achievingtechnological feasibility), new features or enhancements for existing productsor applications.  Sustaining maintenanceactivities are expensed as incurred and charged to cost of revenues-softwaremaintenance fees.

 

**Other income (expense)**

 

Other income (expense) is comprised of the following:

 
| ** **                                                                | ** ** | **Three Months  Ended July 31,** | ** ** | **Six Months  Ended July 31,** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                      |       |                             |       |                           |       |   |   |   |   |
| Gain on sale of Cash Services Australia  Pty. Limited.                    |       | $                                | —     |                           | $          | — |   | $ | 539 |   | $ | — |   |
| Equity in earnings (loss) of Cash Services  Australia Pty.  Limited. |       | —                           |       | 2                              |       | (17 | ) | 74 |   |
| Minority share of  net loss of Carretek LLC                               |       | 133                              |       | —                         |       | 219 |   | — |   |
| Foreign exchange  gains (losses)                                          |       | (159                             | )          | 34                             |       | (288 | ) | (47 | ) |
| Other                                                                     |       | (1                               | )          | —                         |       | 4 |   | 23 |   |
| Total                                                                     |       | $                                | (27        | )                              | $          | 36 |   | $ | 457 |   | $ | 50 |   |

 

In April 2004, the Company sold its 25% interest in Cash ServicesAustralia Pty. Limited.  The carryingvalue of this investment was approximately $383,000 and the Company received$922,000 in proceeds collected in May 2004. As a result of this transaction, the Company recorded a $539,000 gain.

 

During Q2 2003, the Company formed Carretek LLC (“Carretek”), in whichthe Company owns a 51% interest to offer financial institutions off-shorecentric outsourcing of their business processes.  To date, Carretek has generated minimalrevenue and accordingly, the 49% share, or $133,000 on a quarterly basis and$219,000 on a YTD basis of the minority interest in this loss was recorded inother income (expense).

 

13

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**Income Taxes**

 

The Company accounts for income taxes using the liability method,whereby deferred tax assets and liabilities are determined based on differencesbetween financial reporting and tax basis of assets and liabilities measuredusing enacted tax rates and laws that will be in effect when the differencesare expected to reverse.  The measurementof deferred tax assets is adjusted by a valuation allowance, if necessary, torecognize the extent to which, based on available evidence, it is more likelythan not that the future tax benefits will not be realized.

 

**Earnings Per Share**

 

Basic earnings per share is computed using the weighted average numberof shares of common stock outstanding during each period. Diluted earnings pershare is computed using the weighted average number of shares of common stockoutstanding during each period and common equivalent shares consisting of stockoptions (using the treasury stock method), if such stock options have adilutive effect in the aggregate.

 

**Stock-Based Compensation**

 

The Company has elected to follow Accounting Principles Board (“APB”),Opinion No. 25, “*Accounting for Stock Issuedto Employees*,” in accounting for its employees and director stockoptions.  Under APB 25, if the exerciseprice of a stock option equals or exceeds the market price of the underlyingstock on the date of grant, no compensation expense is recognized.  The Company accounts for stock-basedcompensation for non-employees under the fair value method prescribed by SFAS123, “*Accounting for Stock-BasedCompensation”* (“SFAS 123”).

 

On June 20, 2003, the Company issued 245,000 shares of restrictedcommon stock to several employees and officers. The market price of the stock was $4.35. The stock vests one-third on June 20, 2006, one-third on June 20, 2007and one-third on June 20, 2008.  TheCompany is amortizing the resulting compensation expense on a straight-linebasis from the date of issuance through June 20, 2008, and any forfeitures willbe accounted for in the period the forfeiture takes place.  The Company recorded $47,000 and $82,000 ofcompensation expense, during the three and six months ended July 31, 2004, and$36,000 of compensation expense during the three and six months ended July 31,2003.  215,000 restricted common sharesremain outstanding at July 31, 2004.

 

On May 3, 2004, the Company issued 151,370 shares of restricted commonstock to its employees.  The market priceof the stock was $7.22.  The stock vests20% on each of the next five anniversaries from the date of issuance.  The Company will amortize the resultingcompensation expense on a straight-line basis from the date of issuance throughMay 3, 2009, and any forfeitures will be accounted for in the period theforfeiture takes place.  The Companyrecorded $61,000 of compensation expense during the three months ended July 31,2004, and 143,070 shares of restricted common stock remain outstanding at July31, 2004.

 

On June 11, 2004, the Company issued 100,000 shares of restrictedcommon stock to several employees and officers. The market price of the stock was $10.03.  The stock vests 20% on each of the next fiveanniversaries from the date of issuance. The Company will amortize the resulting compensation expense on astraight-line basis from the date of issuance through June 11, 2009, and anyforfeitures will be accounted for in the period the forfeiture takesplace.  The Company recorded $33,000 ofcompensation expense during the three months ended July 31, 2004, and 100,000shares of restricted common stock remain outstanding at July 31, 2004.  Additionally, on June 11, 2004, 640,450 stockoptions were granted to officers and employees at a market price of $10.03.

 

 

Pursuant to the Director Stock Option Plan, each outside director onAugust 1st is granted a number of options with a Black-Scholesvaluation of $60,000.  As there were nofurther options available for grant under the Director Stock Option Plan, onAugust 2, 2004, each outside director received 8,141 options, or 56,987 optionsin the aggregate, under the 1994 Incentive Stock Option Plan.

 

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Although SFAS 123 allows APB 25 guidelines to be applied in accountingfor stock options, the Company is required to disclose pro forma net income(loss) and net income (loss) per share as if they had adopted SFAS 123.  The following table sets forth the pro formainformation as if the provisions of SFAS 123 had been applied to account for stockbased compensation (in thousands, except per share data):

 
| ** **                                                                 | ** ** | **Three Months Ended  July 31,** | ** ** | **Six Months Ended  July 31,** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                 | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Net income (loss), as reported                                             |       | $                                | 199        |                           | $          | 3,931 |   | $ | (613 | ) | $ | 964 |   |
| Stock compensation expense recorded under  the intrinsic value method      |       | 141                              |       | 35                             |       | 176 |   | 35 |   |
| Pro forma stock compensation expense  computed under the fair value method |       | (861                             | )          | (505                           | )          | (2,422 | ) | (2,278 | ) |
| Pro forma net income (loss)                                                |       | $                                | (521       | )                              | $          | 3,461 |   | $ | (2,859 | ) | $ | (1,279 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Basic earnings (loss) per common share, as  reported                       |       | $                                | 0.01       |                           | $          | 0.17 |   | $ | (0.03 | ) | $ | 0.04 |   |
| Diluted earnings (loss) per common share,  as reported                     |       | $                                | 0.01       |                           | $          | 0.17 |   | $ | (0.03 | ) | $ | 0.04 |   |
| Pro forma basic earnings (loss) per common  share                          |       | $                                | (0.02      | )                              | $          | 0.15 |   | $ | (0.12 | ) | $ | (0.05 | ) |
| Pro forma diluted earnings (loss) per  common share                        |       | $                                | (0.02      | )                              | $          | 0.15 |   | $ | (0.12 | ) | $ | (0.05 | ) |

 

 

Inputs used forthe fair value method of the Company’s employee stock options are as follows:

 
| ** **                                      | ** ** | **Three Months Ended  July 31,** | ** ** | **Six Months Ended  July 31,** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                            |       |                             |       |                           |       |   |   |   |   |
| Volatility                                      |       | 0.797                            |       | 0.956                          |       | 0.800 |   | 0.956 |   |
| Weighted-average expected lives                 |       | 4.500                            |       | 4.500                          |       | 4.500 |   | 4.500 |   |
| Expected dividend yields                        |       | —                           |       | —                         |       | — |   | — |   |
| Weighted-average risk-free interest rates       |       | 3.930                            |       | 2.460                          |       | 3.900 |   | 2.431 |   |
| Weighted-average fair value of options  granted |       | $                                | 5.960      |                           | $          | 3.060 |   | $ | 5.970 |   | $ | 2.940 |   |
|                                                 |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

**Risks and Uncertainties**

 

The Company’s future results of operations and financial conditioncould be impacted by the following factors, among others: dependence on thebanking industry, decline in check volumes, fluctuations in operating results,lack of long-term agreements, dependence on key personnel, product liability,rapid technological change and dependence on new products, focus on providingbusiness process outsourcing with significant offshore component, ability toattract and retain qualified personnel, customer concentration, competition,potential strategic alliances and acquisitions, proprietary rights,infringement claims, dependence on third parties for technology licenses,liability claims, pending lawsuits, stock price fluctuations, internationaloperations, use of independent contractors, changing government and taxregulations, anti-takeover provisions in our charter, impairment of goodwill orintangible assets and realization of revenue from contracted sales and backlog.

 

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**Financial Guarantees**

 

The following is a summary of the applicable guarantees andindemnifications:

 

Under theterms of the majority of the Company’s software license agreements with itscustomers, the Company agrees that in the event the software sold infringesupon any patent, copyright, trademark, or any other proprietary right of athird party, it will indemnify its customer license, against any loss, expense,or liability from any damages that may be awarded against its customer.  The Company includes this infringementindemnification in all of its software license agreements.  In the event the customer cannot use thesoftware or service due to infringement and the Company cannot obtain the rightto use, replace or modify the license or service in a commercially feasiblemanner so that it no longer infringes, then the Company may terminate the licenseand provide the customer a pro-rata refund of the fees paid by the customer forthe infringing license or service.  TheCompany has recorded no liability associated with this indemnification, as itis not aware of any pending or threatened infringement actions that areprobable losses.  The Company believesthe estimated fair value of these intellectual property indemnification clausesis minimal.

 

The Companyhas agreed to indemnify members of the board of directors, as well as officersof the Company, if they are made a party or are threatened to be made a partyto any proceeding (other than an action by or in the right of the Company) byreason of the fact that they are acting in their capacities on behalf of theCompany, or by reason of anything done or not done by them in any suchcapacities.  The indemnity is for any andall expenses and liabilities of any type whatsoever (including but not limitedto, judgments, fines and amounts paid in settlement) actually and reasonablyincurred by the directors or officers in connection with the investigation,defense, settlement or appeal of such proceeding, provided they acted in goodfaith.  The Company maintains insurancecoverage for directors and officers liability (“D&O insurance”).  No maximum liability is stipulated in theseagreements that include indemnifications of members or the board of directorsand officers of the Company.  The Companyhas recorded no liability associated with these indemnifications as it is notaware of any pending or threatened actions or claims against its members ofboard of directors or officers that are probable losses in excess of amountscovered by its D&O insurance.  As aresult of the insurance policy coverage, the Company believes the estimatedfair value of these indemnification agreements is minimal.

 

**Recently Issued Accounting Standards**

 

In January 2003, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standards Board Interpretation No. 46, *“Consolidation of Variable Interest Entities, anInterpretation of ARB No. 41 (FIN 46).”*  In December 2003, the FASB modified FIN 46 tomake certain technical corrections and address certain implementation issuesthat had arisen.  FIN 46 provides a newframework for identifying variable interest entities (VIEs) and determiningwhen a company should include these assets, liabilities, non-controllinginterests and results of activities of a VIE in its consolidated financialstatements.

 

In general, a VIE is a corporation, partnership, limited liability corporation,trust or any other legal structure used to conduct activities or hold assetsthat either (1) has an insufficient amount of equity to carry out its principalactivities without additional subordinated financial support, (2) has a groupof equity owners that are unable to make significant decisions about itsactivities, or (3) has a group of equity owners that do not have the obligationto absorb losses or the right to receive returns generated by its operations.

 

The Company adopted the provisions of FIN 46 as of April 30, 2004.  The effect of adopting the provisions of FIN46 was not material to the Company’s financial position.

 

16

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**3.****              Goodwill andIntangible Assets**

 

The Company adopted SFAS No. 142, *“Goodwilland Other Intangible Assets,”* effective February 1, 2002.  Under SFAS 142, goodwill and intangibleassets deemed to have indefinite lives are no longer amortized but are subjectto annual impairment tests in accordance with this statement.  Other intangible assets which includeacquired developed technology and customer relationships will continue to beamortized over their useful lives.

 

Customer relationships with definite useful lives are amortized on astraight-line basis, which resulted in amortization expense of $350,000 for thethree months ended July 31, 2004 and 2003, respectively, and $700,000 for thesix months ended July 31, 2004 and 2003.

 

The following table sets forth the estimated amortization expense ofcustomer relationships for the indicated fiscal years ending January 31 (inthousands):

 
| **Period**                             | ** ** | **Amount** | ** ** |
|----------------------------------------|------------|------------|------------|
|                                   |       |       |       |
| August 1, 2004 – January 31, 2005 |       | $          | 700        |   |
| Fiscal year ended January 31, 2006     |       | 1,400      |       |
| Fiscal year ended January 31, 2007     |       | 1,400      |       |
| Fiscal year ended January 31, 2008     |       | 467        |       |
|                                        |            |            |            |  |

 

Certain accrued liabilities were recorded during the acquisition ofCheck Solutions Company in June 2001. During the three months ended April 30, 2004, these estimates wererevised and $388,000 of these accrued liabilities were reversed and recorded asan adjustment to Goodwill.

 

**4.****              Revolving CreditAgreement**

 

The Company is a party to a revolving credit agreement with a group ofbanks providing for a commitment amount of $30.0 million and a maturity date ofJuly 31, 2006.  Borrowings under the creditagreement, as amended, currently bear interest equal to either the greater ofprime or federal funds rate plus a margin ranging from 1.25% to 2.25% dependingon the Company’s ratio of funded debt to Earnings before Interest, Taxes,Depreciation and Amortization (“EBITDA”), or LIBOR plus a margin equal to 2.75%to 3.75% depending on the Company’s ratio of funded debt to EBITDA.  Interest payments are due quarterly.  The Company is required to pay a commitmentfee equal to 0.50% on the unused amount of the revolving credit agreement.  The revolving credit agreement containscustomary affirmative and negative covenants, including financial covenantsrequiring the maintenance of specified interest coverage, ratio of EBITDA tofunded debt, and ratio of 80% of accounts receivable, cash and short-terminvestments to funded debt. Additionally, the payment of dividends is precluded except upon approvalof the banks.  Substantially all of theCompany’s assets collateralize the revolving credit agreement.  As of July 31, 2004, the Company is incompliance with the covenants of the revolving credit agreement, as amended.

 

The Company did not have any borrowings outstanding under the revolvingcredit agreement at July 31, 2004. Because the interest on the debt outstanding under the credit agreementis variable, the carrying value approximates the fair value.  Interest expense, including the commitmentfee and exclusive of the amortization of deferred loan costs, on the credit agreementwas $53,000 and $231,000 for the three months ended July 31, 2004 and 2003,respectively, and $94,000 and $541,000 for the six months ended July 31, 2004and 2003.

 

17

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**5.****              Provision for IncomeTaxes**

 

The Company has established a valuation allowance to reserve its netdeferred tax assets at July 31, 2004 because the more likely than not criteriafor future realization of the Company’s net deferred tax assets specified inStatements of Financial Accounting Standards No. 109, “*Accounting for Income Taxes,”* (“SFAS No.109”) were not met.

 

The net tax provision was $350,000 for the three and six months endedJuly 31, 2004, which consists of a provision for state and foreign taxes.  The net tax provision of $133,000 and$226,000 for the three and six months ended July 31, 2003 consists of aprovision for state and foreign taxes. No U.S. Federal tax benefit was recorded due to the uncertaintyregarding the Company’s ability to generate taxable income, and resultinguncertainty relative to the recoverability of deferred tax assets.

