OFFICIAL PAYMENTS HOLDINGS, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) This Management's Discussion and Analysis of Financial Condition and Results of Operations includes forward-looking statements. We have based these forward-looking statements on our current plans, expectations and beliefs about future events. Our actual performance could differ materially from the expectations and beliefs reflected in the forward-looking statements in this section and throughout this report, as a result of the risks, uncertainties and assumptions discussed under Item 1A-Risk Factors of this Annual Report on Form 10-K and other factors discussed in this section. For information regarding what constitutes a forward-looking statement please refer to the Private Securities Litigation Reform Act Safe Harbor Statement on page .

OVERVIEW Official Payments provides electronic payment solutions for over 3,000 Clients across all 50 states, Puerto Rico and the District of Columbia. Official Payments' solutions enable government agencies, educational institutions, utility companies and charitable organizations to accept payments by credit card, debit card and electronic check via mobile, web, telephone and point of sale environments.

KEY FISCAL 2012 INITIATIVES AND EVENTS During fiscal 2012 Official Payments continued to focus on initiatives aimed at improving the quality and reliability of our technology infrastructure, and on improving our operational efficiency.

During our first fiscal quarter, we completed the relocation of our principal executive offices to Norcross, Georgia from Reston, Virginia. As previously disclosed, we believe that our operating and personnel costs will be lower in Georgia than in Virginia and that Georgia offers a labor force with more experience in electronic payments.

During fiscal 2012, we completed substantial upgrades to our hardware, software, and services infrastructure to improve the reliability and security of our core payments systems, and to provide network capacity that will enable us to deliver expanded product capabilities and handle future increases in transaction volumes. As of September 30, 2012, we completed this project and the related assets were placed into service.

We consolidated certain operations functions, which allowed us to reduce our number of active data centers from five to three as of the end of fiscal 2012 thus reducing related costs and operational complexity.

Effective with the commencement of fiscal 2012, the Durbin Amendment to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 became effective. The Durbin Amendment limits debit card discount fees charged by card issuing banks. Because we process a large number of debit card transactions, the Durbin Amendment has caused us to experience a meaningful decrease in Direct Costs in our Consolidated Statements of Operations throughout fiscal 2012 and to date in fiscal 2013. Given that this cost savings is a function of regulatory action, we are unable to predict the long-term impact of the Durbin Amendment.

KEY FISCAL 2013 INITIATIVES Platform Consolidation We currently support three processing platforms, a legacy of past acquisitions.

We believe that our Clients would be better served by combining our payment operations into a single processing platform. By using one platform we believe that we will be more efficient, more flexible in delivering new product features and services, and able to provide a better overall Client and Customer experience. We therefore intend to execute the previously discussed platform consolidation project with a target of being substantially complete by the end of calendar 2013. We estimate that this consolidation project will cost approximately $2.5 million, a substantial cost savings, compared to prior estimates.

17-------------------------------------------------------------------------------- Back to table of contents Product Building products that Customers want to use is important to our ability to sign up new Clients and to get their Customers and Constituents to make more payments utilizing Official Payments' services. We intend to supplement our current browser-based mobile solutions with the launch of native applications (apps) for iPad, iPhone, and Android users in fiscal 2013. In addition, we believe that there is a significant opportunity to enable our Clients to deliver their bills electronically to their Customers and Constituents, so we plan to introduce a suite of electronic bill presentment solutions in fiscal 2013 as well.

Continued Operational Efficiency We also continue to work to reduce our overall processing costs, including discount fees and other related transaction processing fees. We believe that promoting lower cost, higher margin payment types may result in both higher Customer adoption and higher Payment Solutions net revenue.

RESULTS OF OPERATIONS-FISCAL 2012 AND 2011 The following table provides an overview of our results from continuing operations for fiscal 2012 and 2011: Variance Year ended September 30, 2012 vs. 2011 (in thousands, except percentages) 2012 2011 $ % Revenues $ 135,741 $ 130,170 $ 5,571 4.3 % Costs and expenses: Direct costs 95,373 100,764 (5,391 ) (5.4 )% General and administrative 30,457 22,766 7,691 33.8 % Selling and marketing 8,468 6,940 1,528 22.0 % Depreciation and amortization 7,354 7,314 40 0.5 % Total costs and expenses 141,652 137,784 3,868 2.8 % Loss from continuing operations before other income and income taxes (5,911 ) (7,614 ) 1,703 22.4 % Other income (1 ) 82 (83 ) (101.2 )% Loss from continuing operations before income taxes (5,912 ) (7,532 ) 1,620 21.5 % Income tax provision (benefit) 54 (100 ) 154 154.0 % Loss from continuing operations (5,966 ) (7,432 ) 1,466 19.7 % (Loss) income from discontinued operations, net (14 ) 219 (233 ) (106.4 )% Net loss $ (5,980 ) $ (7,213 ) $ 1,233 17.1 % CONTINUING OPERATIONS The Continuing Operations section of our Consolidated Statements of Operations includes the results of operations of our Payment Solutions business and our VSA operations.

