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SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q /X/ Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended June 30, 2004 or / / Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from          to Commission File Number: 1-11905 National Processing, Inc.  Ohio
(State or other jurisdiction
of incorporation or organization)
    
    61-1303983
(I.R.S. Employer Identification No.)
 1900 East Ninth Street
Cleveland, Ohio
(Address of principal executive offices)
    
    44114-3484
(Zip Code)
 (216) 222-3368
(Registrants telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES X  NO Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES X  NO The number of shares outstanding of the Registrants Common Stock as of July
31, 2004 was 53,213,224.




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NATIONAL PROCESSING, INC. INDEX Page No.Part I. Financial InformationItem 1. Consolidated Financial Statements (unaudited)Consolidated Balance Sheets  June 30, 2004,
December 31, 2003, and June 30, 2003
    
    
    3Consolidated Statements of Income  Three and Six Months
Ended June 30, 2004 and 2003
    
    
    4Consolidated Statement of Changes in Shareholders
Equity  Six Months Ended June 30, 2004
    
    
    5Consolidated Statements of Cash Flows -
Six Months Ended June 30, 2004 and 2003
    
    
    6Notes to Consolidated Financial Statements
    
    
    7Item 2. Managements Discussion and Analysis of
Financial Condition and Results of Operations
    
    
    17Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    26Item 4. Controls and Procedures
    
    
    26Part II. Other InformationItem 1. Legal Proceedings (None)
    
    
    27Item 2. Unregistered Sales of Equity Securities (None)
    
    
    27Item 3. Defaults Upon Senior Securities (None)
    
    
    27Item 4. Submission of Matters to a Vote of Security Holders
    
    
    27Item 5. Other Information (None)
    
    
    27Item 6. Exhibits and Reports on Form 8-K
    
    
    27Signatures
    
    
    30EX-10.32 Severance AgreementEX-10.33 Retention AgreementEX-10.34 Retention AgreementEX-31.1 Section 302 CertificationEX-31.2 Section 302 CertificationEX-32.1 Section 906 CertificationEX-32.2 Section 906 Certification
 2




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##### Table of Contents



National Processing, Inc. 
 Consolidated Balance Sheets
 June 30
    
    December 31
    
    June 302004
    
    2003
    
    2003AssetsCurrent assets:Cash and cash equivalents
    
    $
    290,650
    
    
    $
    246,957
    
    
    $
    214,806Accounts receivable  trade
    
    
    121,200
    
    
    
    136,346
    
    
    
    113,456Deferred tax assets
    
    
    4,568
    
    
    
    2,775
    
    
    
    1,396Other current assets
    
    
    7,709
    
    
    
    7,402
    
    
    
    9,606Total current assets
    
    
    424,127
    
    
    
    393,480
    
    
    
    339,264Property and equipment:Furniture and equipment
    
    
    54,111
    
    
    
    50,324
    
    
    
    51,641Building and leasehold improvements
    
    
    12,682
    
    
    
    12,490
    
    
    
    12,153Software
    
    
    44,629
    
    
    
    40,034
    
    
    
    39,702Property leased under capital leases
    
    
    5,285
    
    
    
    4,599
    
    
    
    4,173Land and improvements
    
    
    442
    
    
    
    442
    
    
    
    442117,149
    
    
    
    107,889
    
    
    
    108,111Less: Accumulated depreciation and amortization
    
    
    63,603
    
    
    
    57,238
    
    
    
    56,843Property and equipment, net
    
    
    53,546
    
    
    
    50,651
    
    
    
    51,268Other assets:Goodwill
    
    
    115,306
    
    
    
    115,306
    
    
    
    115,195Other intangible assets, net of accumulated amortization of $35,248,
$30,187 and $25,129 at June 30, 2004, December 31, 2003, and June 30,
2003, respectively
    
    
    38,251
    
    
    
    43,312
    
    
    
    48,070Deferred tax assets
    
    
    6,698
    
    
    
    13,117
    
    
    
    10,444Other assets
    
    
    6,235
    
    
    
    6,108
    
    
    
    4,061Total other assets
    
    
    166,490
    
    
    
    177,843
    
    
    
    177,770Total assets
    
    $
    644,163
    
    
    $
    621,974
    
    
    $
    568,302Liabilities and shareholders equityCurrent liabilities:Accounts payable  trade
    
    $
    26,362
    
    
    $
    26,426
    
    
    $
    23,612Accrued bankcard assessments
    
    
    29,636
    
    
    
    33,335
    
    
    
    24,562Accrued compensation and benefits
    
    
    3,816
    
    
    
    3,725
    
    
    
    2,583Income tax payable
    
    
    10,980
    
    
    
    11,693
    
    
    
    11,606Other accrued liabilities
    
    
    17,973
    
    
    
    20,295
    
    
    
    25,130Total current liabilities
    
    
    88,767
    
    
    
    95,474
    
    
    
    87,493Obligations under capital leases
    
    
    2,445
    
    
    
    1,945
    
    
    
    2,093Minority interest
    
    
    1,713
    
    
    
    2,772
    
    
    
    1,247Total liabilities
    
    
    92,925
    
    
    
    100,191
    
    
    
    90,833Shareholders equity:Preferred stock, without par value; 5,000,000 shares authorized; no
shares issued or outstanding
    
    
    
    
    
    
    
    
    
    
    Common stock, without par value; 95,000,000 shares authorized;
53,199,875, 53,113,009, and 52,245,178 issued and outstanding at
June 30, 2004, December 31, 2003, and June 30, 2003, respectively
    
    
    1
    
    
    
    1
    
    
    
    1Contributed capital
    
    
    217,632
    
    
    
    214,944
    
    
    
    200,120Stock-based compensation plans
    
    
    529
    
    
    
    112
    
    
    
    (230
    )Retained earnings
    
    
    333,076
    
    
    
    306,726
    
    
    
    277,578Total shareholders equity
    
    
    551,238
    
    
    
    521,783
    
    
    
    477,469Total liabilities and shareholders equity
    
    $
    644,163
    
    
    $
    621,974
    
    
    $
    568,302
 See notes to Consolidated Financial Statements 3




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National Processing, Inc. 
 Consolidated Statements of Income
 Three Months Ended
    
    Six Months EndedJune 30
    
    June 302004
    
    2003
    
    2004
    
    2003Revenue
    
    $
    132,623
    
    
    $
    113,614
    
    
    $
    254,837
    
    
    $
    219,568Operating expenses
    
    
    57,383
    
    
    
    50,209
    
    
    
    113,250
    
    
    
    101,755Assessments expense
    
    
    38,160
    
    
    
    32,963
    
    
    
    73,077
    
    
    
    64,169General and administrative expenses
    
    
    7,363
    
    
    
    5,748
    
    
    
    13,448
    
    
    
    10,054Depreciation and amortization
    
    
    5,742
    
    
    
    5,044
    
    
    
    11,435
    
    
    
    10,011Impairment, restructuring and related
expenses
    
    
    
    
    
    
    1,273
    
    
    
    
    
    
    
    1,273Operating profit
    
    
    23,975
    
    
    
    18,377
    
    
    
    43,627
    
    
    
    32,306Net interest income
    
    
    687
    
    
    
    830
    
    
    
    1,349
    
    
    
    1,672Income before provision for income taxes
and minority interest
    
    
    24,662
    
    
    
    19,207
    
    
    
    44,976
    
    
    
    33,978Provision for income taxes
    
    
    9,313
    
    
    
    7,444
    
    
    
    16,921
    
    
    
    13,139Income before minority interest
    
    
    15,349
    
    
    
    11,763
    
    
    
    28,055
    
    
    
    20,839Minority interest
    
    
    963
    
    
    
    697
    
    
    
    1,705
    
    
    
    1,226Net income
    
    $
    14,386
    
    
    $
    11,066
    
    
    $
    26,350
    
    
    $
    19,613Basic net income per common share
    
    $
    0.27
    
    
    $
    0.21
    
    
    $
    0.49
    
    
    $
    0.38Diluted net income per common share
    
    $
    0.27
    
    
    $
    0.21
    
    
    $
    0.49
    
    
    $
    0.37
 See notes to Consolidated Financial Statements 4




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National Processing, Inc. 
 Consolidated Statement of Changes in Shareholders Equity
 Stock-BasedCommon
    
    Common
    
    Contributed
    
    Compensation
    
    RetainedShares
    
    Stock
    
    Capital
    
    Plans
    
    Earnings
    
    TotalBalance at January 1, 2004
    
    
    53,113,009
    
    
    $
    1
    
    
    $
    214,944
    
    
    $
    112
    
    
    $
    306,726
    
    
    $
    521,783Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    26,350
    
    
    
    26,350Issuance of common shares under stock-based
compensation plans, including related
tax effects
    
    
    86,866
    
    
    
    
    
    
    
    2,688
    
    
    
    417
    
    
    
    
    
    
    
    3,105Balance at June 30, 2004
    
    
    53,199,875
    
    
    $
    1
    
    
    $
    217,632
    
    
    $
    529
    
    
    $
    333,076
    
    
    $
    551,238
 See notes to Consolidated Financial Statements 5




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National Processing, Inc. 
 Consolidated Statements of Cash Flows
 Six Months EndedJune 302004
    