 

**6.****              IncentiveCompensation Plans**

 

**Profit Sharing Plan**

 

The Company has adopted a profit sharing plan pursuant to Section401(k) of the Internal Revenue Code (the Code) whereby participants maycontribute a percentage of compensation not in excess of the maximum allowedunder the Code. The plan provides for a matching contribution by theCompany.  Employer matching contributionsamounted to $165,000 and $0 for the three months ended July 31, 2004 and 2003,respectively, and $330,000 and $0 for the six months ended July 31, 2004 and2003. The Company may make additional contributions at the discretion of theBoard of Directors.  No discretionarycontributions were made during the three and six months ended July 31, 2004 and2003.

 

**Incentive Compensation Plans**

 

Effective May 3, 2004, the variable compensation plan wasterminated.  The Company did not recordexpense under this plan for the three or six months ended July 31, 2004 and2003.

 

The Carreker Incentive Bonus Plan (“CIBP”) awards employees based onthe Company’s and the applicable business unit’s operating results.  Substantially, all employees are eligible toreceive cash awards under the CIBP. Awards from this plan are paid to employees subsequent to the end of thefiscal year.  In the three months endedJuly 31, 2004 and 2003, the Company recorded expense under this plan ofapproximately $424,000 and $1.1 million, respectively.  In the six months ended July 31, 2004 and2003, the Company recorded expense under this plan of approximately $529,000and $1.1 million, respectively.

 

The Company pays discretionary bonuses to key employees from time totime in recognition of exemplary results. The Company recorded discretionarybonus expense of approximately $314,000 and $32,000 for the three months endedJuly 31, 2004 and 2003, respectively, and $403,000 and $220,000 for the sixmonths ended July 31, 2004 and 2003.

 

18

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**7.****              Earnings Per Share**

 

The following table sets forth the computation of basic and dilutedearnings (loss) per share (in thousands, except per share amounts):

 
| ** **                                             | ** ** | **Three Months Ended  July 31,** | ** ** | **Six Months Ended  July 31,** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Basic earnings (loss) per share:                       |       |                             |       |                           |       |   |   |   |   |
| Net income                                             |       | $                                | 199        |                           | $          | 3,931 |   | $ | (613 | ) | $ | 964 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Weighted average shares outstanding                    |       | 24,671                           |       | 23,547                         |       | 24,524 |   | 23,547 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Basic earnings (loss) per share                        |       | $                                | 0.01       |                           | $          | 0.17 |   | $ | (0.03 | ) | $ | 0.04 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Diluted earnings (loss) per share:                     |       |                             |       |                           |       |   |   |   |   |
| Net earnings (loss)                                    |       | $                                | 199        |                           | $          | 3,931 |   | $ | (613 | ) | $ | 964 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Weighted average shares outstanding                    |       | 24,671                           |       | 23,547                         |       | 24,524 |   | 23,547 |   |
| Assumed conversion of employee stock  options          |       | 810                              |       | 176                            |       | — |   | 84 |   |
| Shares used in diluted earnings per share  calculation |       | 25,481                           |       | 23,723                         |       | 24,524 |   | 23,631 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Diluted earnings (loss) per share                      |       | $                                | 0.01       |                           | $          | 0.17 |   | $ | (0.03 | ) | $ | 0.04 |   |

 

Options totaling 2,024,866 and 4,319,880, for the three months endedJuly 31, 2004 and 2003, respectively, and 1,361,509 and 4,603,532, for the sixmonths ended July 31, 2004 and 2003 have been excluded from the dilutedearnings per share computation as the options were anti-dilutive.

 

19

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**8.****              Contingencies**

 

On June 15, 2004, by mutual agreement between the parties, Civil ActionNo. 303CV1211-M was reinstated in the United States District Court for theNorthern District of Texas, Dallas Division. This action was originally filedon May 29, 2003, in the United States District Court for the Northern Districtof Texas, Dallas Division as Civil Action no. 303CV1211-D. On January 15, 2004,the Court, acting upon the joint motion of the parties, dismissed the actionwithout prejudice. This action was brought as a shareholders’ derivative actionpursuant to Rule 23.1, Fed.R.Civ.P. for the benefit of Nominal DefendantCarreker Corporation against certain of its current and former officers anddirectors, i.e., John D. Carreker, Jr., James D. Carreker, Richard R.Lee, Jr., James L. Fischer, Donald L. House, David K. Sias, Terry L. Gage,James R. Erwin, Ronald G. Steinhart and Ronald Antinori, seeking to remedytheir individual breaches of fiduciary duty, including their knowing violationsof Generally Accepted Accounting Principles (“GAAP”), knowing violations offederal and state securities laws, acts of bad faith and other breaches offiduciary duty. The plaintiff seeks redress (the form of, among others,unspecified amounts of compensatory damages, interest and costs, includinglegal fees) for injuries to the Company and its shareholders caused byDefendants’ misfeasance and/or malfeasance during the period from May 20, 1998through December 10, 2002.

 

On February 12, 2004, in the Court of Chancery of the State of Delawarein and for New Castle County (Civil Action No. 251-N), Barbara I. Smith broughta shareholders’ derivative action for the benefit of Nominal Defendant CarrekerCorporation against John D. Carreker, Jr., James D. Carreker, Richard R. Lee,Jr., James L. Fischer, Donald L. House, David K. Sias, Terry L. Gage, James R.Erwin, Ronald G. Steinhart and Ernst & Young, seeking to remedy theirindividual breaches of fiduciary duty and to remedy Ernst & Young’saccounting malpractice/negligence in connection with its annual audits of theCompany. The plaintiff seeks redress (the form of, among others, unspecifiedamounts of compensatory damages, interest and costs, including legal fees) forinjuries to the Company and its shareholders caused by Defendants’ misfeasanceand/or malfeasance during the period from May 20, 1998 through December 10,2002.

 

On June 2, 2003, in the District Court, Dallas County, Texas, WalterEvans brought a shareholders’ derivative action, for the benefit of NominalDefendant Carreker Corporation against James D. Carreker, John D. Carreker,Jr., James R. Erwin, James L. Fischer, Michael D. Hansen, Donald L. House,Richard R. Lee, Jr., David K. Sias, Ronald J. Steinhart, and Ernst & Young,LLP and Carreker Corporation, Nominal Defendant (Cause No. 0305505). Thecomplaint alleges that the director defendants breached their fiduciary duty tothe company. In addition the complaint makes certain allegations against thecompany’s independent auditors Ernst & Young LLP. The complaint seeks unspecifiedamounts of compensatory damages, as well as interest and costs, including legalfees from the director defendants.

 

On April 16, 2003 the United States District Court for the NorthernDistrict of Texas, Dallas Division, issued an order consolidating a number ofpurported class action lawsuits against the Company, John D. Carreker Jr. andTerry L. Gage into a Consolidated Action styled In re Carreker CorporationSecurities Litigation, Civil Action No. 303CV0250-M.  Also, on March 3, 2003, Claude Alton Coulterfiled a purported class action lawsuit (Civil Action No. 503-CV-5-Q) againstthe Company, John D. Carreker Jr. and Terry L. Gage in the United StatesDistrict Court for the Eastern District of Texas, Texarkana Division.  These complaints, filed on behalf ofpurchasers of the Company’s common stock between May 20, 1998 and December 10,2002, inclusive, allege violations of Section 10(b) of the Securities ExchangeAct of 1934 and Rule 10b-5 against all defendants and violations of Section20(a) of the Exchange Act against the individual defendants.  These complaints also allege, among otherthings, that defendants artificially inflated the value of the Company’s stockby knowingly or recklessly misrepresenting the Company’s financial resultsduring the purported class period.  Theplaintiffs are seeking unspecified amounts of compensatory damages, interestsand costs, including legal fees.

 

On July 8, 2004 Carreker Corporation and Earnings Performance Group(“EPG”) amicably resolved the action that EPG filed against Carreker inSeptember 1998, which was pending in the United States District Court for theDistrict of New Jersey, to the satisfaction of both parties.

 

The Company is periodically involved in various other legal actions andclaims which arise in the normal course of business.  In the opinion of management, the finaldisposition of these matters are not expected to have a material adverse effecton the Company’s financial position or results of operations.

 

20

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**9.****              Business Segmentsand Revenue Concentration**

 

The tables below show revenues and income (loss) from operations forthe periods indicated for our three reportable business segments: RevenueEnhancement, Global Payments Technologies and Global Payments Consulting.  Certain prior year amounts have beenreclassified to conform with the current year business segmentpresentation.  Our customer projects aresold on a solution basis, so it is necessary to break them down by segment andallocate accordingly.  Included in“Corporate Unallocated” are costs related to selling and marketing, unallocatedcorporate overhead expense and general software management.  Business segment results include costs forresearch and development as well as product royalty expense, the amortizationof intangible assets and restructuring and other charges, were as follows (inthousands):

 
| ** **                                                                                                       | ** ** | **Three Months ended July 31, 2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                       | ** ** | **Revenue  Enhancement**             | ** ** | **Global Payments  Technologies** | ** ** | **Global Payments  Consulting** | ** ** | **Corporate  Unallocated** | ** ** | **Total** | ** ** |
| Revenues:                                                                                                        |       |                                 |       |   |   |   |   |   |   |   |   |
| Consulting fees                                                                                                  |       | $                                    | 9,351      |   | $ | 314 |   | $ | 849 |   | $ | — |   | $ | 10,514 |   |
| Software license fees                                                                                            |       | 13                                   |       | 4,564 |   | — |   | — |   | 4,577 |   |
| Software maintenance fees                                                                                        |       | 215                                  |       | 9,782 |   | 235 |   | — |   | 10,232 |   |
| Software implementation fees                                                                                     |       | 159                                  |       | 3,284 |   | 199 |   | — |   | 3,642 |   |
| Outsourcing services fees                                                                                        |       | —                               |       | — |   | — |   | 10 |   | 10 |   |
| Out-of-pocket expense reimbursements                                                                             |       | 304                                  |       | 267 |   | 91 |   | — |   | 662 |   |
| Total revenues                                                                                                   |       | $                                    | 10,042     |   | $ | 18,211 |   | $ | 1,374 |   | $ | 10 |   | $ | 29,637 |   |
|                                                                                                             |       |                                 |       |   |   |   |   |   |   |   |   |
| Income (loss) from operations before  amortization of customer relationships and restructuring and other charges |       | $                                    | 4,994      |   | $ | 3,102 |   | $ | (263 | ) | $ | (6,655 | ) | $ | 1,178 |   |
|                                                                                                             |       |                                 |       |   |   |   |   |   |   |   |   |
| Amortization of customer relationships                                                                           |       | —                               |       | 350 |   | — |   | — |   | 350 |   |
| Restructuring and other charges                                                                                  |       | 28                                   |       | (852 | ) | — |   | 1,021 |   | 197 |   |
| Income (loss) from operations                                                                                    |       | $                                    | 4,966      |   | $ | 3,604 |   | $ | (263 | ) | $ | (7,676 | ) | $ | 631 |   |
|                                                                                                             |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                             |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |

 
| ** **                                                                                                       | ** ** | **Three Months ended July 31, 2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                       | ** ** | **Revenue  Enhancement**             | ** ** | **Global Payments  Technologies** | ** ** | **Global Payments  Consulting** | ** ** | **Corporate  Unallocated** | ** ** | **Total** | ** ** |
| Revenues:                                                                                                        |       |                                 |       |   |   |   |   |   |   |   |   |
| Consulting fees                                                                                                  |       | $                                    | 7,803      |   | $ | 14 |   | $ | 385 |   | $ | — |   | $ | 8,202 |   |
| Software license fees                                                                                            |       | 815                                  |       | 7,536 |   | — |   | — |   | 8,351 |   |
| Software maintenance fees                                                                                        |       | 234                                  |       | 13,830 |   | 220 |   | — |   | 14,284 |   |
| Software implementation fees                                                                                     |       | 191                                  |       | 4,158 |   | 159 |   | — |   | 4,508 |   |
| Out-of-pocket expense reimbursements                                                                             |       | 256                                  |       | 406 |   | 154 |   | — |   | 816 |   |
| Intercompany revenue                                                                                             |       | —                               |       | (20 | ) | 20 |   | — |   | — |   |
| Total revenues                                                                                                   |       | $                                    | 9,299      |   | $ | 25,924 |   | $ | 938 |   | $ | — |   | $ | 36,161 |   |
|                                                                                                             |       |                                 |       |   |   |   |   |   |   |   |   |
| Income (loss) from operations before  amortization of customer relationships and restructuring and other charges |       | $                                    | 4,065      |   | $ | 10,139 |   | $ | (1,029 | ) | $ | (7,753 | ) | $ | 5,422 |   |
|                                                                                                             |       |                                 |       |   |   |   |   |   |   |   |   |
| Amortization of customer relationships                                                                           |       | —                               |       | 350 |   | — |   | — |   | 350 |   |
| Restructuring and other charges                                                                                  |       | —                               |       | — |   | 199 |   | 579 |   | 778 |   |
| Income (loss) from operations                                                                                    |       | $                                    | 4,065      |   | $ | 9,789 |   | $ | (1,228 | ) | $ | (8,332 | ) | $ | 4,294 |   |

 

21

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| ** **                                                                                                       | ** ** | **Six Months ended July 31, 2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                       | ** ** | **Revenue  Enhancement**           | ** ** | **Global Payments  Technologies** | ** ** | **Global Payments  Consulting** | ** ** | **Corporate  Unallocated** | ** ** | **Total** | ** ** |
| Revenues:                                                                                                        |       |                               |       |   |   |   |   |   |   |   |   |
| Consulting fees                                                                                                  |       | $                                  | 17,838     |   | $ | 350 |   | $ | 1,383 |   | $ | — |   | $ | 19,571 |   |
| Software license fees                                                                                            |       | 192                                |       | 10,208 |   | 33 |   | — |   | 10,433 |   |
| Software maintenance fees                                                                                        |       | 384                                |       | 20,470 |   | 462 |   | — |   | 21,316 |   |
| Software implementation fees                                                                                     |       | 315                                |       | 5,841 |   | 365 |   | — |   | 6,521 |   |
| Outsourcing services fees                                                                                        |       | —                             |       | — |   | — |   | 10 |   | 10 |   |
| Out-of-pocket expense reimbursements                                                                             |       | 795                                |       | 567 |   | 190 |   | — |   | 1,552 |   |
| Total revenues                                                                                                   |       | $                                  | 19,524     |   | $ | 37,436 |   | $ | 2,433 |   | $ | 10 |   | $ | 59,403 |   |
|                                                                                                             |       |                               |       |   |   |   |   |   |   |   |   |
| Income (loss) from operations before  amortization of customer relationships and restructuring and other charges |       | $                                  | 9,609      |   | $ | 7,548 |   | $ | (829 | ) | $ | (13,521 | ) | $ | 2,807 |   |
|                                                                                                             |       |                               |       |   |   |   |   |   |   |   |   |
| Amortization of customer relationships                                                                           |       | —                             |       | 700 |   | — |   | — |   | 700 |   |
| Restructuring and other charges                                                                                  |       | 1,747                              |       | (639 | ) | — |   | 1,604 |   | 2,712 |   |
| Income (loss) from operations                                                                                    |       | $                                  | 7,862      |   | $ | 7,487 |   | $ | (829 | ) | $ | (15,125 | ) | $ | (605 | ) |

 
| ** **                                                                                                       | ** ** | ** **                         | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                       | ** ** | ** **                         | ** ** |
| ** **                                                                                                       | ** ** | **Six Months ended July 31, 2003** | ** ** |
| ** **                                                                                                       | ** ** | **Revenue  Enhancement**           | ** ** | **Global Payments  Technologies** | ** ** | **Global Payments  Consulting** | ** ** | **Corporate  Unallocated** | ** ** | **Total** | ** ** |
| Revenues:                                                                                                        |       |                               |       |   |   |   |   |   |   |   |   |
| Consulting fees                                                                                                  |       | $                                  | 13,881     |   | $ | 129 |   | $ | 943 |   | $ | — |   | $ | 14,953 |   |
| Software license fees                                                                                            |       | 1,722                              |       | 13,207 |   | — |   | — |   | 14,929 |   |
| Software maintenance fees                                                                                        |       | 469                                |       | 22,071 |   | 454 |   | — |   | 22,994 |   |
| Software implementation fees                                                                                     |       | 420                                |       | 8,623 |   | 359 |   | — |   | 9,402 |   |
| Out-of-pocket expense reimbursements                                                                             |       | 865                                |       | 980 |   | 294 |   | — |   | 2,139 |   |
| Intercompany revenue                                                                                             |       | —                             |       | (40 | ) | 40 |   | — |   | — |   |
| Total revenues                                                                                                   |       | $                                  | 17,357     |   | $ | 44,970 |   | $ | 2,090 |   | $ | — |   | $ | 64,417 |   |
|                                                                                                             |       |                               |       |   |   |   |   |   |   |   |   |
| Income (loss) from operations before  amortization of customer relationships and restructuring and other charges |       | $                                  | 7,428      |   | $ | 14,015 |   | $ | (2,107 | ) | $ | (15,431 | ) | $ | 3,905 |   |
|                                                                                                             |       |                               |       |   |   |   |   |   |   |   |   |
| Amortization of customer relationships                                                                           |       | —                             |       | 700 |   | — |   | — |   | 700 |   |
| Restructuring and other charges                                                                                  |       | —                             |       | 11 |   | 346 |   | 1,105 |   | 1,462 |   |
| Income (loss) from operations                                                                                    |       | $                                  | 7,428      |   | $ | 13,304 |   | $ | (2,453 | ) | $ | (16,536 | ) | $ | 1,743 |   |

 

During the three months endedJuly 31, 2003, the Company formed Carretek LLC (Carretek), in which the Companyowns a 51% interest, to offer financial institutions offshore-centricoutsourcing of their business processes. During July 2004, Carretek signed a contract to perform outsourcedservices under a pilot phase agreement with a customer.  As this outsourcing business is in thedevelopment phase and its operations immaterial, the financial results for thethree months ended July 31, 2004 are contained in the Corporate-Unallocatedbusiness segment in the tables above.