COMPARISON-FISCAL 2012 TO 2011 Payment Solutions net revenue Net Revenue Year ended September 30, (in thousands, except percentages) 2012 2011 Change ($) Change (%) Payment Solutions net revenue $ 45,938 $ 33,719 $ 12,219 36.2 % 18-------------------------------------------------------------------------------- Back to table of contents The increase in Payment Solutions net revenue in fiscal 2012 was driven primarily by lower discount fees we incurred in connection with processing payments. These better rates are primarily a function of cost benefits we realized as result of the Durbin Amendment and savings associated with negotiating lower processing fees. There is no assurance that these savings will continue in future periods.

Revenues (Continuing Operations) Year ended September 30, Variance (in thousands, except percentages) 2012 2011 $ % Revenues Payment Solutions $ 134,406 $ 128,644 $ 5,762 4.5 % VSA 1,335 1,526 (191 ) (12.5 )% Total $ 135,741 $ 130,170 $ 5,571 4.3 % Payment Solutions Revenues: Our core business consists of Payment Solutions that we offer to a variety of federal, state and local governments, utility companies, higher education institutions, and charitable organizations. Our Clients utilize our services to provide electronic payment alternatives to their Customers or Constituents. Examples of payment transactions made utilizing our services include federal and state income taxes, real property taxes, tuition payments, court and other fines, utility and other payment obligations and charitable donations. In fiscal 2012 we processed approximately 20 million transactions, representing approximately $9.0 billion in payment volume.

We offer our Clients two primary pricing options: convenience fees paid by the Customer, and absorbed fees paid by the Client. These fees are generally calculated as a percentage of the underlying transaction amount, but may also be expressed as a fixed fee in some cases. Payment Solutions revenue is comprised almost solely of such fees.

During fiscal 2012, we processed 0.5% fewer transactions than in fiscal 2011, principally due to a decrease in transaction volume in our utilities market.

The decline in transaction volume was more than offset by a 10.6% increase in our average payment size, which resulted in a 10.1% increase in total dollars processed in fiscal 2012 over fiscal 2011. Most of the growth in payment size and dollars processed was attributable to higher education, federal, state and local government Clients. Offsetting these increases, we experienced a 15.0% decrease in transactions for utilities Clients during fiscal year 2012 versus fiscal year 2011, due to a decrease in transactions for large utilities.

Our gross margin from Continuing Operations is calculated by subtracting (i) direct costs from Continuing Operations from (ii) revenue from Continuing Operations. Our gross margin percentage is calculated by dividing (i) gross margin from Continuing Operations by (ii) revenue from Continuing Operations.

Our gross margin and gross margin percentage depend on four principal factors: revenue, cost, the number of transactions processed, and the mix of transactions by Client type and payment type.

· Our revenue from a transaction depends on whether we receive a flat fee or a fee based on a percentage of the transaction amount. The type and amount of a fee depends on many competitive considerations, including regulations of payment networks, industry competition, and the level of service that we provide at each Client. If our revenue is equal to a percentage of the amount paid, then revenue will also be affected by all the factors that cause payment amounts to vary.

· Our direct cost for a transaction depends principally on how the payment is made. It costs us more to process certain types of transactions such as credit card payments and less to process other types of transactions such as electronic checks and debit card payments. We discuss our direct costs in more detail below.

19-------------------------------------------------------------------------------- Back to table of contents · The number of transactions we process and the mix of transactions among Client types are influenced by, among other things: Customers' and Constituents' payment preferences; the type of payments being processed (annual, monthly, quarterly, or periodic); the market penetration of electronic payment options among federal, state, and local governments, higher education institutions, utility companies and charitable organizations; the success of our sales and marketing efforts; and the usability of our products and services.

Each of these factors is subject to change, and as a result, our gross margin from Continuing Operations and our gross margin percentage may change at different rates.

We expect to experience continued growth in revenue, Payment Solutions net revenue and gross margin in fiscal 2013 as compared with fiscal 2012, as we execute on our key strategic initiatives.

VSA Revenues: Consistent with our plan to wind down our VSA operation, our revenue decreased for fiscal 2012 when compared to fiscal 2011, as underlying contracts expire. We expect to see continued revenue decreases during fiscal 2013 and 2014.