    2003Operating ActivitiesNet income
    
    $
    26,350
    
    
    $
    19,613Items not requiring cash currently:Depreciation of properties and equipment
    
    
    6,374
    
    
    
    6,351Amortization of intangible assets
    
    
    5,061
    
    
    
    3,660Impairment, restructuring and related expenses
    
    
    
    
    
    
    1,273Deferred income taxes
    
    
    4,626
    
    
    
    2,504Loss on disposition of fixed assets
    
    
    
    
    
    
    33Change in current assets and liabilities:Accounts receivable  trade
    
    
    15,146
    
    
    
    41,989Accounts payable  trade
    
    
    (64
    )
    
    
    (1,601
    )Accrued bankcard assessments
    
    
    (3,699
    )
    
    
    (3,188
    )Income taxes payable
    
    
    (467
    )
    
    
    (5,382
    )Other current assets/liabilities
    
    
    (2,538
    )
    
    
    (409
    )Other, net
    
    
    1,216
    
    
    
    7Minority interest, net of distributions
    
    
    (1,059
    )
    
    
    (1,215
    )Net cash provided by operating activities
    
    
    50,946
    
    
    
    63,635Investing ActivitiesCapital expenditures
    
    
    (8,583
    )
    
    
    (3,408
    )Acquisitions, net of cash received
    
    
    
    
    
    
    (32,356
    )Net cash used in investing activities
    
    
    (8,583
    )
    
    
    (35,764
    )Financing ActivitiesPrincipal payments under capital lease obligations
    
    
    (186
    )
    
    
    (65
    )Issuance of common stock under stock-based compensation plans
    
    
    1,516
    
    
    
    1,487Net cash provided by financing activities
    
    
    1,330
    
    
    
    1,422Net increase in cash and cash equivalents
    
    
    43,693
    
    
    
    29,293Cash and cash equivalents, beginning of period
    
    
    246,957
    
    
    
    185,513Cash and cash equivalents, end of period
    
    $
    290,650
    
    
    $
    214,806Supplemental cash flow information:Taxes paid
    
    $
    12,762
    
    
    $
    16,244
 See notes to Consolidated Financial Statements 6




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National Processing, Inc. 
 Notes to Consolidated Financial Statements
  1.
    
    ORGANIZATION AND BUSINESSOrganization National Processing, Inc. and subsidiaries (the Company) are
providers of electronic payment processing services. The Company is 83%
owned by National City Corporation (National City), a financial holding
company headquartered in Cleveland, Ohio. The Companys primary operating
subsidiary, National Processing Company, LLC is located in Louisville,
Kentucky.  Business The Company derives approximately 97% of its revenue from merchant
processing services. The majority of this revenue is derived from the
authorization, processing, financial settlement and reporting of card
transactions, including credit and debit card transactions. The Company
provides these services to merchants located primarily in the United
States. Approximately 3% of the Companys revenue is derived from processing
non-card based payments. Through an exclusive contract, the Company
settles 100% of domestic airline tickets issued by travel agencies and
settled through the Airlines Reporting Corporation. The Company also
settles commission payments for car rental companies, cruise line
operators, and hotels. In the healthcare industry, the Company provides
financial settlement and reporting to healthcare organizations such as
insurance companies, managed care organizations, and self-insured
organizations.  Sponsorship Agreement The Company and National City Bank of Kentucky (NCBK), a wholly
owned subsidiary of National City, are parties to a sponsorship agreement
(the Sponsorship Agreement) whereby the Company acts as NCBKs sole
agent for the purpose of providing electronic data authorization and
capture, reporting, settlement, and clearing services for merchants who
participate in Visa® and MasterCard® programs. The Company, along with
other nonbank processors, must be sponsored by a financial institution
that is a member of the Visa® and MasterCard® associations. NCBK is a
member of such associations and acts as the Companys primary sponsor. 7




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2.
    
    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESPrinciples of Consolidation and Basis of Presentation The Consolidated Financial Statements include the accounts of
National Processing, Inc. and its subsidiaries, including a 70% ownership
interest in ABN AMRO Merchant Services, LLC (AAMS). The results of
operations of AAMS are included in the Consolidated Financial Statements,
and the 30% minority ownership interest has been accounted for as a
minority interest. All significant intercompany transactions and balances
have been eliminated in consolidation. The accounting and reporting
policies of the Company conform with accounting principles generally
accepted in the United States. Certain 2003 amounts have been
reclassified to conform with the 2004 presentation. Reclassifications had
no effect on previously reported net income or equity. Financial statements prepared in accordance with accounting
principles generally accepted in the United States require the use of
estimates and assumptions by management that affect the reported amounts
of revenue and expenses, assets and liabilities, and the disclosure
requirements for contingent assets and liabilities during and at the date
of the financial statements. Consequently, actual results could differ
from those estimates. For the interim periods presented, management believes the unaudited
Consolidated Financial Statements reflect all adjustments of a normal
recurring nature and disclosures, which are necessary for a fair
presentation of the results for the interim periods presented. The
results of operations for the interim periods are not necessarily
indicative of the results that may be expected for the full year or any
other interim period. The Company experiences seasonality in its businesses and typically
realizes higher revenue from increased transaction volume in the summer
and holiday months. Accounts receivable is generally highest in the
fourth quarter, as December is typically the highest volume month due to
holiday sales. Although the Consolidated Balance Sheet at December 31, 2003 has been
derived from the audited Consolidated Financial Statements at that date,
the accompanying interim Consolidated Financial Statements do not include
all of the information and footnotes required by accounting principles
generally accepted in the United States. These interim financial
statements should be read in conjunction with the Companys 2003 Annual
Report on Form 10-K.  Revenue Recognition The Company recognizes revenue as services are performed, recording
revenue net of certain costs not controlled by the Company, primarily
interchange and debit network fees. Interchange and debit network fees
for the three months ended June 30, 2004 and 2003 were $674 million and
$611 million, respectively. For the six months ended June 30, 2004 and
2003, interchange and debit network fees were $1.275 billion and $1.182
billion, respectively. 8




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Stock-Based Compensation The Company has various stock-based compensation plans that allow for
the granting of stock to eligible employees and directors. Prior to
January 1, 2003, the Company accounted for these plans under the
recognition and measurement principles of Accounting Principles Board
Opinion (APB) 25, Accounting for Stock Issued to Employees, and related
interpretations. Under APB 25, compensation expense for employee stock
options was not recognized if the exercise price of the option equaled or
exceeded the market price of the stock on the date of grant. Effective
January 1, 2003, the Company adopted the fair value method of recording
stock options under the transitional guidance of Statement of Financial
Accounting Standards (SFAS) 148, Accounting for Stock-Based Compensation
 Transition and Disclosure. Compensation expense for employee stock
options granted after January 1, 2003 is recognized in the Consolidated
Financial Statements under the fair value method. Compensation expense for
restricted share awards is recognized ratably over the period of service,
generally the restricted period, based on the fair value of the stock on
the date of grant. The following table illustrates the effect on net income and earnings
per share if the Company had applied the fair value recognition provisions
of SFAS 123, Accounting for Stock-Based Compensation, to stock-based
employee awards for all periods. For purposes of providing the pro forma
disclosures required under SFAS 123, the fair value of stock options
granted were estimated at the date of grant using a Black-Scholes option
pricing model. The Black-Scholes option pricing model was originally
developed for use in estimating the fair value of traded options, which
have different characteristics than the Companys employee stock options.
The model is also sensitive to changes in the subjective assumptions,
which can materially affect the fair value estimate.  (in thousands, except share amounts) Three Months Ended
    
    Six Months EndedJune 30
    
    June 302004
    
    2003
    
    2004
    
    2003Net income, as reported
    
    $
    14,386
    
    
    $
    11,066
    
    
    $
    26,350
    
    
    $
    19,613Add: Stock-based compensation
expense included in net income
under fair value based method, net
of related tax effects
    
    
    145
    
    
    
    5
    
    
    
    375
    
    
    
    5Deduct: Total stock-based
compensation expense determined
under fair value based method, net
of related tax effects
    
    
    (1,157
    )
    
    
    (1,795
    )
    
    
    (2,812
    )
    
    
    (3,766
    )Pro forma net income
    
    $
    13,374
    
    
    $
    9,276
    
    
    $
    23,913
    
    
    $
    15,852Earnings per share:Basic  as reported
    
    $
    0.27
    
    
    $
    0.21
    
    
    $
    0.49
    
    
    $
    0.38Basic  pro forma
    
    $
    0.25
    
    
    $
    0.18
    
    
    $
    0.45
    
    
    $
    0.30Diluted  as reported
    
    $
    0.27
    
    
    $
    0.21
    
    
    $
    0.49
    
    
    $
    0.37Diluted  pro forma
    
    $
    0.25
    
    
    $
    0.18
    
    
    $
    0.45
    
    
    $
    0.30
 The following weighted-average assumptions were used in the
option-pricing model for stock options issued in each of the respective
years: 2004
    
    2003Risk free interest rate
    
    2.5%
    
    2.6%Expected option life
    
    4 years
    
    4 yearsExpected dividend yield
    
    0%
    
    0%Volatility factor
    
    .457
    
    .473Weighted average grant dateFair value of options
    
    $9.65
    
    $6.38
 9




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3.
    