 

Since Carretek’sinception, the Company and its partner funded Carretek with an aggregate amountof $730,000 from both partners.  $100,000was in equity and another $630,000 in the form of a note payable.  The $309,000 minority interest in the notepayable is reflected as a long-term liability in the accompanying condensedconsolidated balance sheets.

 

22

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The following table summarizes revenues, exclusive of out-of-pocketexpense reimbursements, derived from the Company’s largest customer and topfive customers during the periods indicated.

 
| ** **         | ** ** | **Three Months Ended  July 31,** | ** ** | **Six Months Ended  July 31,** | ** ** |
|--------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **         | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|               |       |                             |       |                           |       |   |   |   |   |
| Single customer    |       | 13.7                             | %          | 12.7                           | %          | 9.9 | % | 9.5 | % |
| Top five customers |       | 39.2                             | %          | 37.5                           | %          | 34.3 | % | 33.0 | % |

 

The Company markets its solutions in several foreign countries.  Revenues, exclusive of out-of-pocket expensereimbursements, for the three months ended attributed to countries based on thelocation of the customers was as follows (in thousands):

 
| ** **     | ** ** | **Three Months Ended****July 31****,  2004** | ** ** | **Three Months Ended****July 31****,  2003** | ** ** |
|----------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **     | ** ** | **Amount**                                   | ** ** | **Percent  of total  revenues**              | ** ** | **Amount** | ** ** | **Percent  of total  revenues** | ** ** |
| United States  |       | $                                            | 21,330     |                                         | 73.7       | % | $ | 28,290 |   | 80.0 | % |
| Europe         |       | 2,151                                        |       | 7.4                                          |       | 2,414 |   | 6.8 |   |
| Canada         |       | 1,517                                        |       | 5.2                                          |       | 2,116 |   | 6.0 |   |
| Asia Pacific   |       | 955                                          |       | 3.3                                          |       | 1,114 |   | 3.2 |   |
| South Africa   |       | 2,788                                        |       | 9.6                                          |       | 1,264 |   | 3.6 |   |
| Other          |       | 234                                          |       | 0.8                                          |       | 147 |   | 0.4 |   |
| Total revenues |       | $                                            | 28,975     |                                         | 100        | % | $ | 35,345 |   | 100 | % |

 
| ** **     | ** ** | **Six Months Ended****July 31****,  2004** | ** ** | **Six Months Ended****July 31****,  2003** | ** ** |
|----------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **     | ** ** | **Amount**                                 | ** ** | **Percent  of total  revenues**            | ** ** | **Amount** | ** ** | **Percent  of total  revenues** | ** ** |
| United States  |       | $                                          | 43,523     |                                       | 75.2       | % | $ | 50,411 |   | 80.9 | % |
| Europe         |       | 4,526                                      |       | 7.8                                        |       | 4,381 |   | 7.0 |   |
| Canada         |       | 3,042                                      |       | 5.3                                        |       | 3,439 |   | 5.6 |   |
| Asia Pacific   |       | 2,290                                      |       | 4.0                                        |       | 2,254 |   | 3.6 |   |
| South Africa   |       | 3,997                                      |       | 6.9                                        |       | 1,539 |   | 2.5 |   |
| Other          |       | 473                                        |       | 0.8                                        |       | 254 |   | 0.4 |   |
| Total revenues |       | $                                          | 57,851     |                                       | 100        | % | $ | 62,278 |   | 100 | % |

 

23

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**10.****       Restructuring and OtherCharges**

 

The Company recorded various merger, restructuring and other chargesduring the three months ended July 31, 2004 and 2003 as follows (in thousands):

 
| ** **                            | ** ** | **Workforce  Reductions** | ** ** | **Charges  relating to  CheckFlow  Suite** | ** ** | **EPG  Litigation  Settlement** | ** ** | **Legal and  Professional  Fees** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|---------------------------|------------|--------------------------------------------|------------|---------------------------------|------------|-----------------------------------|------------|-----------|------------|
|                                  |       |                      |       |                                       |       |                            |       |                              |       |      |       |
| **YTD 2003:**                         |       |                      |       |                                       |       |                            |       |                              |       |      |       |
| Quarterly period ended April 30, 2003 |       | $                         | 545        |                                       | $          | —                          |       | $                                 | —     |      | $          | 139 |   | $ | 684 |   |
| Quarterly period ended July 31, 2003  |       | 648                       |       | —                                     |       | —                          |       | 130                               |       | 778       |       |
| Total YTD 2003                        |       | $                         | 1,193      |                                       | $          | —                          |       | $                                 | —     |      | $          | 269 |   | $ | 1,462 |   |
|                                  |       |                      |       |                                       |       |                            |       |                              |       |      |       |
| **YTD 2004:**                         |       |                      |       |                                       |       |                            |       |                              |       |      |       |
| Quarterly period ended April 30, 2004 |       | 308                       |       | —                                     |       | 1,686                           |       | 521                               |       | 2,515     |       |
| Quarterly period ended July 31, 2004  |       | 192                       |       | (1,215                                     | )          | 14                              |       | 1,206                             |       | 197       |       |
| Total YTD 2004                        |       | $                         | 500        |                                       | $          | (1,215                          | )          | $                                 | 1,700      |      | $          | 1,727 |   | $ | 2,712 |   |

 

**QuarterEnded April 30, 2003**

 

The Company recorded $545,000 in restructuring and other charges duringthe three month period ended April 30, 2003, principally associated with theseparation of 17 employees, within both the Corporate and Global PaymentsConsulting (“GPC”) business segments. During the quarterly period ended April 30, 2003, the Company recorded acharge of $139,000 relating to legal and professional fees relating to theCompany’s restatement efforts and the legal actions described in Note 8.

 

**QuarterEnded July 31, 2003**

 

The Company recorded $648,000 in restructuring and other charges duringthe three month period ended July 31, 2003, principally associated with theseparation of 9 employees, within both the Corporate and GPC businesssegments.  During the quarterly periodended July 31, 2003, the Company recorded a charge of $130,000 relating tolegal fees relating to the legal actions described in Note 8.

 

**QuarterEnded April 30, 2004**

 

The Company recorded $308,000 in restructuring and other charges duringthe three month period ended April 30, 2004, principally associated with theseparation of 10 employees.  During thequarterly period ended April 30, 2004, the Company recorded a charge of$521,000 relating to legal and professional fees relating to the Company’slegal actions described in Note 8. Approximately, $462,000 of the $521,000 of legal and professional feeswere recorded as selling, general and administrative costs during the quarterended April 30, 2004 and reclassified to restructuring and other charges in thequarter ended July 31, 2004.

 

The Company expensed approximately $1.7 million for compensatorydamages to EPG after the jury returned a verdict in favor of EPG on one claimand Carreker on three claims.

 

24

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**QuarterEnded July 31, 2004**

 

The Company recorded $192,000 in restructuring and other charges duringthe three month period ended July 31, 2004, principally associated with theseparation of 8 employees.  During thequarter ended July 31, 2004, the Company recorded a charge of $36,000 relatingto legal and professional fees relating to the Company’s shareholder legalactions described in Note 8.

 

On July 8, 2004, the Company settled with EPG for $1.7 million.  An additional $14,000 was expensed and thesettlement paid to the plaintiff.  Additionally,the Company recorded a charge for the litigation costs related to this legalaction totaling $1.2 million.

 

Finally, the Company received a final payment of $455,000 from acustomer in the final settlement with one of its original CheckFlow Suite customers.  This payment was recorded directly to thisreserve.  Concurrently, based on revisedcost estimates, the Company lowered its estimate of the cost to develop andinstall any additional software, or software modifications, with thesecustomers and reversed approximately $1.2 million of this reserve.

 

The activity related to the accrued merger and restructuring costsduring the three and six months ended July 31, 2004 is as follows (inthousands):

 
| ** **                      | ** ** | **Workforce  Reductions** | ** ** | **Charges  relating to  CheckFlow  Suite** | ** ** | **Facility  Closures** | ** ** | **Other** | ** ** | **Total** | ** ** |
|---------------------------------|------------|---------------------------|------------|--------------------------------------------|------------|------------------------|------------|-----------|------------|-----------|------------|
|                            |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Balance at January 31, 2004     |       | $                         | 500        |                                       | $          | 1,296                  |       | $         | 5          |      | $          | 97 |   | $ | 1,898 |   |
|                            |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Additions to reserve balance:   |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Severance charges               |       | 308                       |       | —                                     |       | —                 |       | —    |       | 308       |       |
| Reductions to reserve balances: |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Cash paid                       |       | (412                      | )          | (29                                        | )          | —                 |       | (5        | )          | (446      | )          |
| Balance at April 30, 2004       |       | $                         | 396        |                                       | $          | 1,267                  |       | $         | 5          |      | $          | 92 |   | $ | 1,760 |   |
|                            |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Additions to reserve balance:   |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Severance charges               |       | 192                       |       | —                                     |       | —                 |       | —    |       | 192       |       |
| Cash received from customer     |       | —                    |       | 455                                        |       | —                 |       | —    |       | 455       |       |
| Reductions to reserve balances: |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Cash paid                       |       | (495                      | )          | (149                                       | )          | —                 |       | (12       | )          | (656      | )          |
| Change in estimate              |       | —                    |       | (1,215                                     | )          | —                 |       | —    |       | (1,215    | )          |
| Balance at July 31, 2004        |       | $                         | 93         |                                       | $          | 358                    |       | $         | 5          |      | $          | 80 |   | $ | 536 |   |

 

25

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**Item2.****Management’s Discussion and Analysis of****Financial Condition and Results of Operations**

 

All statements other than statements of historical fact contained inthis report, including statements in this “Management’s Discussion and Analysisof Financial Condition and Results of Operations” concerning our financialposition and liquidity, results of operations, prospects for future growth, andother matters, are forward-looking statements. Although we believe that the expectations reflected in suchforward-looking statements are reasonable, no assurance can be given that suchexpectations will prove correct.  Factorsthat could cause our results to differ materially from the results discussedin, or contemplated by, such forward-looking statements include the risksdescribed under “Business – Forward Looking Statements and Risk Factors”contained in our Form 10-K for the year ended January 31, 2004, as filed withthe Securities and Exchange Commission (SEC). Such risks include, without limitation: dependence on the bankingindustry, decline in check volumes, fluctuations in operating results, lack oflong-term agreements, dependence on key personnel, product liability, rapidtechnological change and dependence on new products, focus on providingbusiness process outsourcing with significant offshore component, ability toattract and retain qualified personnel, customer concentration, competition,potential strategic alliances and acquisitions, proprietary rights,infringement claims, dependence on third parties for technology licenses,liability claims, pending lawsuits, stock price fluctuations, internationaloperations, use of independent contractors, changing government and taxregulations, anti-takeover provisions in our charter and impairment of goodwillor intangible assets.  In addition, fromtime to time we provide information regarding our contract sales and backlogand our expectations with regard to the related realization of revenues. Ourexpectations with regard to the realization of revenues from these sales andbacklog are forward-looking statements and are subject to the foregoing risksand those set forth under “Item 5. Other Information” in this report.  All forward-looking statements in this reportare expressly qualified in their entirety by the cautionary statements in thisparagraph, in the “risk factors” included in our SEC filings and elsewhere inthis report.

 

**Overview**

 

We provide payments-related software and consulting solutions tofinancial institutions and financial service providers.  We serve all of the top 20 and 75 of the nextlargest 100 commercial banks in the United States.  We also consider other geographic regions tobe important elements of our market opportunity.  Our products and services traverse a broadspectrum of payment activities and are designed to improve operationalefficiency in how payments are processed; enhance revenue and profitabilityfrom payments-oriented products and services; reduce losses associated withfraudulent payment transactions; and/or improve the alignment of productofferings with our customer needs, hence maximizing their customer incomestreams.

 

We are organized into three primary operating divisions: GlobalPayments Technologies (“GPT”), Revenue Enhancement (“RevE”) and Global PaymentsConsulting (“GPC”).  These threedivisions bring together the capabilities essential to providing the innovationand delivery engines for our products and services.

 

26

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*Global Payments TechnologiesSolutions.*  Carreker’s technology solutions help financial institutions address theneeds of some critical payment services and delivery functions that impactoverall operating costs and risk management. These functions include presentment of checks in paper and electronicform, identification and mitigation of fraudulent payments, handling irregularitems such as checks returned unpaid (exceptions), maintaining a record of pasttransactions (archiving), responding to related customer inquiries (research),and correcting any errors that are discovered (adjustments).  The Global Payments Technologies (“GPT”)solutions suite addresses these key functions in the context of improvingoperational efficiency and a gradual transition from paper to electronic-basedpayment systems.  In addition, we offertechnology solutions that optimize the inventory management of a bank’s cashstock levels, including managing how much is needed, when it is needed andwhere it is needed.  Our solutions reducethe amount of cash banks need to hold in reserve accounts and as cash-on-hand,while ensuring a high level of customer service through timely replenishment ofATM cash supplies.