Direct Costs (Continuing Operations) Direct costs, which represent costs directly attributable to providing services to Clients, consist predominantly of discount fees. Discount fees include payment card interchange fees, assessments payable to banks and payment card processing fees. Other, less significant costs include: payroll and payroll-related costs; travel-related expenditures; co-location and telephony costs; and the cost of hardware, software and equipment sold to VSA Clients.

The following table provides a year-over-year comparison of direct costs incurred by our Continuing Operations during fiscal years 2012 and 2011: Year ended September 30, Variance (in thousands, except percentages) 2012 2011 $ % Direct costs Payment Solutions: Discount fees $ 88,468 $ 94,925 $ (6,457 ) (6.8 )% Other costs 6,248 5,583 665 11.9 % Total Payment Solutions 94,716 100,508 (5,792 ) (5.8 )% VSA 657 256 401 156.6 % Total $ 95,373 $ 100,764 $ (5,391 ) 5.4 % The following sections discuss the key factors that caused these changes in direct costs for Continuing Operations.

Payment Solutions Direct Costs: Discount fees decreased $6.5 million, or 6.8%, from fiscal 2011 to fiscal 2012. The decrease in discount fees is a result of cost savings from the Durbin Amendment, as well as lower negotiated processing fees for some of our Clients.

Other direct costs increased $0.6 million, or 10.1%, during fiscal 2012 as compared with fiscal 2011 as a result of increased co-location facility costs.

VSA Direct Costs: During fiscal 2012, direct costs from our VSA operations increased $0.4 million, or 156.6%, as compared with fiscal 2011. This increase is attributable to the costs associated with contracted services provided in connection with a one-time project for a VSA Client. As we continue the wind down of VSA, we expect VSA direct costs to decrease during fiscal 2013.

General and Administrative (Continuing Operations) General and administrative (G&A) expenses consist primarily of: payroll and payroll-related costs for technology, product management, finance, accounting, legal and executive management; information systems; and outside services fees, including regulatory compliance, audits and other costs that we incur as a public company. Information systems expenses include costs to enhance our processing platforms as well 20-------------------------------------------------------------------------------- Back to table of contents as the costs associated with ongoing maintenance of these platforms. The following table compares general and administrative costs incurred during fiscal 2012 and 2011: Year ended September 30, Variance (in thousands, except percentages) 2012 2011 $ % General and administrative Payment Solutions $ 30,261 $ 22,761 $ 7,500 33.0 % VSA 196 5 191 3,820.0 % Total $ 30,457 $ 22,766 $ 7,691 33.8 % Payment Solutions General and Administrative: During fiscal 2012, Payment Solutions G&A expenses increased $7.5 million, or 33.0%, over fiscal year 2011.

Several factors contributed to the overall increase in G&A expenses during fiscal 2012. First, we accrued performance-related compensation expenses $3.3 million higher than in fiscal 2011. Second, our share based compensation expense is $1.8 million greater in fiscal 2012 than in fiscal 2011 primarily due to the fiscal 2011 reversal of $1.5 million of expense related to restricted stock units ("RSUs") that had been granted to our former CEO. The vesting conditions of the RSUs were not satisfied and $1.5 million of previously recorded expense was reversed in the quarter ended March 31, 2011. Third, during fiscal 2012, we recorded a restructuring charge of $1.6 million, including relocation costs of $0.1 million, related to the relocation of our principal executive offices from Reston, Virginia to Norcross, Georgia. In connection with vacating and subletting our Reston, Virginia facility we wrote off certain balances associated with our original lease agreement including leasehold improvements, net of accumulated amortization and deferred rent. Lastly, we incurred an increase in nonperformance-related employee compensation expense of $1.2 million in fiscal 2012 as compared to fiscal 2011, primarily as a result of increased headcount in our technology organization, related to the previously discussed infrastructure and platform consolidation projects.

We expect fiscal 2013 G&A expenses to decrease over fiscal 2012, due to the one-time nature of our restructuring costs, as well as an expected decrease in management incentive plan costs.

VSA General and Administrative: G&A costs for VSA operations increased $0.2 million in fiscal 2012 over fiscal 2011. We expect to see de minimis general and administrative expenses for our VSA operation during fiscal 2013, as we continue to wind-down the related contracts.