    RECENT ACCOUNTING PRONOUNCEMENTSAccounting for Stock-Based Compensation In December 2002, the Financial Accounting Standards Board (FASB)
issued SFAS 148, Accounting for Stock-Based Compensation  Transition and
Disclosure, which provides guidance on how to transition from the
intrinsic value method of accounting for stock-based employee compensation
under APB 25 to SFAS 123s fair value method of accounting, if a company
so elects. Effective January 1, 2003, the Company adopted the fair value method
of recording stock options under SFAS 123. In accordance with the
transitional guidance of SFAS 148, the fair value method of accounting for
stock options is being applied prospectively to awards granted subsequent
to December 31, 2002. As permitted, options granted prior to January 1,
2003 will continue to be accounted for under APB 25, and the proforma
impact of accounting for these options at fair value will continue to be
disclosed in the Consolidated Financial Statements until the last of those
options vest in 2005. As the cost of anticipated future option awards is phased in over a
four-year period (generally, the vesting period), the annual impact will
rise assuming options are granted in future years at a similar level and
under similar market conditions. The actual impact per diluted share may
vary in the event the fair value or the number of options granted
increases or decreases from the current estimate, or if the current
accounting guidance changes.  Accounting for Certain Financial Instruments with Characteristics of Both
Liabilities and Equity In May 2003, the FASB issued SFAS 150, Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity.
This Statement establishes standards for classifying and measuring
certain financial instruments that embody obligations of the issuer and
have characteristics of both liabilities and equity. The provisions of
SFAS 150 became effective for the Company on June 1, 2003 for any new
qualifying financial instruments that were subsequently entered into or
modified. The provisions of SFAS 150 for all other qualifying instruments
within its scope became effective as of July 1, 2003. The adoption of
this standard did not have a material impact on the Companys financial
condition, results of operations, or liquidity. In December 2003, the
FASB deferred for an indefinite period the application of the guidance in
SFAS 150 to noncontrolling interests that are classified as equity in the
financial statements of a subsidiary but would be classified as a
liability in the parents financial statements under SFAS 150.  Consolidation of Variable Interest Entities In January 2003, the FASB issued FASB Interpretation No. 46 (FIN
46), Consolidation of Variable Interest Entities. FIN 46 provides
guidance on how to identify a variable interest entity (VIE) and
determine when the assets, liabilities, noncontrolling interests, and
results of operations of a VIE are to be included in an entitys
Consolidated Financial Statements. A VIE exists when either the total
equity investment at risk is not sufficient to permit the entity to
finance its activities by itself, or the equity investors lack one of
three characteristics associated with owning a controlling financial
interest. Those characteristics include the direct or indirect ability to
make decisions about an entitys activities through voting rights or
similar rights, the obligation to absorb the expected losses of an entity
if they occur, and the right to receive the expected residual returns of
the entity if they occur. 10




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In December 2003, the FASB reissued FIN 46 with certain modifications
and clarifications. Application of this guidance was effective for
interests in certain VIEs commonly referred to as
special-purpose entities (SPEs) as of December 31, 2003.
Application for all other types of entities is required for periods ending
after March 15, 2004, unless previously applied. The provisions of FIN 46
have not had a material impact on the Companys financial position,
results of operations, or liquidity.  4.
    
    ACQUISITIONS On June 9, 2003, the Company acquired Bridgeview Payment Solutions,
Inc. (BPS) from Bridgeview Bank and Trust Company for $32.4 million in
cash. The allocation of the purchase price increased the Companys
goodwill by approximately $24 million. The remainder of the purchase
price was primarily allocated to merchant contracts, which are included in
other intangible assets on the Consolidated Balance Sheets and are being
amortized on a straight-line basis over 5 years. The results of
operations for BPS have been included in the Consolidated Financial
Statements since the date of acquisition. The Company renamed BPS
to Best Payment Solutions after the acquisition.  5.
    
    IMPAIRMENT, RESTRUCTURING AND RELATED EXPENSES In May 2003, the Company implemented various initiatives focused on
improving the long-term profitability of the Company. In connection with
these initiatives, the Company eliminated 48 information technology
positions, which resulted in severance for approximately 30 employees.
The Company also incurred a loss on the sale of 14 regional sales offices.
The remaining obligations for these initiatives are included in other
accrued liabilities on the Consolidated Balance Sheet. A rollforward of
the liability for severance and related charges incurred in connection
with these initiatives is presented in the table below. Six Months Ended(in thousands)
    
    June 30, 2004
    
    June 30, 2003Beginning Balance
    
    $
    560
    
    
    $
    Severance and related charges
    
    
    
    
    
    
    1,273Payments and adjustments
    
    
    (254
    )
    
    
    (134
    )Ending Balance
    
    $
    306
    
    
    $
    1,139
  6.
    
    COMMITMENTS AND CONTINGENCIES Under
the rules of Visa® and MasterCard®, when a merchant processor
acquires card transactions, it has certain contingent liabilities for the
transactions processed. This contingent liability arises in the event of
a billing dispute between the merchant and a cardholder that is ultimately
resolved in the cardholders favor. In such a case, the transaction is
charged back to the merchant and the disputed amount is credited or
otherwise refunded to the cardholder. If the Company is unable to collect
this amount from the merchants account, and if the merchant refuses or is
unable to reimburse the Company for the chargeback due to liquidation or
other reasons, the Company will bear the loss for the amount of the refund
paid to the cardholder. 11




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A cardholder, through its issuing bank, generally has until the later
of up to four months after the date a transaction is processed or the
delivery of the product or service to present a chargeback to
the Company as the merchant processor. Management believes the
maximum potential exposure for chargebacks would not exceed the total
amount of merchant transactions processed through Visa® and MasterCard®
for the last four months, plus any outstanding delayed-delivery, as
defined below, transactions and unresolved chargebacks in the process of
resolution. For the four-month period from March through June 2004, this
amount totaled approximately $54 billion. At June 30, 2004, the Company
had $5.2 million of unresolved chargebacks that were in process of
resolution. For the three months ended June 30, 2004 and 2003, the Company
processed $33.2 million and $36.0 million, respectively, in chargebacks
presented by issuing banks. For the six months ended June 30, 2004 and
2003, the Company processed $73.5 million and $76.2 million, respectively,
in chargebacks presented by issuing banks. Actual losses recorded for the
three months ended June 30, 2004 and 2003 were $0.9 million and $0.8
million, respectively. Actual losses recorded for the six months ended
June 30, 2004 and 2003, were $2.0 million and $1.8 million, respectively.
The Company accrues for probable losses based on historical experience and
at June 2004 and 2003 had $1.2 million and $1.1 million, respectively,
recorded in other accrued liabilities for expected losses. In most cases, a contingent liability for chargebacks is unlikely to
arise, as most products or services are delivered when purchased, and
credits are issued on returned items. Where the product or service is not
provided, however, until some time after the purchase
(delayed-delivery), the potential for this contingent liability
increases. For the six months ended June 30, 2004, the Company processed
approximately $4.6 billion of merchant transactions related to
delayed-delivery purchases. The Company currently processes card transactions for United
Airlines, Inc., which is currently operating under Chapter 11 protection.
In May 2002, the Company announced its decision to discontinue processing
debit and credit card transactions for the airline industry. The Company
will honor its existing contractual obligations to United Airlines but
does not intend to renew the contract when its current term expires. In
the event of liquidation of United Airlines, the Company could become
financially responsible for refunding tickets purchased through Visa® and
MasterCard® under the chargeback rules of those associations. At June 30,
2004, the estimated dollar value of tickets purchased, but as yet unflown,
under the United Airlines merchant processing contract, was approximately
$853 million. Based upon available information, this amount represents
managements best estimate of its maximum potential chargeback exposure
related to United Airlines, Inc. As of June 30, 2004, the Company held no
significant collateral under this contract. During 2003 and 2004, the Companys obligation to process card
transactions for three other airline merchants ceased with these merchants
transitioning to new processors. At June 30, 2004, the estimated dollar
value of tickets purchased, but as yet unflown, under these concluding
contracts was approximately $36 million. This amount represents
managements best estimate of its maximum potential chargeback exposure
under these contracts. As of June 30, 2004, the Company held cash
collateral of $1.3 million and third-party indemnifications of $110
million against this remaining chargeback exposure. 12