 

Specificsolutions in the GPT group include:

 
| **Solution**                                           | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                   | ** ** | **Products Offered**                                                                                                                                                                                                                                                  |
|--------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                             | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | ** **                                                                                                                                                                                                                                                            |
| Fraud  Mitigation and Anti-Money Laundering Compliance |       | Automated fraud detection  and prevention solutions that reduce incidents of check fraud, deposit fraud,  check kiting, and electronic fraud. Anti-money laundering solutions screen  names and related data against industry blacklists, local high-risk lists and  other customized databases. The solution automatically alerts appropriate  bank personnel for timely and decisive action and reporting. Scalable  solutions are offered for community banks. |       | FraudLink On-Us, FraudLink  Deposit, FraudLink, FraudLink Deposit – Branch Access Option, Kite, FraudLink  Positive Pay, FraudLink eTracker, FraudLink PC, CORE Workflow Manager, CORE  AML Filter, FraudLink ACHeCK, eFraudLink.com, Fraud Solutions Consulting |
|                                                   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |                                                                                                                                                                                                                                                                  |
| Back Office Processing                                 |       | Products that bring new  efficiencies to back-office operations through leading-edge image, workflow,  and RECO (character recognition) technologies.                                                                                                                                                                                                                                                                                                             |       | Adjustments/Express,  Exceptions/Express, Input/Express, Inbound Returns/Express, Image Bulk-File,  All Transactions File and Fine Sort                                                                                                                               |
|                                                   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |                                                                                                                                                                                                                                                                  |
| Remittance Processing                                  |       | Both host and  client/server-based platforms for improved productivity in processing retail  and wholesale remittance transactions.                                                                                                                                                                                                                                                                                                                               |       | NeXGen Remittance                                                                                                                                                                                                                                                     |
|                                                   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |                                                                                                                                                                                                                                                                  |
| Conventional Check Capture                             |       | An extensive array of  enhancement products that add flexibility and usability to IBM’s Check  Processing Control System (CPCS) and the IBM 3890/XP series of Document  Processors.                                                                                                                                                                                                                                                                          |       | Conventional Capture  Products, CPCS Enhancements Products, XP/Productivity Tools, Platform  Emulation, NeXGen Settlement, NeXGen Balancing, LTA (Large Table Access)                                                                                                 |
|                                                   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |                                                                                                                                                                                                                                                                  |
| Check Image Capture                                    |       | Products and services  related to the capture, storage and delivery of check images.                                                                                                                                                                                                                                                                                                                                                                              |       | ALS & CIMS Products  (MVS, AIX, Windows), NeXGen Image Processor, Image Enhancement Products,  Reject Repair, RECO Technology, Image POD, Image Delivery Products, Delivery  Express                                                                              |
|                                                   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |                                                                                                                                                                                                                                                                  |
| Check Image Archive  Management                        |       | Comprehensive array of  check image archive management products that may be tailored to a bank’s  unique requirements based on their operational environments and volumes.  Carreker offers archive technology for both  in-house solutions and shared outsource providers.                                                                                                                                                                             |       | Check Image Archive-AIX,  Check Image Archive-MVS, Check Image Archive Load                                                                                                                                                                                           |
|                                                   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |                                                                                                                                                                                                                                                                  |
| Other Check Image  Applications                        |       | An array of solutions that  address revenue enhancement, risk reduction,   and expense reduction issues through the application of image,  workflow and RECO technologies.                                                                                                                                                                                                                                                                                   |       | Image Statements, NeXGen  Remittance, + CDRom Delivery, Input/Express, Express Capture, Payee Name  Verification, Amount Encoding Verification                                                                                                                        |
|                                                   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |                                                                                                                                                                                                                                                                  |
| Global  Tracking                                       |       | A complete bar code  tracking system eliminates manual log sheets, automates data gathering and  maximizes workflow by tracking accountable mail, branch bags, item volumes,  currency bags, incoming domestic and international deposits, outgoing cash  letters, exceptions and much more.                                                                                                                                                                      |       | Receive Sentry                                                                                                                                                                                                                                                        |

 

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| **Solution**                  | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **Products Offered**                                                         |
|-------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|
|                          |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                                                         |
| eMetrics                      |       | Performance-measurement  software suite that uses historical data to generate key performance  indicators, item processing volume data, productivity statistics and quality  control benchmarks.                                                                                                                                                                                                                                                                      |       | Lumen, ProModel, eiMICR,  eiStats, eiQuality, eiPerform                      |
|                          |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                                                         |
| Electronic Check  Presentment |       | Enables banks to  transition from paper-based to electronic payment systems by automating key  elements of the processing stream, as well as improving a bank’s yield from  float management. These solutions are designed to reduce and eventually  eliminate the movement of paper payments through the system, improving  productivity, reducing errors, increasing customer satisfaction and reducing  fraud.                                                |       | CheckLink, CheckLink PC,  Deposit Manager, Branch Truncation Manager, Cnotes |
|                          |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                                                         |
| ATM Solutions                 |       | Advanced ATM monitoring  and management, improving ATM availability and ensuring service levels are  met. These solutions include an automated ATM monitoring and dispatching  system for maximizing network availability; an Internet-based cash  forecasting and inventory management desktop system for reducing cash needs  by 20-40% across the enterprise; and a real-time Internet-based system for  efficient handling of ATM service requests and responses. |       | eiManager, eiGateway, iCom                                                   |
|                          |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                                                         |
| Cash Solutions                |       | A product suite, now  optimized through Web-based software solutions, that dramatically reduces the  amount of cash banks, financial institutions and companies need to hold as  cash-on-hand throughout vault, branch and ATM networks. These solutions also  automate and standardize the cash ordering process.  Consulting solutions can drive further  efficiency and automation in vault, branch and ATM operations.                                       |       | iCom, ReserveLink,  ReserveLink Plus, Cash Supply Chain Consulting           |

 

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*Revenue Enhancement Solutions.*  TheRevenue Enhancement division includes two business units:  RevE and EnAct. RevE is a highly specializeddivision that provides consulting services focused on tactical methods ofincreasing banks’ fee income. The scope and depth of this practice has expandedthroughout its 13 year history and now includes retail, small business, andcommercial deposits, treasury management, consumer and commercial lending,credit card lending and trust and investment services. Our solutions involvedeveloping strategies that enable our clients to take advantage ofelectronification trends, often gaining first mover advantages for our clients.In addition to developing strategies, our business model ensures that wecontinue to translate those strategies into tactical implementations withmeasurable revenue streams. Our client base has continued to expand with veryhigh penetration rates in the markets in which we operate. Thus, we haveexperienced a trend of becoming longer term strategic partners with ourclients.

 

Another component of our Revenue Enhancement Division is our businessproviding EnAct software and proprietary sales management methodology. OurEnAct solutions assist financial institutions in leveraging centralintelligence with local insight. This enables our clients to recognize thosecustomers and prospects representing the greatest value or potential. Ourapproach is unique and complimentary to many CRM investments that banks havemade in recent years and is designed to focus their activities such that theycan actually attain increased returns on these CRM investments.

 

*Global Payments Consulting.*  Carrekerhelps financial institutions pro-actively plan, prepare and optimize for theregulatory, competitive and technological impacts affecting the financialpayments environment.

 

Our Global Payments Consulting (GPC) division provides strategicplanning and implementation advisory services for financial institutions andother clients.  These planning andimplementation services include:

 

•                  Enterprise payment strategy

•                  Payment research services

•                  Predictive financial and operational modelingof the implications of payment trends and strategies

•                  Image-enabled payment infrastructure planning

•                  Transportation, float and funds availabilityoptimization

•                  Organizational design

•                  Consolidation and merger/integration planning

•                  Program Management

•                  Check 21 readiness

 

Each service’s objective is to assist our clients in preparing andpositioning their organization for the rapidly changing payment landscape.

 

The GPC division also contains the consulting license, maintenance andservice revenue of our Float Management software products.  These Float Management products providesolutions that manage a bank’s float through float analysis and pricing toimprove profitability, reporting, workflow and check clearing operations.  These products also provide critical activitysummaries, aid in creating multiple availability and pricing schedules, and pinpointthe cost/profitability of transactions or relationships.  The products offered consist of FloatAnalysis System and Float Pricing System.

 

*Outsourcing*.  Carretek LLC, is atransformational business processing outsourcer for payment and transaction processingjointly owned by Carreker Corporation and Majesco Software Inc., the USsubsidiary of Mastek Limited, a leading Indian outsourcing company with globaloperations.  Carretek was formed infiscal 2003.  While the venture hassigned its first contract, it is still in the developmental phase and itsresults are contained in the Corporate-Unallocated business segment.

 

Carretek’s mission is to enable financial institutions and theirprocessors to realize the benefits of transformational offshore-centricoutsourcing (offshoring) of their business processes.  The benefits to clients could includereduction in operating costs, improvements in productivity, and enhancement ofquality.

 

Initially, Carretek is focused on offshoring payments-related business processes.  Through Carretek, financial institutions canleverage the global work force at this critical period when Check 21 and otherpayment electronification trends are pressuring financial institutions toreduce their payment per item costs beyond the power of traditional costmanagement practices.  Carretek hasdesigned and built specific product offerings targeted at payment andtransaction processing functions for this express purpose.  Within this area of expertise, the Carretekoffering includes a flexible array of offshore outsourcing services tofinancial institutions, which include: global sourcing strategy development(consulting, methodology, and tools) to help banks understand their offshoringopportunities and optimize their decisions in this regard; and outsourcing ofselected payment processes to India through a range of business models suitedto each bank’s needs.

 

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Carretekdraws on Carreker’s expertise in payments systems and associated businessprocesses to help banks rationalize the business case for transitioning some ofthese processes to cost-efficient offshore locations and improving banks’return on investments in payments technologies. Carreker’s image-related technologies, already in place at many largeU.S. banks, enable such transitioning and leverage the banks’ previousinvestment in these systems.

 

**Executive Summary**

 

InQ2 2004, we generated net income of $199,000 and on a year-to-date basis wegenerated a loss of $613,000, we expect revenues in Q3 2004 to remainrelatively flat and operating profits to be approximately break-even orslightly negative, due to the effect of soft sales in Q4 2003 and Q1 2004,delays in implementation schedules, increases in non-capitalizable research anddevelopment expenses associated with new product opportunities and investmentin our GPC business segment.  The outlookfor Q4 2004 will be very sensitive to the volume and timing of sales, productdelivery and customer implementation schedules.

 

Themarket in which we operate is healthy and the buying climate continues to befavorable with Check 21 and payment electronification.  However, these conditions have also attractedcompetition for our GPT business segment, including point solution providerstrying to broaden their offerings to large hardware and solution providers likeIBM, Unisys and NCR who view Check 21 as an opportunity for incrementalsoftware and advisory services revenue.

 

OurQ2 2004 sales activity reflected this strong market demand with our GPTbusiness segment having one of the strongest contract sales quarters to datefor software and services; however, given that a portion of these sales relateto products that are still in development and in light of our percent-complete revenuerecognition model, these sales did not significantly impact our GAAP revenue inQ2 2004.  In Q2 2004, our GPT segmentrevenue declined 30% on a quarter-over-quarter basis and declined 17% on a YTDbasis.

 

InQ2 2004, our RevE segment revenue grew 8% on a quarter-over-quarter basis and13% on a YTD basis.  We continue toexperience good demand in this business because banks continue to be challengedto grow, or maintain existing revenue streams, primarily by two major shifts inthe banking industry: (1) the shift from end-of-day paper payment services toelectronic intra-day services and (2) the value proposition shift from paperhandling to risk mitigations/information services.  Both of these shifts are intensified by thefact that Check 21, a momentum builder for both shifts, goes into effect inOctober 2004.  Within RevE, we doexperience moderate competition.  Thereare a number of smaller competitors that have put downward pressure on ourpricing; however, customers value our larger size and the quality of ourconsultants, which provide better assurance of a successful engagement.

 

InQ2 2004, our GPC segment revenue grew 47% on a quarter-over-quarter basis and16% on a YTD basis.  Over the past year,we have been repositioning this business from a staff supplement focus to oneof thought leadership where margins and growth potential is superior.  While the path to profitability andsignificant growth has taken longer than originally anticipated, we consider thisbusiness to be an important part of our overall integrated solutionoffering.  The two drivers that webelieve will fuel this growth are: (1) Check 21 with all of the changes itrequires and (2) our own technology, designed to facilitate our customers’ transitionfrom paper to electronics.  Banks’decision making process with regard to adopting image technology can be costly and complex, which provides a goodopportunity for our consulting business. The competition we face in GPC resembles that of GPT.  We have both very large providers on one sideand small single-service consultancies on the other.  We believe we maintain a strong competitiveposition because of our long-time and hard-earned reputation of advising thesebanks on similar operations and technology changes.

 

InQ2 2004, we announced our first contract for Carretek, our 51% owned offshorebusiness process outsourcing initiative. Presently, the revenue impact is minimal, however there are two driversfor growth: (1) Check 21 has accelerated the pressure on banks to reduce the costof processing papers payments and (2) the availability of image technology thatmakes it possible to separate the information to be processed from the paperitself.  As for competition, there aremany offshoring vendors; however, we believe our model is unique as we bringpayment knowledge and bank expertise, along with an experienced offshorepartner and facilities.

 

Beginningin Q3 2003, we began to increase our research and development (“R&D”)spending to address new product offerings and existing product enhancementsthat will be required by our customers to address all of the significantchanges brought about by Check 21 legislation, USA Patriot Act and BaselII.  Through July 31, 2004, total R&Dspending (including amounts capitalized) has increased to $5.2 million in 2004,as compared to $3.6 million for the same period in 2003.  We expect this trend to continue for thebalance of 2004 as we continue to develop new products.

 

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Tohelp fund these investments in our products, we are continually trying toimprove both the quality and efficiency within our organization to controlselling, general and administrative expenses and improve the utilization of ourtechnical staff and consultants.  Whilewe have managed to lower these expenses, the reductions have been partiallyoffset by increases in Directors and Officers’ Insurance, professional fees forSarbanes-Oxley compliance, employee benefits, and increased GPT sellingexpenses.

 

Finally,2004 operating results have been negatively affected by several non-recurringitems.  The EPG litigation settlement of$1.7 million, along with $462,000 in litigation costs, were recorded in Q12004.  In Q2 2004, an additional $1.2million in litigation costs were incurred. These Q2 2004 litigation costs were offset by a $1.2 million change inestimated reserves related to a discontinued product.

 

**Resultsof Operations**

 

***Comparison of Three Months Ended July 31, 2004 (Q2 2004) to ThreeMonths Ended July 31, 2003 (Q2 2003) and Six Months Ended July 31, 2004 (YTD2004) to Six Months Ended July 31, 2003 (YTD 2003)***

 

***Revenues by Segment ($ in thousands):***

 
| ** **                      | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|---------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                      | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                            |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Revenue Enhancement             |       | $                                | 10,042     |         | $          | 9,299                          |       | $            | 743        |   | 8.0 | % | $ | 19,524 |   | $ | 17,357 |   | $ | 2,167 |   | 12.5 | % |
| Global Payments Technologies    |       | 18,211                           |       | 25,924       |       | (7,713                         | )          | (29.8        | )          | 37,436 |   | 44,970 |   | (7,534 | ) | (16.8 | ) |
| Global Payments Consulting      |       | 1,374                            |       | 938          |       | 436                            |       | 46.5         |       | 2,433 |   | 2,090 |   | 343 |   | 16.4 |   |
| Corporate (Outsourcing) Revenue |       | 10                               |       | —       |       | 10                             |       | —       |       | 10 |   | — |   | 10 |   | — |   |
|                            |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Total Revenues                  |       | $                                | 29,637     |         | $          | 36,161                         |       | $            | (6,524     | ) | (18.0 | )% | $ | 59,403 |   | $ | 64,417 |   | $ | (5,014 | ) | (7.8 | )% |

 

Thedecline in revenue for Q2 2004, as compared to Q2 2003, was driven by a 29.8%decline in revenue within the GPT business segment, offset by a 8.0% increasein RevE revenue and a 46.5% increase in revenue within our GPC businesssegment.  The decline in revenue on a YTDbasis was driven by a 16.8% decline within the GPT business segment, offset by12.5% growth within the RevE business segment and a 16.4% increase in our GPCbusiness segment.

 

Thedecline in our GPT business segment, on both a quarter-over-quarter basis and aYTD basis, was primarily the result of weak software and related servicescontract sales in Q4 2003 and Q1 2004, due to delays in technology investmentsby our customers and the availability of our new product offerings relating toCheck 21 legislation and our other new Cash and Risk solutions products.  The timing of maintenance collections alsocontributed to the decline in revenue. Additionally, the maintenance revenue in Q2 2003 was unusually large ascustomers delayed payment of their 2003 maintenance renewals until we completedour restatement efforts at the end of Q1 2003.

 

Theincrease within our RevE business segment, on both a quarter-over-quarter andYTD basis, was principally driven by a 20% increase in consulting revenues on aquarterly basis and a 29% increase on a YTD basis.  The increase in consulting revenues cameprincipally from higher international consulting revenue.  These increases in consulting revenue wereoffset by a 69% decline in EnAct software and services revenue on a quarterlybasis and a 66% decline on a YTD basis. The steep declines within EnAct were the result of three large 2003engagements that have not been replaced in 2004.

 

Theincreases in revenues in 2004 within our GPC business segment, on both aquarter-over-quarter and YTD basis, reflects the traction gained in thissegment as we repositioned this business to focus on Check 21 enterprise-widepayment strategies and image enablement planning and integration.

 

31

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Overall,as we look across our three major business segments, we believe that we arewell positioned and have a competitive advantage to capitalize on thesignificant changes brought about by the Check 21 legislation, USA Patriot Actand Basel II due to our subject matter expertise in the impacted areas.  We believe the revenue that will be derivedfrom these regulatory changes will result in revenue growth in late 2004 or2005.

 

*Consulting Fees ($ in thousands):*

 
| ** **      | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|-----------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **      | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|            |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Consulting Fees |       | $                                | 10,514     |         | $          | 8,202                          |       | $            | 2,312      |   | 28.2 | % | $ | 19,571 |   | $ | 14,953 |   | $ | 4,618 |   | 30.9 | % |
|                 |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Consultingrevenue in the RevE segment increased $1.6 million, or 19.8%, to $9.4 millionin Q2 2004 from $7.8 million in Q2 2003. Domestically, consulting revenue for RevE declined approximately$746,000 on a quarterly basis, however there were 13 revenue producing engagementsin Q2 2004, as compared to 10 in Q2 2003. International RevE consulting revenue increased $2.3 million in Q2 2004,as compared to Q2 2003, and there were 3 international revenue producingengagements in Q2 2004, as compared to 1 in Q2 2003.  Consultingrevenue in the RevE segment increased $3.9 million, or 28.5%, to $17.8 millionon a YTD basis from $13.9 million for the same period in 2003.  Domestically, consulting revenue for RevEdeclined approximately $786,000 on a YTD basis and there was 15 revenueproducing engagements on a YTD basis in both 2004 and 2003.  International RevE consulting revenueincreased $4.8 million in YTD 2004, as compared to YTD 2003.  Additionally, there were 4 internationalrevenue producing engagements in YTD 2004, as compared to 1 in YTD 2003.

 

Consultingrevenue in our GPC segment increased 120.5%, to $849,000 in Q2 2004 from$385,000 in Q2 2003, and increased 46.7% to $1.4 million in YTD 2004 from$943,000 in YTD 2003.  While we have seensome momentum from our redefined GPC segment, we continue to be cautiouslyoptimistic about the future prospects of the GPC segment.

 

*Software License Fees ($ in thousands):*

 
| ** **            | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|-----------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **            | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                  |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Software License Fees |       | $                                | 4,577      |         | $          | 8,351                          |       | $            | (3,774     | ) | (45.2 | )% | $ | 10,433 |   | $ | 14,929 |   | $ | (4,496 | ) | (30.1 | )% |
|                       |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Themajority of our software license fees are derived from our GPT businesssegment.  GPT software license revenuedecreased $2.9 million, or 39.4%, to $4.6 million in Q2 2004 from $7.5 millionin Q2 2003.  GPT software license revenuedeclined $3.0 million, or 22.7%, to $10.2 million in YTD 2004 from $13.2million in YTD 2003.  In Q2 2004,$484,000, or 10.6%, and $3.4 million, or 33.2%, in YTD 2004 of software licenserevenue in the GPT business segment was the result of a license sale to asingle customer in our Check Image Archive area, which did not requireimplementation services.  In 2003, thesoftware license revenue was more evenly distributed over our customer base.

 

Beginningin the latter half of fiscal 2002, and continuing into fiscal 2003 and Q1 2004,the number and dollar amount of software license and related servicesarrangements began to decline.  Thistrend resulted from a natural decline in software revenue derived from ourexisting products as they reached a state of maturity in their product lifecycle.

 

Thesoftware revenue derived from our EnAct product offering, contained in our RevEbusiness segment, declined to $13,000 in Q2 2004, as compared to $815,000 in Q22003 and declined to $192,000 in YTD 2004, as compared to $1.7 million in YTD2003.  This decline is the result of alack of sales capacity.

 

32

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Duringthe latter half of fiscal 2003 and continuing in the first two quarters of2004, several new product initiatives were launched.  These initiatives include:

 

•                  ExchgLink: an application designed to send and receive check images.  This product is being installed at ourfunctional partner site, along with an additional beta site.  All license revenues continue to be deferredsince the product is not generally available.

 

•                  Source Capture:  an application that enables customers tocapture check images at corporate sites, bank branches and ATM’s.  License revenues are deferred since theproduct is not generally available.

 

•                  CORE Fraud Manager:  our next generation fraud application whichintegrates multiple fraud detection and regulatory compliance functions into asingle unified framework.

 

•                  CORE Filter: an anti-money laundering application.

 

•                  Express Research:  an image-enabled back office application.

 

Asanticipated, in Q2 2004 we began to see market clarity emerging in theindustry, especially as it relates to software solutions surrounding Check 21,which gives us increased clarity regarding customer buying decisions duringfiscal 2004.  The GPT business segmenthad one of its largest sales volume quarters in recent history and increased ouramount of deferred software and services revenue.

 

*Software Maintenance Fees ($ in thousands):*

 
| ** **                | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|---------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                      |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Software Maintenance Fees |       | $                                | 10,232     |         | $          | 14,284                         |       | $            | (4,052     | ) | (28.4 | )% | $ | 21,316 |   | $ | 22,994 |   | $ | (1,678 | ) | (7.3 | )% |
|                           |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Themajority of our maintenance revenue is derived from our GPT businesssegment.  Software maintenance fees areinvoiced and collected pursuant to annually renewable product and telephonesupport agreements with our software customers. The annual maintenance fee is generally paid by the customer at thebeginning of the maintenance period and we recognized this maintenance revenueratably over the term of the related contract. If the annual maintenance fee is not paid at the beginning of themaintenance period, we defer revenue recognition until the time that themaintenance fee is paid by the customer. When the payment is received, maintenance revenue is recognized for theperiod that maintenance revenue was previously deferred.  The decrease in Q2 2004 compared to Q2 2003reflects more timely payment by our customer base for their maintenanceagreements.  In Q1 2003, our maintenancerevenue was extremely low as customers delayed making their 2003 maintenancerenewal payments until after we completed our restatement effort at the end ofQ1 2003.  This delay caused our Q2 2003maintenance revenue to be unusually high. Maintenance contracts usually carry annual maintenance fee escalationclauses generally based on an index, such as the consumer price index.  Increases for maintenance revenue in 2004 dueto this escalation will be offset by the fact that a major customer gave noticeof their intent to not renew their $2.5 million maintenance contract for 2004.

 

33

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*Software Implementation Fees ($ in thousands):*

 
| ** **                   | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                   | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                         |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Software Implementation Fees |       | $                                | 3,642      |         | $          | 4,508                          |       | $            | (866       | ) | (19.2 | )% | $ | 6,521 |   | $ | 9,402 |   | $ | (2,881 | ) | (30.6 | )% |
|                              |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Themajority of our software implementation fees are derived from our GPT businesssegment.  In that segment, softwareimplementation fees declined $874,000, or 21.0%, in Q2 2004 to $3.3 millionfrom $4.2 million in Q2 2003.  Softwareimplementation revenue within GPT declined $2.8 million, or 32.3%, in YTD 2004to $5.8 million from $8.6 million in YTD 2003. These declines reflect the lower volume of both software license andsoftware implementation sales contracts signed in the latter half of 2003 andQ1 2004.  However, the number of salescontracts signed in Q2 2004 did increase significantly, especially in the firsthalf of the quarter, which increased GPT implementation revenue $727,000 overQ1 2004.  In the majority of our customerarrangements, installation services are provided to the customer when a licenseis purchased.

 

*Out-of-Pocket Expense Reimbursements ($ in thousands)*:

 
| ** **                           | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                           | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                                 |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Out-of-Pocket Expense Reimbursements |       | $                                | 662        |         | $          | 816                            |       | $            | (154       | ) | (18.9 | )% | $ | 1,552 |   | $ | 2,139 |   | $ | (587 | ) | (27.4 | )% |
|                                      |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thedecrease in these reimbursements, on both a quarter-over-quarter and YTD basis,occurred within the GPT business segment, and corresponds with the decline insoftware implementation revenue noted above. Most of the software services and consulting engagements require ouremployees to be at the customer location for extended periods of time, whichgives rise to out-of-pocket expense reimbursements.

 

34

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***Cost of Revenues by Segment ($ inthousands):***

 
| ** **                       | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|----------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                       | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                             |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Revenue Enhancement              |       | $                                | 4,598      |         | $          | 5,057                          |       | $            | (459       | ) | (9.1 | )% | $ | 8,974 |   | $ | 9,511 |   | $ | (537 | ) | (5.6 | )% |
| % of revenue                     |       | 45.8                             | %          | 54.4         | %          |                           |       |         |       | 46.0 | % | 54.8 | % |   |   |   |   |
|                             |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Global Payments Technologies     |       | $                                | 8,659      |         | $          | 9,811                          |       | $            | (1,152     | ) | (11.7 | )% | $ | 17,177 |   | $ | 19,405 |   | $ | (2,228 | ) | (11.5 | )% |
| % of revenue                     |       | 47.5                             | %          | 37.8         | %          |                           |       |         |       | 45.9 | % | 43.2 | % |   |   |   |   |
|                             |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Global Payments Consulting       |       | $                                | 1,343      |         | $          | 1,554                          |       | $            | (211       | ) | (13.6 | )% | $ | 2,686 |   | $ | 3,480 |   | $ | (794 | ) | (22.8 | )% |
| % of revenue                     |       | 97.7                             | %          | 165.7        | %          |                           |       |         |       | 110.4 | % | 166.5 | % |   |   |   |   |
|                             |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Corporate (Outsourcing) Services |       | $                                | 14         |         | $          | —                         |       | $            | 14         |   | — | % | $ | 14 |   | $ | — |   | $ | 14 |   | — | % |
| % of revenue                     |       | 140.0                            | %          | —       | %          |                           |       |         |       | 140.0 | % | — | % |   |   |   |   |
|                             |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Total Cost of Revenues           |       | $                                | 14,614     |         | $          | 16,422                         |       | $            | (1,808     | ) | (11.0 | )% | $ | 28,851 |   | $ | 32,396 |   | $ | (3,545 | ) | (10.9 | )% |
| % of revenue                     |       | 49.3                             | %          | 45.4         | %          |                           |       |         |       | 48.6 | % | 50.3 | % |   |   |   |   |

 

Costsof revenues in absolute dollars declined in all segments in Q2 2004 and YTD2004 and were also lower as a percentage of revenues in both the RevE and GPC business segments.  However, with significant declines insoftware license, software maintenance and software implementation revenue,GPT’s direct costs as a percentage of revenue increased.

 

The largest decline in absolute dollars within GPT, forboth quarter-over-quarter and YTD, was the reduction in direct costs related toservices.  These declines represent some personnelreductions, as well as the redeployment of the services staff to Research andDevelopment projects, software maintenance projects and sales support.

 

Similarly, within the RevE business segment, the declinein cost of revenues was related to the declines in the direct costs within theEnAct software business; however, these declines were partially offset bysmaller increases in the cost of consulting revenue.  As with GPT, there have been personnelreductions within the EnAct software business, as well as a redeployment ofstaff to sales support.

 

The direct cost reductions within GPC were attributableto personnel reductions within their consulting practices to bring costs inline with expected consulting revenues.

 

*Cost of Consulting ($ in thousands):*

 
| ** **              | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|-------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **              | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                    |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Cost of Consulting      |       | $                                | 5,082      |         | $          | 5,288                          |       | $            | (206       | ) | (3.9 | )% | $ | 9,611 |   | $ | 10,257 |   | $ | (646 | ) | (6.3 | )% |
| % of consulting revenue |       | 48.3                             | %          | 64.5         | %          |                           |       |         |       | 49.1 | % | 68.6 | % |   |   |   |   |
|                         |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thecost of consulting consists primarily of personnel costs related to ourconsulting engagements within our RevE and GPC segments.  The majority of the decline in 2004, ascompared to 2003, is attributed to a $228,000 decrease on a quarterly basis anda $757,000 decrease on a YTD basis within our GPC segment.  Personnel costs, along with contractor costsand travel, have been reduced to bring them in line with expected near-termconsulting revenues.

 

35

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       *Cost of Software Licenses($ in thousands):*

 
| ** **                    | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|-------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                    | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                          |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Cost of Software Licenses     |       | $                                | 1,670      |         | $          | 1,905                          |       | $            | (235       | ) | (12.3 | )% | $ | 3,268 |   | $ | 3,626 |   | $ | (358 | ) | (9.9 | )% |
| % of software license revenue |       | 36.5                             | %          | 22.8         | %          |                           |       |         |       | 31.3 | % | 24.3 | % |   |   |   |   |
|                               |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The cost of softwarelicenses consists primarily of amortization of capitalized and acquiredsoftware costs along with royalties payable to third parties.  The decline in cost of software license feesfor both the three and six month periods is due primarily to lower softwareroyalty costs.

 

In connection with softwarelicense and maintenance agreements entered into with certain banks and purchaseagreements with vendors under which we acquired software technology used inproducts sold to our customers, we are required to pay royalties on sales ofcertain software products.  Under thesearrangements, we accrue royalty expense when the associated revenue isrecognized.  The royalty percentagesgenerally range from 20% to 50% of the associated revenue.  In Q2 2004 we recorded $433,000 of royaltyexpense compared to $592,000 of royalty expense recorded in Q2 2003.  In YTD 2004, we recorded $688,000 of royaltyexpense compared to $1.0 million for the YTD 2003.  Depending on our future product mix, ourmargins from software license fees may be negatively impacted by increasedsoftware royalty expense.

 

*Cost of Software Maintenance ($ in thousands):*

 
| ** **                        | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                        | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                              |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Cost of Software Maintenance      |       | $                                | 3,386      |         | $          | 3,133                          |       | $            | 253        |   | 8.1 | % | $ | 7,184 |   | $ | 6,310 |   | $ | 874 |   | 13.9 | % |
| % of software maintenance revenue |       | 33.1                             | %          | 21.9         | %          |                           |       |         |       | 33.7 | % | 27.4 | % |   |   |   |   |
|                                   |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Costof software maintenance consists primarily of personnel and facility costs toprovide telephone support, products defect support and other enhancements toour existing products, which are not significant enough to extend the product’slife cycle or substantially increase its marketability. The increase in Q22004, compared to Q2 2003, and YTD 2004, as compared to YTD 2003, occurred inboth our GPT and RevE business segments. This increase is personnel related and reflects increased emphasis insupporting and enhancing our current product mix.  This increase was not attributable toadditional overall headcount; rather, this cost increase representsredeployment of our technical staff from the software services area to themaintenance area.