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In November 2003, Congress passed the Federal Aviation Administration
Reauthorization Act. This legislation included an extension of the
airline ticket re-accommodation provision, which requires airlines to
honor tickets through November 2004 for other airlines that may suspend,
interrupt or discontinue services due to insolvency or liquidation. Based on current conditions in the airline industry and other
information currently available to the Company, management believes the
risk of a material loss under the chargeback rules is unlikely.  MasterCard® Guarantee The Company has provided a financial guarantee relating to NCBKs
obligations with MasterCard®. The agreement guarantees the payment of
NCBKs membership obligations pursuant to its license agreement with
MasterCard®, the Bylaws and Rules of MasterCard®, and all regulations and
policies of MasterCard® should NCBK default or fail to meet its
obligations of membership. The Companys primary risk under this
guarantee is related to potential chargebacks; however, the Company
believes its exposure to a material loss under the guarantee is not
probable at this time. The Company processes all transactions received
from MasterCard® by NCBK under the exclusive terms of the Sponsorship
Agreement.  Visa® Guarantee The Company has provided a financial guarantee relating to NCBKs
membership obligations with Visa®. The agreement guarantees the payment
of NCBKs membership obligations pursuant to the Visa® Certificate of
Incorporation and Amendments, Bylaws, rules, policies and operating rules
should NCBK default or fail to meet its obligations of membership
including NCBKs obligations to pay any Visa® member attendant to NCBKs
membership in Visa®, and Visas expenses incurred in payment of such
obligations on NCBKs behalf or otherwise because of NCBKs failure to
meet such obligations. The Companys primary risk under this guarantee is
related to potential chargebacks; however, the Company believes its
exposure to a material loss under the guarantee is not probable at this
time. The Company processes all transactions received from Visa® by NCBK
under the exclusive terms of the Sponsorship Agreement.  Litigation In the normal course of business, the Company is involved in
litigation from time to time. In the opinion of management, the ultimate
liability, if any, arising from this litigation is not expected to have a
material adverse effect on the Companys financial condition, results of
operations, or liquidity. 13




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7.
    
    NET INCOME PER COMMON SHARE The calculation of net income per common share follows (in
thousands, except per share amounts): Three Months Ended
    
    Six Months EndedJune 30
    
    June 302004
    
    2003
    
    2004
    
    2003BASICNet income
    
    $
    14,386
    
    
    $
    11,066
    
    
    $
    26,350
    
    
    $
    19,613Average common shares outstanding
    
    
    53,320
    
    
    
    52,213
    
    
    
    53,299
    
    
    
    52,168Net income per common share  basic
    
    $
    0.27
    
    
    $
    0.21
    
    
    $
    0.49
    
    
    $
    0.38DILUTEDNet income
    
    $
    14,386
    
    
    $
    11,066
    
    
    $
    26,350
    
    
    $
    19,613Average common shares outstanding
    
    
    53,320
    
    
    
    52,213
    
    
    
    53,299
    
    
    
    52,168Dilutive effect of stock awards
    
    
    167
    
    
    
    239
    
    
    
    145
    
    
    
    209Average common shares outstanding 
diluted
    
    
    53,487
    
    
    
    52,452
    
    
    
    53,444
    
    
    
    52,377Net income per common share  diluted
    
    $
    0.27
    
    
    $
    0.21
    
    
    $
    0.49
    
    
    $
    0.37
  8.
    
    TRANSACTIONS WITH AFFILIATES The Company leases certain facilities from NCBK under long-term
agreements classified as Obligations Under Capital Leases in the
accompanying Consolidated Balance Sheets. The Company paid $0.1 million,
including interest, under this lease for each of the six months ended June
30, 2004 and 2003. Substantially all of the Companys cash and cash equivalents are held
by NCBK and other National City subsidiaries. The majority of the
interest income and earnings on customer balances included in the
Consolidated Statements of Income are derived from accounts held at NCBK
and other National City subsidiaries. The Company and National City are parties to agreements pursuant to
which the Company outsources a portion of certain functions to National
City and its affiliates including information technology services, tax
services, human resource services, internal audit and legal services. The
Company also utilizes NCBK and other National City subsidiaries for the
majority of its banking services. Charges for these services totaled $1.3
million and $2.5 million for the quarter and six months ended June 30,
2004, respectively. For the quarter and six months ended June 30, 2003,
charges for these services totaled $0.8 million and $1.6 million,
respectively. 14




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##### Table of Contents



9.
    
    SUBSEQUENT EVENT Merger Agreement with Bank of America On July 12, 2004, the Company and Bank of America entered into an
Agreement and Plan of Merger by and among Bank of America Corporation,
Monarch Acquisition, Inc. and National Processing, Inc. At the effective
time of the merger, Monarch Acquisition, an indirect wholly owned
subsidiary of Bank of America, will be merged with and into National
Processing. National Processing will continue as the surviving
corporation and will become an indirect wholly owned subsidiary of Bank
of America. At the closing of the merger, each share of National
Processing common stock will be converted into the right to receive
$26.60 in cash, without interest. The completion of this transaction is
subject to the approval of the Companys shareholders, regulatory
approval and other customary conditions and is expected to occur in the
fourth quarter of 2004. The Company expects to incur expenses of approximately $10 million
related to the merger with Bank of America. These merger-related
expenses include investment banking fees, and legal and professional
fees. The Company will also pay up to $23 million in cash resulting from
accelerated vesting of equity awards and payments under previously
existing compensation plans and employment agreements. A contingent termination fee of $50 million is payable by the
Company to Bank of America in the event that the merger agreement is
terminated due to the Companys failure to meet certain conditions
precedent to close as detailed in the merger agreement. Certain Other Agreements Pursuant to, and simultaneously with the execution of, the merger
agreement, National City and certain of its affiliates entered into, or
agreed to enter into, various agreements with the Company and Bank of
America. These agreements are discussed below. Service and Sponsorship Agreement The Company and NCBK are parties to a Sponsorship Agreement entered
into on June 30, 1996. Pursuant to the sponsorship agreement, the
Company serves as NCBKs sole agent for the purpose of providing
electronic data authorization and capture, reporting, settlement and
clearing services for merchants who participate in
Visa® and MasterCard®
programs. In connection with NCBKs role as sponsor, NCBK, the Company
and United Airlines, Inc. entered into the Charge Card Processing
Agreement dated November 15, 2000 (the UAL Contract). The sponsorship
agreement provides, among other things, that the Company will indemnify NCBK against certain losses and claims, including
chargebacks for airline tickets that have been purchased pursuant to the
UAL Contract. In connection with the merger, the Company and NCBK entered into a
Service and Sponsorship Agreement dated July 12, 2004, effective upon
closing of the merger, with respect to the UAL Contract. Pursuant to
this Service and Sponsorship Agreement, Bank of America through the
Company has agreed to make a one-time payment of $36 million to NCBK in
exchange for NCBKs agreement to release the Company from its obligation
under the sponsorship agreement to 15




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##### Table of Contents



indemnify NCBK against any losses or
claims to the extent related to and arising from the UAL Contract. National City has also agreed, pursuant to the
Shareholders Agreement, to assume the Companys obligations and potential
liabilities under, and to indemnify Bank of America for losses related
to, the UAL Contract. As a result of the arrangement, NCBK will remain
liable for any such losses or claims under the UAL Contract. In addition, pursuant to the terms of service and sponsorship
agreement, the Company will pay NCBK processing fees for NCBKs
settlement of United Airlines transactions services set forth in the
service and sponsorship agreement. The Company will pass through to NCBK
the fees it receives from United Airlines, less the cost of processing
such transactions. National City will have the opportunity to earn a
profit of approximately $1 million under the Service and Sponsorship
Agreement over the term of that agreement. Master Referral Agreement National City and Bank of America entered into a Master Referral
Agreement dated July 12, 2004, effective upon closing of the merger,
pursuant to which National City is eligible to receive fees from Bank of
America based on National Citys and its affiliates use of Bank of
Americas merchant services. National City and its affiliates are also
eligible to receive fees in the event that their respective business
customers utilize Bank of Americas merchant services. National City and
its affiliates have agreed to refer their processing business through the
Company. The agreement has a ten-year term, which includes a repricing
option after the fifth year. National City is subject to termination
fees in the event of a termination of the agreement other than in certain
limited circumstances. Transition Services Agreement In connection with the merger, National City and the Company will
enter into a Transition Services Agreement, pursuant to which National
City or its affiliates will provide, at cost, certain services to the
Company following the completion of the merger with respect to
information technology and human resources. Human resources services
will be provided for up to six months following the merger and
information technology services will be provided for up to twelve months
after the merger. Any provision of services beyond the applicable term
for such service will be on a cost plus 15% basis. 16