 

Asdiscussed above, the annual maintenance fee is generally paid by the customerat the beginning of the maintenance period and we recognize this maintenancerevenue ratably over the term of the related contract.  If the annual maintenance fee is not paid atthe beginning of the maintenance period, we defer the revenue recognition untilthe time that the maintenance fee is paid by the customer.  When the payment is received, maintenancerevenue is recognized for the period that maintenance revenue was previouslydeferred.  As a result, our cost ofsoftware maintenance as a percentage of related maintenance revenue may fluctuate.

 

36

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*Cost of Software Implementation ($ in thousands):*

 
| ** **                           | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                           | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                                 |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Cost of Software Implementation      |       | $                                | 3,810      |         | $          | 5,058                          |       | $            | (1,248     | ) | (24.7 | )% | $ | 7,179 |   | $ | 9,913 |   | $ | (2,734 | ) | (27.6 | )% |
| % of software implementation revenue |       | 104.6                            | %          | 112.2        | %          |                           |       |         |       | 110.1 | % | 105.4 | % |   |   |   |   |
|                                      |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Costsof software implementation consist primarily of personnel and facility costs toprovide software implementation and project management support to customersoftware implementations within our GPT business segment and our RevEsegment.  The decline in costs ofsoftware implementation, for both the quarterly and YTD periods, is due to adecline in new software license and implementation projects, in both the GPTsegment and the RevE segment.  On aquarterly basis, the cost of service implementations declined $869,000 and$401,000 in the GPT and RevE segments, respectively.  On a YTD basis, the cost of serviceimplementations declined $2.0 million and $726,000 in the GPT and RevEsegments, respectively.  These lowercosts correspond to the lower volume of active software implementationengagements in 2004, as compared to 2003. The volume of software implementation projects has increasedconsiderably in Q2 2004, as compared to Q1 2004, therefore improving oursoftware implementation margins on a quarterly basis.

 

*Out-of-Pocket Expenses ($ in thousands):*

 
| ** **                                | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                                | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                                      |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Cost of Out-of-Pocket Expenses            |       | $                                | 652        |         | $          | 1,038                          |       | $            | (386       | ) | (37.2 | )% | $ | 1,595 |   | $ | 2,291 |   | $ | (696 | ) | (30.4 | )% |
| % of out-of-pocket expense reimbursements |       | 98.5                             | %          | 127.2        | %          |                           |       |         |       | 102.8 | % | 107.1 | % |   |   |   |   |
|                                           |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thesecosts represent travel, meals and other sundry expenses incurred by ouremployees.  These costs are invoiced tothe customer, without mark-up, usually on a monthly basis.  The absolute costs have declined, on both a quarterlyand YTD basis in 2004, due to fewer software implementation engagements asdiscussed above.  In addition, certaincustomer contracts contain expense maximums, so in certain cases not allexpenses incurred can be passed along to the customer.

 

37

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***Operating Costs and Expenses ($ inthousands):***

 

*Selling, General and Administrative Expenses ($ inthousands):*

 
| ** **                                    | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                                    | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                                          |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Selling, General and Administrative  Expenses |       | $                                | 11,971     |         | $          | 12,538                         |       | $            | (567       | ) | (4.5 | )% | $ | 24,163 |   | $ | 24,470 |   | $ | (307 | ) | (1.3 | )% |
| % of total revenue                            |       | 40.4                             | %          | 34.7         | %          |                           |       |         |       | 40.7 | % | 38.0 | % |   |   |   |   |
|                                               |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Selling,general and administrative expenses generally consist of personnel costs suchas salaries, commissions, incentive compensation and non-reimbursable travel.Additionally, the provision for doubtful accounts, insurance, includingdirectors and officers insurance, as well as professional services such aslegal and accounting expense and other related costs are classified withinselling, general and administrative expense.

 

Wehave experienced a decrease in these costs on both a quarterly and YTDbasis.  While we have made progress inreducing costs in this area by reducing personnel costs within our general andadministrative areas, these reductions have been partially offset by increasesin personnel expenses within our selling costs, especially within our GPTsegment.  Additionally, we have incurredincreased non-personnel related expenses such as insurance costs for ourdirectors and officers, travel costs associated with sales efforts andprofessional fees associated with our Sarbanes-Oxley compliance.

 

Additionally,because of the decline in delinquent accounts receivable in which the revenueis already fully deferred, we have reduced our allowance for doubtful accountsby $212,000 in Q2 2004 and $392,000 on a YTD basis.  Finally, we reclassified $462,000 of legalcosts incurred in Q1 2004 from selling, general and administrative expense torestructuring and other charges on a YTD basis.

 

*Research and Development ($ in thousands):*

 
| ** **                        | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                        | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                              |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Research and Development Expenses |       | $                                | 1,874      |         | $          | 1,779                          |       | $            | 95         |   | 5.3 | % | $ | 3,582 |   | $ | 3,645 |   | $ | (63 | ) | (1.7 | )% |
| % of total revenue                |       | 6.3                              | %          | 4.9          | %          |                           |       |         |       | 6.0 | % | 5.7 | % |   |   |   |   |
|                                   |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Researchand development expenses consist primarily of personnel, contract labor, traveland facilities expenses incurred by our research and developmentorganization.  In Q2 2004, research anddevelopment costs have remained relatively flat on both a quarterly and YTDbasis as a result of increased capitalization of research and developmentcosts.  Research and development costsare typically limited to development of new software products, or enhancementsto existing software products, which extend the product’s life cycle and/orsubstantially increase its marketability.

 

Inaccordance with SFAS No. 86, “*Accounting forCosts of Computer Equipment**to beSold, Leased or Otherwise Marketed,”* we capitalized $698,000 for thethree months ended July 31, 2004, as compared to $0 for the three months endedJuly 31, 2003.  On a YTD basis, we havecapitalized $1.6 million in 2004, as compared to $0 in 2003.  In 2004, $540,000 of our capitalization isrelated to our first version of ExchgLink, our product offering to send andreceive check images.  We expect thisproduct to become generally available in Q3 2004.  We have several other development initiativesunderway in fiscal 2004 such as the second version of ExchgLink; ExpressResearch, an image-enabled back office application; Source Capture, anapplication which enables customers to capture check images at corporate sites,bank branches and ATM’s; our next generation fraud application; and ananti-money laundering application. Considering these initiatives, we expect the total amount of researchand development costs to increase during the remainder of fiscal 2004.

 

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Softwaredevelopment costs of a product are capitalized from the time technologicalfeasibility is reached until the general release of the product.  We establish technological feasibilitythrough the process of creating a detailed program design and reviewing thedetailed program design for any high risk development issues.  Capitalization only occurs if we believecosts capitalized are recoverable through future sales of the software productunder development.

 

*Amortization of Intangible Assets:*

 

Amortizationof intangible assets was $350,000 for Q2 2004 and Q2 2003, and $700,000 for YTD2004 and YTD 2003.  The amortizationresults from the periodic recognition of amortization expense of intangiblecustomer relationships acquired in the Check Solutions acquisition.

 

*Restructuring and Other Charges:*  Werecorded various restructuring and other charges during the three months endedJuly 31, 2004 and 2003 as follows ($ in thousands):

 
| ** **                            | ** ** | **Workforce Reductions** | ** ** | **Charges  relating to  CheckFlow  Suite** | ** ** | **EPG  Litigation  Settlement** | ** ** | **Legal and  Professional  Fees** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|--------------------------|------------|--------------------------------------------|------------|---------------------------------|------------|-----------------------------------|------------|-----------|------------|
|                                  |       |                     |       |                                       |       |                            |       |                              |       |      |       |
| **YTD 2003:**                         |       |                     |       |                                       |       |                            |       |                              |       |      |       |
| Quarterly period ended April 30, 2003 |       | $                        | 545        |                                       | $          | —                          |       | $                                 | —     |      | $          | 139 |   | $ | 684 |   |
| Quarterly period ended July 31, 2003  |       | 648                      |       | —                                     |       | —                          |       | 130                               |       | 778       |       |
| Total YTD 2003                        |       | $                        | 1,193      |                                       | $          | —                          |       | $                                 | —     |      | $          | 269 |   | $ | 1,462 |   |
|                                  |       |                     |       |                                       |       |                            |       |                              |       |      |       |
| **YTD 2004:**                         |       |                     |       |                                       |       |                            |       |                              |       |      |       |
| Quarterly period ended April 30, 2004 |       | 308                      |       | —                                     |       | 1,686                           |       | 521                               |       | 2,515     |       |
| Quarterly period ended July 31, 2004  |       | 192                      |       | (1,215                                     | )          | 14                              |       | 1,206                             |       | 197       |       |
| Total YTD 2004                        |       | $                        | 500        |                                       | $          | (1,215                          | )          | $                                 | 1,700      |      | $          | 1,727 |   | $ | 2,712 |   |

 

**QuarterEnded April 30, 2003**

 

Werecorded $545,000 in restructuring and other charges during the three monthperiod ended April 30, 2003, principally associated with the separation of 17employees, within both the Corporate and Global Payments Consulting (“GPC”)business segments.  During the quarterlyperiod ended April 30, 2003, we recorded a charge of $139,000 relating to legaland professional fees relating to our restatement efforts and the legal actionsdescribed in Note 8.

 

**QuarterEnded July 31, 2003**

 

Werecorded $648,000 in restructuring and other charges during the three monthperiod ended July 31, 2003, principally associated with the separation of 9employees, within both the Corporate and GPC business segments.  During the quarterly period ended July 31,2003, we recorded a charge of $130,000 relating to legal fees relating to thelegal actions described in Note 8.

 

**QuarterEnded April 30, 2004**

 

Werecorded $308,000 in restructuring and other charges during the three monthperiod ended April 30, 2004, principally associated with the separation of 10employees.  During the quarterly periodended April 30, 2004, the Company recorded a charge of $521,000 relating tolegal and professional fees relating to our legal actions described in Note8.  Approximately, $462,000 of the$521,000 of legal and professional fees were recorded as selling, general andadministrative costs during the quarter ended April 30, 2004 and reclassifiedto restructuring and other charges in the quarter ended July 31, 2004.

 

TheCompany expensed approximately $1.7 million for compensatory damages to EPGafter the jury returned a verdict in favor of EPG on one claim and Carreker onthree claims.

 

39

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**QuarterEnded July 31, 2004**

 

Werecorded $192,000 in restructuring and other charges during the three monthperiod ended July 31, 2004, principally associated with the separation of 8employees.  During the quarter ended July31, 2004, we recorded a charge of $36,000 relating to legal and professionalfees relating to our shareholder legal actions described in Note 8.

 

OnJuly 8, 2004, we settled with EPG for $1.7 million.  An additional $14,000 was expensed and thesettlement paid to the plaintiff. Additionally, we recorded a charge for the litigation costs related tothis legal action totaling $1.2 million.

 

Finally,we received a final payment of $455,000 from a customer in the final settlementwith one of our original CheckFlow Suite customers.  This payment was recorded directly to thisreserve.  Concurrently, based on revisedcost estimates, we lowered our estimate of the cost to develop and install anyadditional software, or software modifications, with these customers andreversed approximately $1.2 million of this reserve.

 

Theactivity related to the accrued merger and restructuring costs during the threeand six months ended July 31, 2004 is as follows (in thousands):

 
| ** **                      | ** ** | **Workforce  Reductions** | ** ** | **Charges  relating to  CheckFlow  Suite** | ** ** | **Facility  Closures** | ** ** | **Other** | ** ** | **Total** | ** ** |
|---------------------------------|------------|---------------------------|------------|--------------------------------------------|------------|------------------------|------------|-----------|------------|-----------|------------|
|                            |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Balance at January 31, 2004     |       | $                         | 500        |                                       | $          | 1,296                  |       | $         | 5          |      | $          | 97 |   | $ | 1,898 |   |
|                            |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Additions to reserve balance:   |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Severance charges               |       | 308                       |       | —                                     |       | —                 |       | —    |       | 308       |       |
| Reductions to reserve balances: |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Cash paid                       |       | (412                      | )          | (29                                        | )          | —                 |       | (5        | )          | (446      | )          |
| Balance at April 30, 2004       |       | $                         | 396        |                                       | $          | 1,267                  |       | $         | 5          |      | $          | 92 |   | $ | 1,760 |   |
|                            |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Additions to reserve balance:   |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Severance charges               |       | 192                       |       | —                                     |       | —                 |       | —    |       | 192       |       |
| Cash received from customer     |       | —                    |       | 455                                        |       | —                 |       | —    |       | 455       |       |
| Reductions to reserve balances: |       |                      |       |                                       |       |                   |       |      |       |      |       |
| Cash paid                       |       | (495                      | )          | (149                                       | )          | —                 |       | (12       | )          | (656      | )          |
| Change in estimate              |       | —                    |       | (1,215                                     | )          | —                 |       | —    |       | (1,215    | )          |
| Balance at July 31, 2004        |       | $                         | 93         |                                       | $          | 358                    |       | $         | 5          |      | $          | 80 |   | $ | 536 |   |

 

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***Other Income (Expense):***

 

*Interest Income ($ in thousands):*

 
| ** **      | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|-----------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **      | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|            |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Interest Income |       | $                                | 66         |         | $          | 73                             |       | $            | (7         | ) | (9.6 | )% | $ | 115 |   | $ | 154 |   | $ | (39 | ) | (25.3 | )% |
|                 |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interestincome consists of interest earned on cash and cash equivalents.  The decrease is primarily the result of lowerinterest rates.

 

*Interest Expense ($ in thousands):*

 
| ** **       | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **       | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|             |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Interest Expense |       | $                                | 121        |         | $          | 339                            |       | $            | (218       | ) | (64.3 | )% | $ | 230 |   | $ | 757 |   | $ | (527 | ) | (69.6 | )% |
|                  |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interestexpense is primarily the result of borrowings under our $30.0 million revolvingcredit agreement.  Additionally, theamortization of the deferred loan costs are also included in interestexpense.  The decline is attributable toless outstanding borrowings under the revolving credit agreement on a quarterlyand YTD basis in 2004, as compared to 2003.

 

*Other income ($ in thousands):*

 
| ** **                                                  | ** ** | **Three Months Ended  July 31,** | ** ** | **Variance** | ** ** | **Six Months Ended  July 31,** | ** ** | **Variance** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------|------------|--------------|------------|
| ** **                                                  | ** ** | **2004**                         | ** ** | **2003**     | ** ** | **$**                          | ** ** | **%**        | ** ** | **2004** | ** ** | **2003** | ** ** | **$** | ** ** | **%** | ** ** |
|                                                        |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Gain on sale of Cash Services Australia  Pty. Limited       |       | $                                | —     |         | $          | —                         |       | $            | —     |   | — |   | $ | 539 |   | $ | — |   | 539 |   | — | % |
| Equity in earnings of Cash Services  Australia Pty. Limited |       | —                           |       | 2            |       | (2                             | )          | —       |       | (17 | ) | 74 |   | (91 | ) | (123.0 | )% |
| Minority share of net loss of Carretek LLC                  |       | 133                              |       | —       |       | 133                            |       | —       |       | 219 |   | — |   | 219 |   | — | % |
| Foreign exchange gains (losses)                             |       | (159                             | )          | 34           |       | (193                           | )          | 567.6        | %          | (288 | ) | (47 | ) | (241 | ) | (512.8 | )% |
| Other                                                       |       | (1                               | )          | —       |       | 1                              |       | 50.0         | %          | 4 |   | 23 |   | (19 | ) | (82.6 | )% |
|                                                        |       |                             |       |         |       |                           |       |         |       |   |   |   |   |   |   |   |   |
| Total                                                       |       | $                                | (27        | )            | $          | 36                             |       | $            | (61        | ) | (179.4 | )% | $ | 457 |   | $ | 50 |   | $ | 407 |   | 814.0 | % |
|                                                             |            |                                  |            |              |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

InApril 2004, we sold our 25% interest in Cash Services Australia Pty.Limited.  The carrying value of ourinvestment was approximately $383,000 and we received $922,000 in proceedscollected in May 2004.  As a result ofthis transaction, we recorded a $539,000 gain.

 

DuringQ2 2003, we formed Carretek LLC (“Carretek”), in which the Company owns a 51%interest, to offer financial institutions off-shore centric outsourcing oftheir business processes.  To date,Carretek has generated minimal revenue and accordingly, the 49% share, or$133,000 on a quarterly basis and $219,000 on a YTD basis of the minorityinterest in this loss was recorded in other income (expense.)

 

41

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*Provision for Income Taxes:*

 

TheCompany has established a valuation allowance to reserve its net deferred taxassets at July 31, 2004 because the more likely than not criteria for futurerealization of the Company’s net deferred tax assets specified in Statements ofFinancial Accounting Standards No. 109, “*Accountingfor Income Taxes,”* (“SFAS No. 109”) were not met.

 

Thenet tax provision was $350,000 for the three and six months ended July 31, 2004and consists of a provision for foreign taxes. The provision was primarily the result of a change in estimate for prioryear foreign taxes owed.  The net taxprovision of $133,000 and $226,000 for the three and six months ended July 31,2003, respectively, consists of a provision for foreign and state taxes.  No U.S. Federal income tax benefit wasrecorded at July 31, 2004 due to the uncertainty regarding the Company’sability to generate taxable income, and resulting uncertainty relative to therecoverability of deferred tax assets.

 

InMay 2004, the federal tax law changed to allow software license revenue to bedeferred for tax purposes similar to the percent-complete revenue recognitionmodel we use for financial statement purposes. The impact of this change in the tax law will most likely increase theamount of the net operating loss carryforwards and thereby further reduce oureffective tax rate at such time as we begin to generate taxable income.

 

**Liquidity and Capital Resources**

 

Historically,we have funded our operations and cash expenditures primarily with cashgenerated from operating activities.  AtJuly 31, 2004, we had working capital of $9.5 million compared to $11.7 millionat January 31, 2004.  We had $28.5 millionin cash and cash equivalents at July 31, 2004, a decrease of $100,000 from$28.6 million in cash and cash equivalents at January 31, 2004.  At July 31, 2004, we had no long-term debtcompared to $6.3 million at January 31, 2004. We expect that existing cash and cash generated from operatingactivities will be sufficient to meet our presently anticipated requirementsfor the foreseeable future.

 

Cashused in operating activities was $2.3 million in the three months ended July31, 2004 compared to cash provided by operating activities of $1.8 million inthe three months ended July 31, 2003. The decrease is primarily the result of the payment of the $1.7 millionEPG legal settlement and payment of $1.0 million of the approximately $1.2million of legal fees expensed during the three months ended July 31,2004.  Cash provided by operatingactivities was $7.5 million in the six months ended July 31, 2004, compared tocash provided by operating activities of $14.0 million in the six months endedJuly 31, 2003.  Operating cash flowsdecreased as a result of the EPG litigation settlement of $1.7 million, relatedlegal costs of $1.6 million and $4.7 million decline in deferred revenue,especially deferred maintenance revenue during the six months ended July 31, 2004.

 

Average days’ sales outstanding fluctuate for a varietyof reasons, including the timing of billings specified by contractualagreement, and receivables for expense reimbursements.  The following table contains the quarterlydays’ sales outstanding (DSO):

 
| **Quarter ended** | ** ** | **DSO** |
|-------------------|------------|---------|
| July  31, 2004    |       | 46      |
| April  30, 2004   |       | 46      |
| January  31, 2004 |       | 59      |
| October  31, 2003 |       | 56      |
| July  31, 2003    |       | 43      |

 

Cashused in investing activities during the three months ended July 31, 2004 was$1.8 million compared to $259,000 during the three months ended July 31, 2003,and was primarily related to $1.1 million of purchases of software andequipment along with $698,000 of capitalized software costs.  Cash used in investing activities during thesix months ended July 31, 2004 was $3.0 million, compared to $570,000 duringthe six months ended July 31, 2003, and was primarily related to $1.4 millionof purchases of software and equipment and $1.6 million of capitalizedsoftware.  We expect capital expenditurepurchases to decrease in future quarters in fiscal 2004 as our project toreplace certain developmental hardware and software within our technology groupbased in Charlotte, NC is nearing completion.

 

42

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Financingactivities provided cash of $1.1 million in the three months ended July 31,2004, and used cash of $3.0 million in the three months ended July 31,2003.  AtJuly 31, 2004, we had no outstanding debt and the cash provided by financingactivities was the result of $950,000 of proceeds from stock option exercisesand the receipt of $113,000 related to the minority interest and shareholderloan associated with Carretek LLC. During the three months ended July 31, 2003, cash used in financing activitiesincluded a $2.5 million payment on our revolving credit agreement and anadditional $456,000 of loan costs associated with the amendment to therevolving credit agreement completed in July 2003.  The cash used in financing activities in thesix months ended July 31, 2004 was $4.7 million and the cash used in financingactivities in the six months ended July 31, 2003 was $13.0 million.  The cash used during the six months endedJuly 31, 2004 was primarily a $6.3 million debt payment, offset by $1.3 millionof proceeds from the exercise of stock options and $260,000 received related tothe minority interest and shareholder loan associated with Carretek LLC.  The cash used during the six months endedJuly 31, 2003 included a $12.5 million debt payment and the $456,000 ofdeferred loan costs to amend our revolving credit agreement completed in July2003.

 

Weare a party to a revolving credit agreement with a group of banks providing fora commitment amount of $30.0 million and a maturity date of July 31, 2006.  At July 31, 2004, the Company did not haveany borrowings outstanding.  At July 31,2003, we had outstanding borrowings of $12.5 million under the creditagreement.  Borrowings under the creditagreement currently bear interest equal to either the greater of prime orfederal funds rate plus a margin ranging from 1.25% to 2.25% depending on ourratio of funded debt to Earnings Before Interest, Taxes, Depreciation andAmortization (“EBITDA”); or London Interbank Offered Rate (“LIBOR”) plus amargin equal to 2.75% to 3.75% depending on our ratio of funded debt toEBITDA.  Interest payments are duequarterly.  We are required to pay acommitment fee equal to 0.50% on the unused amount of the revolving creditagreement.  The revolving creditagreement contains customary affirmative and negative covenants, some of whichhave been amended, including financial covenants requiring the maintenance ofspecified interest coverage, ratio of EBITDA to funded debt, and ratio of 80%of accounts receivable, cash and short-term investments to funded debt.  Additionally, the payment of dividends isprecluded subject to the approval of the banks. Substantially all of our assets collateralize this revolving creditagreement.  As of July 31, 2004, we arein compliance with the covenants of the revolving credit agreement, as amended.

 

Thefollowing summarizes our contractual obligations at July 31, 2004 and theeffect these contractual obligations are expected to have on our liquidity andcash flows in future periods (in thousands):

 
| ** **       | ** ** | **Payments Due by Period** | ** ** |
|------------------|------------|----------------------------|------------|
| ** **       | ** ** | **Total**                  | ** ** | **1 Year  or Less** | ** ** | **Years 2-3** | ** ** | **Years 4-5** | ** ** | **After  5 Years** | ** ** |
|             |       |                       |       |   |   |   |   |   |   |   |   |
| Operating leases |       | $                          | 15,749     |   | $ | 4,080 |   | $ | 5,778 |   | $ | 4,503 |   | $ | 1,388 |   |
|                  |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

Webelieve that current cash balances and expected future cash flows will besufficient to meet our anticipated cash needs for working capital, capitalexpenditures and other activities during fiscal 2004.  However, if current sources are notsufficient to meet our needs, we may seek additional equity or debt financing.  There can be no assurance that additionalfinancing would be available on acceptable terms, if at all.  We are presently involved in a number oflawsuits.  The final outcomes orresolutions of the lawsuits are unknown, but could include judgments againstus, or settlements that could require additional substantial payments byus.  See Note 8 in our Notes to CondensedConsolidated Unaudited Financial Statements. The timing of the final resolution of these matters is uncertain.  We believe that a material adverse outcome oroutcomes with respect to the lawsuits could have a material adverse effect onour financial results, our business or our management including but not limitedto, significantly impacting our liquidity in a negative manner as well ascausing covenant violations under our revolving credit agreement, possiblyresulting in a default thereunder. Further, we may in the future pursue acquisitions of businesses,products or technologies that could complement or expand our business andproduct offerings, and could change our financing needs.  Our forecast of the period of time throughwhich our financial resources will be adequate to support our operations is aforward looking statement that involves risks and uncertainties, and actualresults could vary.  The failure tosecure additional financing when needed could have a material adverse effect onour business, financial condition and results of operations.

 

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**Critical Accounting Policies**

 

In preparing our condensed consolidated financial statements inconformity with accounting principles generally accepted in the United States,we use certain estimates and assumptions that affect the reported amounts andrelated disclosures and our estimates may vary from actual results.  We consider the following seven accountingpolicies the most important to the portrayal of our financial condition andthose that require the most subjective judgment.  Although we believe that our estimates andassumptions are reasonable, actual results may differ, and such differencescould be significant to our financial results.

 

RevenueRecognition

 

Ourrevenue recognition policies are in accordance with Statement of Position(“SOP”) 97-2, *“Software RevenueRecognition,”* as amended by SOP 98-9, “*Modification of SOP 97-2, Software Revenue Recognition with Respect toCertain Transactions,”* and Staff Accounting Bulletin (“SAB”) No.101, *“Revenue Recognition in FinancialStatements,”* SAB No. 104,**RevenueRecognition and Emerging Issues Task Force (“EITF”) No. 00-21,*“Revenue Arrangements with Multiple Deliverables.”* In the case of software arrangements thatrequire significant production, modification, or customization of software, orthe license agreement requires us to provide implementation services that aredetermined to be essential to other elements of the arrangement, we follow theguidance in SOP 81-1, *“Accounting forPerformance of Construction – Type and Certain Production – Type Contracts.”*

 

*Consulting Fees.*  We employ three primary pricing methods inconnection with our delivery of consulting services. First, we may price ourdelivery of consulting services on the basis of time and materials, in whichcase the customer is charged agreed-upon daily rates for services performed andout-of-pocket expenses. In this case, we are generally paid fees and relatedamounts usually on a monthly basis, and we recognize revenues as the servicesare performed. Second, we may deliver consulting services on a fixed-pricebasis. In this case, we are generally paid on a monthly basis or pursuant to anagreed upon payment schedule, and we recognize revenues on apercentage-of-completion basis. We believe that this method is appropriatebecause of our ability to determine performance milestones and determinedependable estimates of our costs applicable to each phase of a contract.  Because financial reporting of thesecontracts depends on estimates, which are assessed continually during the termof the contract, costs are subject to revisions as the contractprogresses.  Anticipated losses onfixed-priced contracts are recognized when estimable.  Third, we may deliver consulting servicespursuant to a value-priced contract with the customer. In this case, we arepaid, on an agreed upon basis with the customer, either a specified percentageof (1) the projected increased revenues and/or decreased costs that areexpected to be derived by the customer generally over a period of up to twelvemonths following implementation of our solution or (2) the actual increasedrevenues and/or decreased costs experienced by the customer generally over aperiod of up to twelve months following implementation of our solution, subjectin either case to a maximum, if any is agreed to, on the total amount ofpayments to be made to us.  We must firstcommit time and resources to develop projections associated with value-pricingcontracts before a bank will commit to purchase our solutions, and we thereforeassume the risk of making these commitments with no assurance that the customerwill purchase the solution.  Costsassociated with these value-pricing contracts are expensed as incurred**.** These contracts typically include payments to be made to us pursuant toan agreed upon schedule ranging from one to twelve months in length. Werecognize revenues generated from consulting services in connection withvalue-priced contracts based upon projected results only upon completion of allservices and agreement upon the actual fee to be paid (even though billings forthese services may be delayed by mutual agreement for periods not to exceedtwelve months). In an effort to allow customers to more closely match expectedbenefits from our services with payments to us, we may on occasion, offerpayment terms which extend beyond 12 months. When we enter into an agreement that has a significant component of thetotal amount payable under the agreement due beyond 12 months or if it isdetermined payments are not fixed and determinable at the date the agreement isentered into, revenue under the arrangement will be recognized as paymentsbecome due and payable.  When fees are tobe paid based on a percentage of actual revenues and/or savings to ourcustomers, we recognize revenues only upon completion of all services and asthe amounts of actual revenues or savings are confirmed by the customer with afixed payment date.

 

Costs associated with time and materials, fixed-pricedand value-priced consulting fee arrangements are expensed as incurred and areincluded as a component of the cost of consulting fees.

 

Weexpect that value-priced contracts will continue to account for a significantportion of our revenues in the future. As a consequence of the use ofvalue-priced contracts and due to the revenue recognition policy associatedwith those contracts, our results of operations will likely fluctuatesignificantly from period to period.

 

Regardlessof the pricing method employed by us in a given contract, we are typicallyreimbursed on a monthly basis for out-of-pocket expenses incurred on behalf ofour customers.

 

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*Software License Fees.*  A software license is sold either togetherwith implementation services or on a stand-alone basis.  We are usually paid software license fees inone or more installments, as provided in the customer’s contract but not toexceed 12 months.  We recognize softwarelicense revenue upon execution of a contract and delivery of the software,provided that the license fee is fixed and determinable, no significant production,modification or customization of the software is required and collection isconsidered probable by management.  Whenthe software license arrangement requires us to provide implementation servicesthat are essential to the functionality of the software or significantproduction, customization or modification of the software is required, both theproduct license revenue and implementation fees are recognized as services areperformed.

 

In certain instances, especially with recently developedsoftware, we defer software license revenue recognition until the services arecompleted and the project is accepted by the customer.  This practice is followed for the first twoinstallations of a recently developed software product.  After two successful implementations, theproduct is considered generally available (“GA”).

 

Software licenses are often sold as part of a multipleelement arrangement that may include maintenance, implementation orconsulting.  We determine whether thereis vendor specific objective evidence of fair value (“VSOEFV”) for each elementidentified in the arrangement to determine whether the total arrangement feescan be allocated to each element.  IfVSOEFV exists for each element, the total arrangement fee is allocated based onthe relative fair value of each element. In cases where there is not VSOEFV for each element, or if it isdetermined services are essential to the functionality of the software beingdelivered, or if significant production, modification or customization of thesoftware is required, we initially defer revenue recognition of the softwarelicense fees until VSOEFV is established or the services are performed.  However, if VSOEFV is determinable for all ofthe undelivered elements, and assuming the undelivered elements are notessential to the delivered elements, we will defer recognition of the full fairvalue related to the undelivered elements and recognize the remaining portionof the arrangement value through application of the residual method.  Where VSOEFV has not been established forcertain undelivered elements, revenue for all elements is deferred until thoseelements have been delivered or their fair values have been determined.  Evidence of VSOEFV is determined for softwareproducts based on actual sales prices for the product sold to a similar classof customer and based on pricing strategies set forth in our price book.  Evidence of VSOEFV for services(installation, implementation and consulting) is based upon standard billingrates and the estimated level of effort for individuals expected to perform therelated services.  We establish VSOEFVfor maintenance agreements using the percentage method such that VSOEFV formaintenance is a percentage of the license fee charged annually for specificsoftware product, which in most instances is 20% of the portion of arrangementfees allocated to the software license element.

 

Althoughsubstantially all of our current software licenses provide for a fixed-pricelicense fee, some licenses provide for the customer to pay a monthly licensefee based on the actual use of the software product.  The level of license fees earned by us underthis arrangement will vary based on the actual amount of use by thecustomer.  Revenue under thesearrangements is recognized on a monthly basis as the usage becomes determinable.