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations The following should be read in conjunction with the Companys 2003 Annual
Report on Form 10-K and subsequent filings with the Securities and Exchange
Commission. National Processings revenue is primarily derived from processing
contracts with merchants for the authorization, processing and settlement of
credit and debit card transactions. Business volumes tend to be influenced by
overall consumer spending trends as well as competitive conditions within the
marketplace. During 2004, U.S. consumers have continued to substitute
card-based payments for checks and cash. As a result, transactions and dollar
volume processed for the quarter ended June 30, 2004, increased 16% and 15%,
respectively, over 2003. For the six months ended June 30, 2004, transactions
and dollar volume processed increased 16% and 14%, respectively, over the
comparable 2003 period. In 2004, the Company continued to experience strong growth from regional
and small business merchant accounts. Conversely, the merchant processing
industry has experienced a sustained period of lower market pricing for large
national merchants. Negative pricing trends are expected to continue in the
future as these merchant contracts renew at lower market pricing levels. The Company expects consumer preference for card-based payments to
continue to grow in 2004, which would lead to higher processing volumes.
Additionally, in 2004 the Company is focused on continued expansion into higher
margin regional merchant accounts, while also focusing on new product
development and managing its cost structure to offset the expected impact of
lower margins on national merchant contracts. On
July 12, 2004, the Company and Bank of America entered into an
Agreement and Plan of Merger by and among Bank of America
Corporation, Monarch Acquisition, Inc. and National Processing, Inc.
At the effective time of the merger, Monarch Acquisition, an indirect
wholly owned subsidiary of Bank of America, will be merged with and
into National Processing. National Processing will continue as the
surviving corporation and become an indirect wholly owned subsidiary
of Bank of America. At the closing of the merger, each share of
National Processing common stock will be converted into the right to
receive $26.60 in
cash, without interest. The completion of this transaction is subject
to the approval of the Companys shareholders,
regulatory approval and other customary conditions and is expected to
occur in the fourth quarter of 2004. See Note 9 to the accompanying Consolidated Financial Statements for
additional information. Components of Revenue and Expenses Revenue The majority of the Companys revenue is derived from processing contracts
with merchants for the authorization, processing, and settlement of credit and
debit card transactions. Processing fee revenue is earned either on a per
transaction basis or discount basis, which is a percent of dollar volume
processed. Merchant contracts generally have terms ranging from three to five
years. Processing fee revenue is recorded in the period the related
transaction is processed and is recorded net of interchange fees charged by the
credit card associations and fees charged by debit networks. Interchange and
debit network fees for the three months ended June 30, 2004 and 2003 were $674
million and $611 million, respectively. For the six months ended June 30, 2004
and 2003, interchange and debit network fees were $1.275 billion and $1.182
billion, respectively. The increase in interchange and debit network fees is
attributed to higher dollar processing volumes. The Company also derives
revenue from sources other than processing fees, including equipment and supply
sales, equipment repair fees, application and installation fees, and
third-party commissions. 17




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##### Table of Contents



Approximately 3% of the Companys revenue is derived from processing
non-card based payments. Revenue is recorded in the period services are
provided. A portion of total consolidated revenue is derived from earnings on
customer cash balances, which are maintained by NCBK pursuant to contractual
terms. For the three months ended June 30, 2004 and 2003, earnings on customer
balances were $0.7 million and $0.6 million, respectively. For the six months
ended June 30, 2004 and 2003, earnings on customer balances were $1.3 million
and $1.1 million, respectively. Expenses Operating expenses include costs of providing services to customers
including authorization fees and data processing costs. Assessments are
liabilities to Visa® and MasterCard® that originate from the Companys
agreements with these associations. General and administrative expenses include management and administrative
expenses as well as fees for certain administrative services provided by
National City and its affiliates. Three Months Ended June 30, 2004 Compared to Three Months Ended June 30, 2003 % Change from Prior(Dollars in thousands)
    
    2004
    
    2003
    
    YearRevenue
    
    $
    132,623
    
    
    $
    113,614
    
    
    
    17Operating expenses
    
    
    57,383
    
    
    
    50,209
    
    
    
    14Assessments expense
    
    
    38,160
    
    
    
    32,963
    
    
    
    16General and administrative expenses
    
    
    7,363
    
    
    
    5,748
    
    
    
    28Depreciation and amortization
    
    
    5,742
    
    
    
    5,044
    
    
    
    14Impairment, restructuring and related expenses
    
    
    
    
    
    
    1,273
    
    
    
    (100
    )Operating profit
    
    
    23,975
    
    
    
    18,377
    
    
    
    30Net interest income
    
    
    687
    
    
    
    830
    
    
    
    (17
    )Income before taxes and minority interest
    
    
    24,662
    
    
    
    19,207
    
    
    
    28Provision for income taxes
    
    
    9,313
    
    
    
    7,444
    
    
    
    25Net income before minority interest
    
    
    15,349
    
    
    
    11,763
    
    
    
    30Minority interest
    
    
    963
    
    
    
    697
    
    
    
    38Net income
    
    $
    14,386
    
    
    $
    11,066
    
    
    
    30
 Revenue for the three months ended June 30, 2004 increased 17% to $132.6
million from $113.6 million in 2003. Merchant processing revenue was $129.2 million for the quarter, up 18%
from second quarter 2003 revenue of $109.6 million. Merchant processing
transaction volume processed for the three months ended June 30, 2004 increased
16% to 1.19 billion transactions from 1.03 billion transactions in 2003.
Merchant processing dollar volume processed for the three months ended June 30,
2004 increased 15% to $48.4 billion from $42.2 billion in 2003. The increase
in transaction volume is primarily due to growth in existing national customers
and the addition of new regional merchants. Merchant processing revenue for
the second quarter of 2004 versus the comparable 2003 period was higher due
primarily to the increased transaction and dollar volumes, strong customer
retention, additional revenue resulting from the acquisition of Bridgeview
Payment Solutions, and the benefit of rate and pricing changes. 18




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Revenue from non-card based payments was $3.5 million for the quarter,
down 14% from second quarter
of 2003 revenue of $4.0 million. This decrease was due primarily to lower
revenue from the Companys Airlines Reporting Corporation contract. Operating expenses for the three months ended June 30, 2004 increased 14%
to $57.4 million from $50.2 million in 2003 due primarily to increased merchant
transaction volume. Assessments expense increased 16% to $38.2 million for the three months
ended June 30, 2004 from $33.0 million in 2003 due to increased merchant
transaction volume. General and administrative expenses increased by 28% to $7.4 million for
the three months ended June 30, 2004 from $5.7 million in 2003. This increase
was due primarily to increases in incentive compensation and expenses related
to equity-based compensation. Depreciation and amortization increased 14% to $5.7 million for the three
months ended June 30, 2004 from $5.0 million in 2003. This increase was due
primarily to increased intangible asset amortization from the acquisition of
Best Payment Solutions. In May 2003, the Company implemented various initiatives focused on
improving the long-term profitability of the Company. In connection with these
initiatives, the Company eliminated 48 information technology positions, which
resulted in severance for 30 employees. The Company also incurred a loss on
the sale of 14 regional sales offices. The Company recorded a charge of $1.3
million in the second quarter of 2003 related to these initiatives. As of
June 30, 2004, the Company had $0.3 million remaining in accrued liabilities
related to severance and lease commitments. Operating profit margin as a percentage of revenue increased to 18% for
the three months ended June 30, 2004 from 16% in 2003 due to the items
discussed above. Net interest income earned on the Companys cash and cash equivalents for
the three months ended June 30, 2004 was $0.7 million, down 17% from $0.8
million in the 2003 second quarter due to lower average interest rates in 2004,
offset partially by higher balances. The overall effective tax rate for the second quarter of 2004 was 37.8%,
compared to 38.8% for the same quarter a year ago. This decrease is due to
changes in estimated rates for state and local taxes. For the three months ended June 30, 2004, minority interest was $1.0
million, up 38% from $0.7 million in the second quarter of 2003. This increase
is due to higher earnings from AAMS, which is 70% owned by National Processing. Net income increased 30% to $14.4 million for the three months ended June
30, 2004 from $11.1 million in 2003 due to the items discussed above. 19




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##### Table of Contents



Six Months Ended June 30, 2004 Compared to Six Months Ended June 30, 2003 % Change from Prior2004
    
    2003
    
    YearRevenue
    
    $
    254,837
    
    
    $
    219,568
    
    
    
    16Operating expenses
    
    
    113,250
    
    
    
    101,755
    
    
    
    11Assessments expense
    
    
    73,077
    
    
    
    64,169
    
    
    
    14General and administrative expenses
    
    
    13,448
    
    
    
    10,054
    
    
    
    34Depreciation and amortization
    
    
    11,435
    
    
    
    10,011
    
    
    
    14Impairment, restructuring and related expenses
    
    
    
    
    
    
    1,273
    
    
    
    (100
    )Operating profit
    
    
    43,627
    
    
    
    32,306
    
    
    
    35Net interest income
    
    
    1,349
    
    
    
    1,672
    
    
    
    (19
    )Income before taxes and minority interest
    
    
    44,976
    
    
    
    33,978
    
    
    
    32Provision for income taxes
    
    
    16,921
    
    
    
    13,139
    
    
    
    29Net income before minority interest
    
    
    28,055
    
    
    
    20,839
    
    
    
    35Minority interest
    
    
    1,705
    
    
    
    1,226
    
    
    
    39Net income
    
    $
    26,350
    
    
    $
    19,613
    
    
    
    34
 Revenue for the six months ended June 30, 2004 increased 16% to $254.8
million from $219.6 million in 2003. Merchant processing revenue was $248.1 million for the six months ended
June 30, 2004, up 17% from $211.5 million in 2003. Merchant processing
transaction volume processed for the six months ended June 30, 2004 increased
16% to 2.307 billion transactions from 1.982 billion transactions in 2003.
Merchant processing dollar volume processed for the six months ended June 30,
2003 increased 14% to $92.8 billion compared to $81.6 billion in 2003. The
increase in transaction volume is primarily due to growth in existing national
customers and the addition of new regional merchants. Merchant processing
revenue for the six months ended June 30, 2004 versus the comparable 2003
period was higher due primarily to the increased transaction and dollar
volumes, strong customer retention, additional revenue resulting from the
acquisition of Bridgeview Payment Solutions, and the benefit of rate and
pricing changes. Revenue from non-card based payments was $6.7 million for the six months
ended June 30, 2004, down 17% from 2003 revenue of $8.1 million. This decrease
was due primarily to lower revenue from the Companys Airlines Reporting
Corporation contract. Operating expenses for the six months ended June 30, 2004 increased 11% to
$113.3 million from $101.8 million in 2003 due primarily to increased
transaction volume in Merchant Card Services. Assessments expense increased 14% to $73.1 million for the six months
ended June 30, 2004 from $64.2 million in 2003 due to increased merchant
transaction volume. General and administrative expenses increased by 34% to $13.4 million for
the six months ended June 30, 2004 from $10.1 million in 2003 due to increases
in incentive compensation and expenses related to equity-based compensation. Depreciation and amortization increased 14% to $11.4 million for the six
months ended June 30, 2004 from $10.0 million in 2003 due primarily to
increased intangible asset amortization from the acquisition of Best Payment
Solutions. 20




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In May 2003, the Company implemented various initiatives focused on
improving the long-term profitability of the Company. In connection with these
initiatives, the Company eliminated 48 information technology positions, which
resulted in severance for 30 employees. The Company also incurred a loss on
the sale of 14 regional sales offices. The Company recorded a charge of $1.3
million in the second quarter of 2003 related to these initiatives. As of June
30, 2004, the Company had $0.3 million remaining in accrued liabilities related
to severance and lease commitments. Operating profit margin as a percentage of revenue increased to 17% for
the six months ended June 30, 2004 from 15% in 2003 due to the items discussed
above. Net interest income earned on the Companys cash and cash equivalents for
the six months ended June 30, 2004 was $1.3 million, down 19% from $1.7 million
for the six months ended June 30, 2003 due to lower average interest rates in
2003, offset partially by higher balances. The overall effective tax rate for the six months ended June 30, 2004 was
37.6%, compared to 38.7% for the same period a year ago. This decrease is due
to changes in estimated rates for state and local taxes. For the six months ended June 30, 2004, minority interest was $1.7
million, up 39% from $1.2 million in 2003. This increase is due to higher
earnings from AAMS, which is 70% owned by National Processing. Net income increased 34% to $26.4 million for the six months ended June
30, 2004 from $19.6 million in 2003 due to the items discussed above. Chargeback and Market Uncertainties Chargebacks See Note 6 to the Consolidated Financial Statements. Additional Factors The Company is dependent on overall consumer spending trends. The Company
is also subject to competitive pricing in the markets in which it competes.
These factors may impact the Companys future revenue and operating profits. Application of Critical Accounting Policies General The Companys Consolidated Financial Statements are prepared in accordance
with accounting principles generally accepted in the United States.
Application of these principles requires management to make estimates,
assumptions, and judgments that affect the amounts reported in the financial
statements and accompanying notes. These estimates, assumptions, and judgments
are based on information available as of the date of the financial statements;
accordingly, as this information changes, the financial statements could
reflect different estimates, assumptions, and judgments. Certain policies
inherently have greater reliance on the use of estimates, assumptions, and
judgments and as such have greater possibility of producing results that could
be materially different than originally reported. 21




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##### Table of Contents



Income Taxes The Company is included in the consolidated federal income tax return of
National City. National City allocates income taxes to the Company as if it
were a stand-alone tax paying entity. Deferred tax assets and liabilities are
recognized, as certain items are required to be treated differently for
financial statement purposes, versus how they are treated for tax purposes. Management judgments and estimates are required in determining the income
tax provision as well as the balances of deferred tax assets and liabilities.
As of June 30, 2004, the Company had net deferred tax assets of $11.3 million.
The Company records a valuation allowance to reduce deferred tax assets when it
is more likely than not that certain amounts will not be realized. The Company
considers projected future taxable income and tax planning strategies in
assessing the need for a valuation allowance. Should the Company determine in
the future that all or part of its net deferred tax asset is unrealizable, an
adjustment to the deferred tax asset would be charged to income in the period
such determination was made. Management provides reserves when it appears
probable that a taxing authority may take a sustainable position on a matter
contrary to the Companys position. Based on existing levels of pre-tax
earnings, management believes that the Company will generate future taxable
income above minimum amounts required to realize its deferred tax assets. Long-Lived Assets Long-lived assets, consisting primarily of property and equipment,
goodwill, and other intangible assets, comprise a significant portion of the
Companys total assets. Property and equipment, net of accumulated depreciation and amortization,
totaled $53.5 million as of June 30, 2004, which represented 8% of total
assets. Useful lives of property and equipment (which includes internal-use
software) are estimated in order to determine the amount of depreciation and
amortization expense to be recorded during each reporting period. The useful
lives are estimated at the time the assets are acquired based on historical
experience with similar assets and current business plans. Based on future
events and changes in business plans, the useful lives assigned to these assets
may need to be shortened, resulting in the recognition of increased
depreciation and amortization expense in future periods. These changes could
also result in the recognition of an immediate impairment charge to reflect the
write-down in the value of the assets. Alternatively, assets may ultimately be
used by the Company for longer than their assigned depreciable lives. Internal-use software is a component of property and equipment. The
Company capitalizes certain costs incurred to develop or obtain internal-use
software in accordance with Statement of Position 98-1, Accounting for the
Costs of Computer Software Developed or Obtained for Internal Use. The Company
capitalizes costs once the preliminary project stage has been completed,
management has approved funding for the project, and it is probable the project
will be completed and the software will be used for its intended use.
Capitalized software development and purchased software are recorded at cost.
Commencing the month following project completion, these costs are amortized on
a straight-line basis over the estimated useful life of the software, ranging
from three to ten years. Software development costs may become impaired due to
technological obsolescence of the project or where development efforts are
abandoned due to changes in business plans. For purposes of depreciation and
impairment, capitalized costs are treated in the same manner as other property
and equipment. 22




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Goodwill and other intangible assets, net of accumulated amortization,
totaled $153.6 million as of June 30, 2004, which represented 24% of total
assets. The Company determines amortization periods for
intangible assets based on estimated future cash flows. The Company
analyzes goodwill and other intangible assets for impairment on an annual basis
or more frequently if events or circumstances warrant. In assessing the
recoverability of goodwill and intangible assets, the Company makes estimates
regarding future cash flows and assumptions about other factors to determine
the fair value. Changes in estimates or the related assumptions may cause the
Company to record impairment charges for the related assets. Chargebacks and Other Contingencies The Company records reserves for chargebacks and contingent liabilities
when such amounts are deemed to be probable and estimable in accordance with
SFAS 5, Accounting for Contingencies. The required reserves may change in the
future due to new developments, including, but not limited to, changes in
litigation or increased chargeback exposure as the result of merchant
insolvency, liquidation, or other reasons. The required reserves are reviewed
periodically to determine if adjustments are required. See Note 6 to the
accompanying Consolidated Financial Statements. Recent Accounting Pronouncements See Note 3 to the Consolidated Financial Statements. Seasonality The Company experiences seasonality in its businesses and typically
realizes higher revenue from increased transaction volume in the summer and
holiday months. Accounts receivable is generally highest in the fourth
quarter, as December is typically the highest volume month due to holiday
sales. Liquidity and Capital Resources The Companys primary uses of capital resources include capital
expenditures, working capital, and acquisitions. Future business acquisitions
may be funded through current liquidity, borrowed funds, and/or issuances of
common stock. The Companys capital expenditures include amounts for computer hardware,
external and internally developed software, and improvements to operating
facilities. During the six months ended June 30, 2004 and 2003, the Companys
capital expenditures totaled $8.6 million and $3.4 million, respectively. Such
expenditures were financed from operating cash flow, which totaled $50.9
million and $63.6 million for the six months ended June 30, 2004 and 2003,
respectively. Operating cash flow decreased due to the timing of working
capital items, primarily accounts receivable balances. On June 9, 2003, the Company acquired Bridgeview Payment Solutions, Inc.
from Bridgeview Bank and Trust Company for $32.4 million in cash. In February 2004 and March 2003, the Company paid $2.8 million and $2.4
million, respectively, to the minority shareholder of AAMS. These payments
represent the pro rata share of earnings due to the minority shareholder for
the preceding year. 23