 

*Software Maintenance Fees.*  In connection with our sale of a softwarelicense, a customer may elect to purchase software maintenance services. Mostof the customers that purchase software licenses from us also purchase softwaremaintenance services, which typically are renewed annually. We charge an annualmaintenance fee, which is typically a percentage of the initial softwarelicense fee. The annual maintenance fee generally is paid to us at thebeginning of the maintenance period, and we recognize these revenues ratablyover the term of the related contract. If the annual maintenance fee is not paid at the beginning of themaintenance period, we defer revenue recognition until the time that themaintenance fee is paid by the customer. We normally continue to provide maintenance service while awaitingpayment from customers.  When the paymentis received, revenue is recognized for the period that revenue was previouslydeferred.  This may result in volatilityin software maintenance revenue from period-to-period.

 

*Software Implementation Fees.*  In connection with the sale of a softwarelicense, a customer may elect to purchase software implementation services,including software enhancements and other software services.  Most of the customers that purchase softwarelicenses from us also purchase software implementation services.  We price our implementation services on atime-and-material or on a fixed-price basis, and we recognize the relatedrevenues as services are performed. Costs associated with these engagements are expensed as incurred.

 

Ourcontracts typically do not include right ofreturn clauses, and as a result, we do not record a provision for returns.

 

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Royalties

 

In connection with software license and maintenanceagreements entered into with certain banks and purchase agreements with vendorsunder which we acquired software technology used in products sold to itscustomers, we are required to pay royalties on sales of certain softwareproducts.  Under these arrangements, weaccrue royalty expense when the associated revenue is recognized.  For current product offerings, the royaltypercentages generally range from 20%-50% of the associated revenues.  Royalty expense is included as a component ofthe cost of software license fees and cost of software maintenance fees in theaccompanying condensed consolidated statement of operations.

 

Allowancefor Doubtful Accounts

 

Alarge proportion of our revenues and receivables are attributable to ourcustomers in the banking industry.  Ourtrade accounts receivable balance is recorded net of allowances for amounts notexpected to be collected from our customers. Because our accounts receivable are typically unsecured, we periodicallyevaluate the collectibility of our accounts based on a combination of factors,including a particular customer’s ability to pay as well as the age ofreceivables.  In cases where the evidencesuggests a customer may not be able to satisfy its obligation to us or if thecollection of the receivable becomes doubtful due to a dispute that arisessubsequent to the delivery of our products and services, we set up a specificreserve in an amount we determine appropriate for the perceived risk.  If circumstances change, such as higher thanexpected defaults or an unexpected material adverse change in a customer’sability to meet their financial obligations to us, our estimates ofrecoverability of amounts due us could be reduced by a material amount.

 

SoftwareCosts Capitalized, Goodwill, Other Intangible Assets and Other Long-LivedAssets

 

Softwarecosts capitalized include developed technology acquired in acquisitions andcosts incurred by us in developing our products that qualify forcapitalization.  We capitalize our softwaredevelopment costs, other than costs for internal-use software, in accordancewith Statement of Financial Accounting Standards No. 86, “*Accounting for Costs of Computer Software to be Sold,Leased or Otherwise Marketed”* (“SFAS 86”).  Our policy is to capitalize softwaredevelopment costs incurred in developing a product once technologicalfeasibility of the product has been established.  Software development costs capitalized alsoinclude amounts paid for purchased software on products that have reached technologicalfeasibility. Technological feasibility of the product is determined aftercompletion of a detailed program design and a determination has been made thatany uncertainties related to high-risk development issues have been resolved.If the process of developing the product does not include a detailed programdesign, technological feasibility is determined only after completion of aworking model. All capitalized software development costs are amortized usingan amount determined as the greater of: (1) the ratio that current grossrevenues for a capitalized software project bears to the total of current andfuture projected gross revenues for that project or (2) the straight-linemethod over the remaining economic life of the product (generally three to sixyears).

 

Goodwilland intangibles with indefinite lives are assessed on an annual basis forimpairment at the reporting unit level by applying a fair value basedtest.  We performed the initialimpairment test of goodwill and intangibles with indefinite lives assets atFebruary 1, 2002 and a follow up test at November 1, 2002 to determine if animpairment charge should be recognized under SFAS 142.  The initial impairment analysis did notresult in any write-down of capitalized costs. We perform an annual impairment assessment on November 1st ofeach year or when factors indicate that other long-lived assets should beevaluated for possible impairment.  Weuse an estimate of undiscounted future net cash flows over the remaining lifeof the asset to determine if impairment has occurred.  Assets are grouped at the lowest level forwhich there are identifiable cash flows that are largely independent from otherasset groups.  An impairment in thecarrying value of an asset is assessed when the undiscounted, expected futureoperating cash flows derived from the asset are less than its carryingvalue.  Management believes thatassumptions used to determine cash flows are reasonable, but actual future cashflows may differ from those estimated. If we determine an asset has been impaired, the impairment is recordedbased on the estimated fair value of the impaired asset.  During the fourth quarter of the year endedJanuary 31, 2004, we performed our annual evaluation for goodwill impairmentand determined that the carrying amount of goodwill was not impaired and havenot noted any factors subsequent that would indicate impairment.  Goodwill at July 31, 2004 totaled $20.8million.  Any deterioration in marketconditions, increases in interest rates and changes in our projections withrespect to the Global Payments Technologies reporting unit to which goodwill isallocated would result in additional impairment charges in the future.

 

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Restructuring and Other Charges

 

Duringfiscal year 2001, we recorded reserves in connection with our acquisition ofCheck Solutions and subsequent operational restructurings.  Additional reserves were recorded duringfiscal 2002, 2003 and the first two quarters of 2004.  These reserves contain significant estimatespertaining to work force reductions, and the settlement of contractualobligations resulting from our actions. In Q2 2004, we revised our estimate to complete our remaining costs todevelop and install any additional software, or software modifications, withtwo customers and reversed approximately $1.2 million of our reserve.  Although we do not anticipate any significantchanges, the actual costs may differ from these estimates.

 

Contingencies

 

Weare subject to proceedings, lawsuits and other claims.  We are required to assess the likelihood ofany adverse judgments of outcomes to these matters as well as potential rangesof probable losses.  A determination ofthe amount or reserves required, if any, for these contingencies is made aftercareful analysis of each individual issue. The required reserves may change in the future due to new developmentsin each matter or changes in insurance coverage or approach such as change in settlementstrategy.

 

Income Taxes

 

Werecognize deferred tax assets or liabilities for the expected future taxconsequences of temporary differences between the book and tax basis of assetsand liabilities.  We review our deferredtax assets for recoverability and establish a valuation allowance based onhistorical taxable income, projected future taxable income and the expectedtiming of the reversals of existing temporary differences.  As a result of our cumulative net losses wehave provided a full valuation allowance against our net deferred taxassets.  In addition, we expect toprovide a full valuation allowance of any future tax benefits until we cansustain a level of profitability that demonstrates our ability to utilize theseassets.

 

RecentlyIssued Accounting Standards

 

See“Recently Issued Accounting Standards” in Note 2 of the Condensed ConsolidatedUnaudited Financial Statements.

 

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**Item3.  Quantitative and QualitativeDisclosures About Market Risk**

 

**Interest Rate Risk**

 

Weinvest our cash in a variety of financial instruments.  These investments are denominated in U.S.dollars and maintained with nationally recognized financial institutions, andmutual fund companies.

 

Weaccount for our investment instruments in accordance with Statement ofFinancial Accounting Standards No. 115, *“Accountingfor Certain Investments in Debt and Equity Securities”* (“SFAS115”).  We treat all of our cashequivalents and short-term investments as available-for-sale under SFAS 115.

 

Investmentsin both fixed rate and floating rate interest earning instruments carry adegree of interest rate risk.  Fixed ratesecurities may have their fair market value adversely impacted due to a rise ininterest rates, while floating rate securities may produce less income thanexpected if interest rates fall.  Due inpart to these factors, our future investment income may fall short ofexpectations due to changes in interest rates, or we may suffer losses inprincipal if forced to sell securities which have seen a decline in marketvalue due to changes in interest rates. Our investment securities are held for purposes other than trading.  At July 31, 2004, we did not hold anyfixed-rate investments.

 

We had no outstanding borrowings under our revolvingcredit agreement at July 31, 2004.  Asdescribed in Note 4 of our Notes to Condensed Consolidated Unaudited FinancialStatements, the interest rate under the revolving credit agreement is variable.

 

**Foreign Currency Risk**

 

Wecurrently have sales and marketing operations in several internationallocations including Canada, United Kingdom, South Africa and Australia.  As a result, we have assets and liabilitiesoutside the United States that are subject to fluctuations in foreign currency exchangerates.  Due to the nature of theseoperations, we currently utilize the U.S. Dollar as the functional currency forall international operations.

 

Aninsignificant portion of our accounts receivable balance at July 31, 2004, wasdenominated in a foreign currency.  Ourexposure to adverse movements to foreign exchange rates is notsignificant.  Therefore, we do notcurrently hedge our foreign currency exposure; however, we do try to limit ourforeign currency exposure by negotiating these foreign contracts in U.S.Dollars.  We will continue to evaluatethe need to adopt a hedge strategy in the future and may implement a formalstrategy if our business transacted in foreign currencies increases.

 

Foreignexchange gains and losses were a $159,000 loss and a $34,000 gain for the threemonths ended July 31, 2004 and 2003, respectively, and a $288,000 loss and a$47,000 loss for the six months ended July 31, 2004 and 2003, respectively.

 

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**Item4.  Controls and Procedures**

 

*Disclosure Controls*

 

Wemaintain disclosure controls and procedures designed to ensure that we are ableto collect the information we are required to disclose in the reports we filewith the SEC, and to process, summarize and disclose this information withinthe time periods specified in the rules of the SEC.

 

Ourmanagement, under the supervision and with the participation of our ChiefExecutive and Chief Financial Officers, is responsible for evaluating theeffectiveness of our disclosure controls and procedures.  As of July 31, 2004, they carried out anevaluation of our disclosure controls and procedures, and the Chief Executiveand Chief Financial Officers believe that these controls and procedures areeffective to ensure that we are able to collect, process and disclose the informationwe are required to disclose in the reports we file with the SEC within therequired time periods.

 

Indesigning and evaluating the disclosure controls and procedures, managementrecognized that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management necessarily was required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.

 

*Internal Controls*

 

Therehave been no changes in our internal control over financial reporting duringour most recently completed fiscal quarter that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

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**PARTII:  OTHER INFORMATION**

 

**ITEM1.****                                  LEGALPROCEEDINGS**

 

Exceptas noted below, the information contained in Part I, Item 3. Legal Proceedingsin our Form 10-K for the period ended January 31, 2004 is hereby incorporatedby reference.

 

OnJuly 8, 2004 Carreker Corporation and Earnings Performance Group (“EPG”)amicably resolved the action that EPG filed against Carreker in September 1998,which was pending in the United States District Court for the District of NewJersey, to the satisfaction of both parties.

 

OnJune 15, 2004, by mutual agreement between the parties, Civil Action No.303CV1211-M was reinstated in the United States District Court for the NorthernDistrict of Texas, Dallas Division. This action was originally filed on May 29,2003, in the United States District Court for the Northern District of Texas,Dallas Division as Civil Action no. 303CV1211-D. On January 15, 2004, theCourt, acting upon the joint motion of the parties, dismissed the actionwithout prejudice. This action was brought as a shareholders’ derivative actionpursuant to Rule 23.1, Fed.R.Civ.P. for the benefit of Nominal DefendantCarreker Corporation against certain of its current and former officers anddirectors, i.e., John D. Carreker, Jr., James D. Carreker, Richard R.Lee, Jr., James L. Fischer, Donald L. House, David K. Sias, Terry L. Gage,James R. Erwin, Ronald G. Steinhart and Ronald Antinori, seeking to remedytheir individual breaches of fiduciary duty, including their knowing violationsof Generally Accepted Accounting Principles (“GAAP”), knowing violations offederal and state securities laws, acts of bad faith and other breaches offiduciary duty. The plaintiff seeks redress (the form of, among others, unspecifiedamounts of compensatory damages, interest and costs, including legal fees) forinjuries to the Company and its shareholders caused by Defendants’ misfeasanceand/or malfeasance during the period from May 20, 1998 through December 10,2002.

 

**ITEM2.****                                  UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

None.

 

**ITEM3.****                                  DEFAULTSUPON SENIOR SECURITIES**

 

None.

 

**ITEM4.****                                  SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

At our Annual Meeting of Stockholders held on June 15, 2004, twoproposals were adopted by our stockholders: (1) the election of four directorsas Class III directors for terms expiring at the Annual Meeting of Stockholdersin 2007 as described in our Proxy Statement for the Annual Meeting (Messrs.James D. Carreker, Keith W. Hughes, David K. Sias, and Ronald G. Steinhart werere-elected as directors), and (2) the ratification of the appointment of Ernst& Young LLP as independent certified public accountants of the Company forthe fiscal year ending January 31, 2005. The number of shares cast for and against as well as the number ofabstentions as to each of these matters (other than the election of directors)are as follows:

 
| **Election of Directors** | ** ** | **Shares For** | ** ** | **Shares Withheld** | ** ** |
|---------------------------|------------|----------------|------------|---------------------|------------|
|                      |       |           |       |                |       |
| James D. Carreker         |       | 22,576,344     |       | 475,483             |       |
| Keith W. Hughes           |       | 22,485,611     |       | 566,216             |       |
| David K. Sias.            |       | 22,487,495     |       | 564,332             |       |
| Ronald G. Steinhart.      |       | 22,450,711     |       | 601,116             |       |

 
| **Proposal**                | ** ** | **Shares For** | ** ** | **Shares Against** | ** ** | **Abstentions** | ** ** |
|-----------------------------|------------|----------------|------------|--------------------|------------|-----------------|------------|
|                        |       |           |       |               |       |            |       |
| Ratification of accountants |       | 22,930,600     |       | 69,150             |       | 52,077          |       |

 

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**ITEM 5.****                                 ****OTHER INFORMATION**

 

Fromtime to time management provides information regarding our contracted sales andour backlog for contracted services, contracted contingent services, contractedlicenses and contracted maintenance. Management also provides our expectations with regard to the realizationof revenue from such contracted sales and backlog.  These expectations can be influenced by manyfactors, some of which are beyond our control, and include but are not limitedto the following:

 

•                  Customer implementation timelines andschedules

 

•                  Customer budget cycles and priorities

 

•                  Our ability to develop new technologies andservices in a timely manner

 

•                  Customer acceptance of our new technologiesor services

 

•                  Receipt of cash payment

 

**ITEM6.****                             EXHIBITS**

 
| **Number** | ** ** | **Exhibit Description**                                                                                                  |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                     |
| 31.1       |       | Certification Pursuant to  Section 302(a) of the Sarbanes-Oxley Act of 2002                                              |
|       |       |                                                                                                                     |
| 31.2       |       | Certification Pursuant to  Section 302(a) of the Sarbanes-Oxley Act of 2002                                              |
|       |       |                                                                                                                     |
| 32.1       |       | Certification Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |
|       |       |                                                                                                                     |
| 32.2       |       | Certification Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |

 

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**SIGNATURES**

 

Pursuant to the requirements of theSecurities Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 

 
|   | CARREKER CORPORATION      |
|--------|---------------------------|
|   |                      |
|   |                      |
| By:    | /s/ John D. Carreker, Jr. |   |   | Date: |   September 9, 2004 |   |
|   | John D. Carreker, Jr.     |   |   |
|   | Chairman of the Board and |   |   |
|   | Chief Executive Officer   |   |   |
|   |                      |   |
|   |                      |   |
| By:    | /s/ Lisa K. Peterson      |   |   | Date: |   September 9, 2004 |   |
|   | Lisa K. Peterson          |   |   |
|   | Chief Financial Officer   |   |   |
|        |                           |  |  |  |  |  |  |

 

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