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On July 12, 2004, the Company and Bank of America
entered into an
Agreement and Plan of Merger by and among Bank of America
Corporation, Monarch Acquisition, Inc. and National Processing, Inc.
At the effective time of the merger, Monarch Acquisition, an indirect
wholly owned subsidiary of Bank of America, will be merged with and
into National Processing. National Processing will continue as the
surviving corporation and become an indirect wholly owned subsidiary
of Bank of America. At the closing of the merger, each share of
National Processing common stock will be converted into the right to
receive $26.60 in cash, without interest. The completion of this transaction is subject
to the approval of the Companys shareholders,
regulatory approval and other customary conditions and is expected to
occur in the fourth quarter of 2004.
The Company expects to incur expenses of approximately $10 million
related to the merger with Bank of America. These merger-related
expenses include investment banking fees, and legal and professional fees. The
Company will also pay up to $23 million in cash resulting from
accelerated vesting of equity awards and payments under previously
existing compensation plans and employment agreements.
Under the terms of the merger agreement, the Company must pay a
termination fee of $50 million in the event the Company terminates the merger
agreement or fails to meet its obligations set forth in the merger agreement.
Additionally, upon closing of the merger, pursuant to the Service and
Sponsorship Agreement, Bank of America, through the Company has agreed to make
a one-time payment of $36 million to NCBK in exchange for NCBKs agreement to
release the Company from its obligation under the Sponsorship Agreement. See
Note 9 to the accompanying Consolidated Financial Statements for additional
information. As the Company does not carry significant amounts of inventory and
historically has experienced short collection periods for its accounts
receivable, it does not require substantial working capital to support revenue
growth. Working capital requirements will vary depending upon future
acquisition activity. Increases in working capital needs and future capital
expenditures are expected to be financed through operating cash flow and
current cash balances. Due to increased transaction volumes in the holiday
months, accounts receivable balances are typically higher at year end which
typically results in a negative operating cash flow in the fourth quarter. 24




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Forward-Looking Statements The section entitled Managements Discussion and Analysis of Financial
Condition and Results of Operations contains forward-looking statements.
Forward-looking statements give current expectations or forecasts of future
events and are not guarantees of future performance. Forward-looking
statements may be identified by the use of words such as may, will,
intend, expect, believe, anticipate, plan, estimate, project,
target, forecast, seek and other similar words used in connection with
any discussion of future operating or financial performance. The
forward-looking statements are based on managements expectations that involve
a number of risks and uncertainties, and, although management believes the
expectations reflected in such forward-looking statements are reasonable,
actual results may differ materially from those expressed or implied in such
statements. Risks and uncertainties that could cause actual results to differ
materially include, without limitation, the Companys ability to execute its
business plans; changes in general economic conditions in the United States and
other relevant economies; changes in consumer spending habits; changes in the
growth rate of the card processing industry from recent years; ability to
execute the Companys acquisition strategy; successful integration of
acquisitions; consolidation in the banking, card processing or electronic
payment settlement industries; consolidation of major customers or industries
serviced; industry competition; renewal of major customer relationships;
changes in interest rates; governmental and economic stability in foreign
countries in which the Company operates; litigation or changes in existing
litigation, chargebacks, customer bankruptcy, claims and assessments; reliance
on third party processing relationships; changes in banking regulations;
changes in credit card association rules, regulations or operations; changes in
other laws or regulations that impact the Companys business; changes in
accounting policies and procedures as may be required due to new accounting
pronouncements of the Financial Accounting Standards Board or other regulatory
agencies; technological changes; timely and successful implementation of future
processing systems projects; financial or other business impacts due to systems
infiltrations; and successful business continuity plans. Additional
information concerning factors that could cause actual results to differ
materially from those expressed or implied in the forward-looking statements is
available in the Companys Annual Report on Form 10-K for the year ended
December 31, 2003 and subsequent filings with the Securities and Exchange
Commission. You are advised to consult any further disclosures the Company
makes on related subjects in the Companys Forms 10-Q, 8-K and 10-K reports
filed with the Commission. Copies of the Companys filings with the Commission
are available at no cost on the Commissions web site at www.sec.gov or on the
Companys web site at www.npc.net. 25




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##### Table of Contents



Item 3. Quantitative and Qualitative Disclosures About Market Risk Derivative Instruments The Company does not use derivative instruments. Market Risk of Financial Instruments The Companys primary market risk exposure with regard to financial
instruments is to changes in interest rates. As of June 30, 2004, the Company
had $291 million in cash and cash equivalents. For the first six months of
2004, NCBK also held an average of approximately $226 million of customer cash
balances. The Company retains the incremental interest earned on certain of
these funds above what is contractually due to the customers. Interest earned
on customer cash balances is included as a component of revenue. Because of the short-term nature of these instruments, a sudden change in
market interest rates would not impact the fair value of these instruments.
The Companys earnings, however, are impacted by changes in interest rates,
with respect to interest on the Companys cash and cash equivalents and on
customer funds maintained by NCBK. At June 30, 2004, a hypothetical 100 basis
point increase in short-term interest rates would result in an increase of
approximately $5 million in annual pre-tax income. A hypothetical 100 basis
point decrease in short-term interest rates would result in a decrease of
approximately $5 million in annual pre-tax income. 
 Item 4. Controls and Procedures As of June 30, 2004, an evaluation was performed under the supervision and
with the participation of the Companys management, including the Chairman and
Chief Executive Officer (CEO) and the Chief Financial Officer (CFO), of the
effectiveness of the design and operation of the Companys disclosure controls
and procedures. Based on that evaluation, the Companys management, including
the CEO and CFO, concluded the Companys disclosure controls and procedures as
of June 30, 2004 were effective in ensuring information required to be
disclosed in this Quarterly Report on Form 10-Q was recorded, processed,
summarized and reported on a timely basis. There have been no changes in the
Companys internal control over financial reporting that occurred during the
quarter ended June 30, 2004 that have materially affected, or are reasonably
likely to materially affect, the Companys internal control over financial
reporting. 26




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##### Table of Contents



Part II  Other Information 
 Item 1. Legal Proceedings (None) 
 Item 2. Unregistered Sales of Equity Securities (None) 
 Item 3. Defaults Upon Senior Securities (None) 
 Item 4. Submission of Matters to a Vote of Security Holders On May 5, 2004, at the Annual Shareholders Meeting of the Company, the
shareholders took the following actions:  1.
    
    Elected as directors all nominees designated in the proxy statement
dated March 19, 2004 as follows: Number of VotesFor
    
    WithheldAureliano Gonzalez-Baz
    
    
    49,340,050
    
    
    
    3,451,960Jon L. Gorney
    
    
    49,617,978
    
    
    
    3,174,032Preston B. Heller
    
    
    52,690,781
    
    
    
    101,229
  Directors whose terms continued after the Annual Shareholders Meeting
include: J. Armando Ramirez, Paul G. Clark, Jeffrey P. Gotschall, and Jeffrey
D. Kelly.  2.
    
    Approved the Audit Committees selection of Ernst & Young LLP as
independent auditor for the Company for 2004: 52,781,793 votes cast for,
9,657 votes cast against, and 560 votes abstained. 
 Item 5. Other Information (None) 
 Item 6. Exhibits and Reports on Form 8-K: The exhibits filed as part of the Form 10-Q for the quarter ended
June 30, 2004 are accessible at no cost on the Companys website at
www.npc.net or through the Securities and Exchange Commissions website at
www.sec.gov. Copies of the exhibits may be requested at a cost of $0.30
per page from National Processings investor relations department. EXHIBITNUMBER
    
    DESCRIPTION3.1(i)
    
    Amended Articles of Incorporation of the Company. (A)3.1(ii)
    
    Code of Regulations, Amended and Restated, as adopted and
in effect on May 16, 2003, of the Company. (Incorporated herein by
reference to Exhibit 3.1 (ii) to the Companys Quarterly Report on
Form 10-Q for the quarter ended June 30, 2003)4.1
    
    Specimen Certification for the Common Stock, without par value,
of the Company. (B)4.2
    
    Registration Rights Agreement between the Company and National
City Corporation, dated July 16, 1996. (B)4.3
    
    Amended Articles of Incorporation of the Company related to the
capital stock of the Company and shareholders rights. (A)
 27




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##### Table of Contents



EXHIBITNUMBER
    
    DESCRIPTION4.4
    
    Code of Regulations, Amended and Restated, as adopted and in effect
on May 16, 2003, of the Company as related to the capital stock of
the Company and shareholders rights. (Incorporated herein by
reference to Exhibit 3.1 (ii) to the Companys Quarterly Report on
Form 10-Q for the quarter ended June 30, 2003)10.1
    
    Absolute Net Ground Lease by and between Preston Manor, Inc.
and Allied Stores Corporation, dated January 16, 1969. (A)10.2
    
    Second Amendment to Lease by and between William G. Earley,
Plaza Centers, Inc. and First National Bank of Louisville, dated
April 15, 1986. (A)10.3
    
    Sponsorship Agreement between NPC and National City Bank of Kentucky, dated June 30, 1996. (B)10.4
    
    Administrative Services Agreement
between NPC and National City Corporation, dated July 15, 1996. (B)10.5
    
    Tax Sharing Agreement between the Company and National City Corporation, dated July 17, 1996. (B)10.6
    
    Employment Agreement and Undertaking of Confidentiality between
the Company and Mark Pyke dated March 4, 1996. (Incorporated herein
by reference to Exhibit 10.19 to the Companys Annual Report on Form
10-K for the year ended December 31, 2002) **10.7
    
    Employment Agreement and Undertaking of Confidentiality between
National Processing Company and Thomas A. Wimsett dated December 12,
1997. (Incorporated herein by reference to Exhibit 10.21 to the
Companys Quarterly Report on Form 10-Q for the quarter ended
September 30, 2002) **10.8
    
    Separation Agreement, Release and Waiver between National
Processing, Inc. and Thomas A. Wimsett dated September 29, 2002.
(Incorporated herein by reference to Exhibit 10.22 to the Companys
Quarterly Report on Form 10-Q for the quarter ended September 30,
2002) **10.9
    
    Visa® U.S.A. Inc. Guaranty between National Processing, Inc.
and Visa® U.S.A. Inc. dated August 6, 2002. (Incorporated herein by
reference to Exhibit 10.23 to the Companys Quarterly Report on Form
10-Q for the quarter ended September 30, 2002)10.10
    
    National Processing, Inc. 2000 Stock Option Plan.
(Incorporated herein by reference to Exhibit 10.28 to the Companys
Annual Report on Form 10-K for the year ended December 31, 2002) **10.11
    
    National Processing Company 1996 Stock Option Plan.
(Incorporated herein by reference to Exhibit 10.29 to the Companys
Annual Report on Form 10-K for the year ended December 31, 2002) **10.12
    
    Nonemployee Directors Stock Option Plan and Form of Stock
Option Agreement. (B) **10.13
    
    National Processing Company Short-Term Incentive Compensation
Plan for Senior Executives, as amended and restated effective
November 6, 2003. (Incorporated herein by reference to Exhibit 10.13
to the Companys Annual Report on Form 10-K for the year ended
December 31, 2003) **10.14
    
    National Processing Company Long-Term Incentive Compensation
Plan for Senior Officers, as amended and restated effective February
1, 2003. (Incorporated herein by reference to Exhibit 10.32 to the
Companys Annual Report on Form 10-K for the year ended December 31,
2002) **10.15
    
    Amendment to Building Lease between National City Bank of
Kentucky and NPC, dated July 3, 1996. (B)10.16
    
    Form of Severance Agreement between the Company and David
Fountain. (Incorporated herein by reference to Exhibit 10.16 to the
Companys Annual Report on Form 10-K for the year ended December 31,
2003) **10.17
    
    Form of Severance Agreement between the Company and Mark D.
Pyke and Robert Robins. (Incorporated herein by reference to Exhibit
10.38 to the Companys Quarterly Report on Form 10-Q for the quarter
ended September 30, 2002) **10.18
    
    Employment Agreement and Undertaking of Confidentiality
between the Company and David Fountain dated October 27, 1998.
(Incorporated herein by reference to Exhibit 10.39 to the Companys
Quarterly Report on Form 10-Q for the quarter ended September 30,
2002) **10.19
    
    National Processing, Inc. 2001 Restricted Stock Plan.
(Incorporated herein by reference to Exhibit B to National
Processing, Inc.s Proxy Statement on Form 14A #001-11905, dated
March 31, 2001) **10.20
    
    National Processing, Inc.s U.S. Asset Purchase Agreement,
dated July 11, 2001. (Incorporated herein by reference to Exhibit
10.42 to the Companys Quarterly Report on Form 10-Q for the quarter
ended June 30, 2001)10.21
    
    National Processing, Inc.s Mexico Asset Purchase Agreement,
dated July 11, 2001. (Incorporated herein by reference to Exhibit
10.43 to the Companys Quarterly Report on Form 10-Q for the quarter
ended June 30, 2001)10.22
    
    National Processing, Inc.s Stock Purchase Agreement, dated
July 11, 2001. (Incorporated herein by reference to Exhibit 10.44 to
the Companys Quarterly Report on Form 10-Q for the quarter ended
June 30, 2001)10.23
    
    Guarantee between National
Processing, Inc. and MasterCard®
International Incorporated dated May 16, 2003. (Incorporated herein
by reference to Exhibit 10.23 to the Companys Quarterly Report on
Form 10-Q for the quarter ended June 30, 2003)
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EXHIBITNUMBER
    
    DESCRIPTION10.24
    
    The National City Corporation Savings and Investment Plan, as
amended and restated effective January 1, 2001. (Incorporated
herein by reference to Exhibit 10.33 to National City Corporations
Annual Report on Form 10-K for the year ended December 31, 2002)10.25
    
    The National City Corporation Savings and Investment Plan No.
2, as amended and restated effective January 1, 2001. (Incorporated
herein by reference to Exhibit 10.34 to National City Corporations
Annual Report on Form 10-K for the year ended December 31, 2002)10.26
    
    Amendment No. 1 to the National City Savings and Investment
Plan, as amended and restated effective January 1, 2001.
(Incorporated herein by reference to Exhibit 10.35 to National City
Corporations Annual Report on Form 10-K for the year ended December
31, 2002)10.27
    
    Amendment No. 1 to the National City Savings and Investment
Plan No. 2, as amended and restated effective January 1, 2001.
(Incorporated herein by reference to Exhibit 10.36 to National City
Corporations Annual Report on Form 10-K for the year ended December
31, 2002)10.28
    
    Agreement and Plan of Merger by and among Bank of America
Corporation, Monarch Acquisition, Inc. and National Processing, Inc.
dated as of July 12, 2004. (Incorporated herein by reference to
Exhibit 99.2 to the Companys Current Report on Form 8-K filed July
13, 2004)10.29
    
    Service and Sponsorship Agreement between the Company, the
successor to the Company and National City Bank of Kentucky.
(Incorporated herein by reference to Exhibit 99.3 to the Companys
Current Report on Form 8-K filed July 13, 2004)10.30
    
    Master Referral Agreement by and between Bank of America, N.A.
and National City Corporation. (Incorporated herein by reference to
Exhibit 99.4 to the Companys Current Report on Form 8-K filed July
13, 2004)10.31
    
    Shareholders Agreement by and among Bank of America
Corporation and National City Corporation. (Incorporated herein by
reference to Exhibit 99.5 to the Companys Current Report on Form 8-K
filed July 13, 2004)10.32
    
    Form of Severance Agreement between the Company and Kelly L.
Lanham and Norman M. Martin. **10.33
    
    Retention Agreement between the Company and Mark D. Pyke dated
July 12, 2004. **10.34
    
    Retention Agreement between the
Company and Norman M. Martin dated August 4, 2004.**14.1
    
    Code of Ethics. (Incorporated herein by reference to Exhibit
14.1 to the Companys Current Report on Form 8-K filed August 11,
2003)14.2
    
    Senior Financial Officers Code of Ethics. (Incorporated herein
by reference to Exhibit 14.2 to the Companys Current Report on Form
8-K filed August 11, 2003)31.1
    
    Chief Executive Officer 302 Certification dated August 6, 2004
for National Processing, Inc.s Quarterly Report on Form 10-Q for the
quarter ended June 30, 2004.31.2
    
    Chief Financial Officer 302 Certification dated August 6, 2004
for National Processing, Inc.s Quarterly Report on Form 10-Q for the
quarter ended June 30, 2004.32.1
    
    Chief Executive Officer 906 Certification dated August 6, 2004
for National Processing, Inc.s Quarterly Report on Form 10-Q for
quarter ended June 30, 2004.32.2
    
    Chief Financial Officer 906 Certification dated August 6, 2004
for National Processing, Inc.s Quarterly Report on Form 10-Q for
quarter ended June 30, 2004.(A)
    
    Exhibit is incorporated herein by reference to the applicable
exhibit in the Companys Registration Statement on Form S-1
(Registration No. 333-05507) filed on June 7, 1996.(B)
    
    Exhibit is incorporated herein by reference to the applicable
exhibit in the Companys Amendment No. 1 to Form S-1 Registration
Statement (Registration No. 333-05507) filed on July 18, 1996.**
    
    Represents a management contract or compensatory plan required
to be filed pursuant to Item 14 of Form 10-K.
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b.
    
    Reports on Form 8-K April 15, 2004: On April 15, 2004, the Company issued a news release
reporting earnings and including a financial summary for the quarter ended
March 31, 2004. May 28, 2004: On May 28, 2004, the Company issued a news release
announcing that its Board of Directors is reviewing the Companys various
strategic alternatives. July 13, 2004: On July 13, 2004, the Company and Bank of America
announced a definitive agreement had been reached for Bank of America to
purchase all outstanding shares of the Company. July 16, 2004: On July 16, 2004, the Company issued a news release
reporting earnings and including a financial summary for the quarter and
six months ended June 30, 2004. 
 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934,
the Company has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. NATIONAL PROCESSING, INC.Date: August 6, 2004
    
    By: /s/ Jon L. GorneyJon L. GorneyChairman and Chief Executive Officer(Duly Authorized Signer)/s/ David E. FountainDavid E. FountainSenior Vice President and Chief Financial Officer(Principal Financial Officer)/s/ Kelly L. LanhamKelly L. LanhamSenior Vice President and Chief Accounting Officer(Principal Accounting Officer)
 30