Selling and Marketing (Continuing Operations) Selling and marketing expenses consist primarily of payroll and payroll-related costs for sales, large account management and marketing personnel, sales commissions, advertising and marketing expenditures and travel-related expenditures. We expect selling and marketing expenses to fluctuate from quarter to quarter due to a variety of factors, such as increased advertising and marketing expenses incurred in connection with the April 15th federal income tax payment deadline. The following table provides a year-over-year comparison of selling and marketing costs incurred during fiscal 2012 and 2011: Year ended September 30, Variance (in thousands, except percentages) 2012 2011 $ % Selling and marketing Payment Solutions $ 8,468 $ 6,940 $ 1,528 22.0 % VSA - - - - Total $ 8,468 $ 6,940 $ 1,528 22.0 % Payment Solutions Selling and Marketing: During fiscal 2012, Payment Solutions selling and marketing expenses increased $1.5 million, or 22.0% over fiscal 2011. The most significant factor in the year over year increase was a $0.4 million increase in commissions paid, which was driven by higher net revenues from Clients. Additionally, both advertising costs and travel related expenses increased by $0.3 million during fiscal 2012, 21-------------------------------------------------------------------------------- Back to table of contents reflecting our efforts to increase revenues. Lastly, we incurred $0.3 million of severance costs in connection with the termination of our Senior Vice President, Strategic Marketing during the fourth quarter of fiscal 2012.

Depreciation and Amortization (Continuing Operations) Depreciation and amortization represents expenses associated with the depreciation of equipment, software and leasehold improvements, as well as the amortization of intangible assets from acquisitions and other intellectual property not directly attributable to Client projects. The following table provides a year-over-year comparison of depreciation and amortization costs during fiscal 2012 and 2011: Year ended September 30, Variance (in thousands, except percentages) 2012 2011 $ % Depreciation and amortization Payment Solutions $ 7,354 $ 7,314 $ 40 0.5 % VSA - - - - Total $ 7,354 $ 7,314 $ 40 0.5 % Depreciation expense was $0.6 million higher in fiscal 2012 as compared with fiscal 2011, due to internally developed software and infrastructure assets, being placed into service during fiscal 2012. This amount was almost completely offset by a decrease in amortization expense due to certain intangible assets becoming fully amortized. We did not incur depreciation or amortization expense for our VSA operation during fiscal 2012 or 2011. We expect fiscal 2013 depreciation and amortization expense to be consistent with the level in fiscal 2012.

Other Income (Continuing Operations) Interest income (expense), net: Interest income during fiscal 2012 decreased $0.08 million compared to fiscal 2011 primarily due to a decrease in interest rates earned on our invested cash. Our interest rates fluctuate with changes in the marketplace.

Income Tax Provision (Continuing Operations) Our income tax provision from continuing operations was $54,000 in fiscal 2012, a $9,000 increase over fiscal 2011. The provision for income taxes represents state tax obligations incurred by our Payment Solutions operations and an intra-period tax allocation between continuing and discontinued operations. Our Consolidated Statements of Operations for fiscal 2012 and 2011 do not reflect a federal tax provision because of offsetting adjustments to our deferred tax asset valuation allowance, which reduces any tax benefit to zero. Our effective tax rates differ from the federal statutory rate due to state income taxes, tax-exempt interest income and the charge for establishing a valuation allowance on our net deferred tax assets. Our future tax rate may vary due to factors including, but not limited to: the relative income contribution by tax jurisdiction; changes in statutory tax rates; the amount of tax exempt interest income generated during the year; changes in our valuation allowance; our ability to utilize net operating losses and any non-deductible items related to acquisitions or other nonrecurring charges.

Tax Loss Carryforwards At September 30, 2012, we had $125.7 million of federal net operating loss carryforwards, which expire beginning in fiscal 2018 through 2032, and $109.0 million of state net operating loss carryforwards, most of which begin to expire after fiscal 2018 through 2032. Of the $125.7 million of federal net operating loss carryforward and $109.0 million of state net operating loss carryforwards, $48.6 million and $28.1 million, respectively, were acquired with the purchase of Official Payments Corporation in 2002. As of September 30, 2012 approximately $108.3 million of our federal net operating loss carryforwards do not have any restrictions. Our acquired federal net operating loss carryforward is limited to $3.4 million per year pursuant to Internal Revenue Code Section 382, and approximately $11.2 million is still limited to this annual amount. If future ownership changes occur, there could be further limitations to our federal net operating loss carryforwards.

22-------------------------------------------------------------------------------- Back to table of contents RESULTS OF OPERATIONS-FISCAL 2011 AND 2010 The following table provides an overview of our results of operations for fiscal 2011 and 2010: Variance Year ended September 30, 2011 vs. 2010 (in thousands, except percentages) 2011 2010 $ % Revenues $ 130,170 $ 130,224 $ (54 ) - Costs and expenses: Direct costs 100,764 98,328 2,436 2.5 % General and administrative 22,766 25,199 (2,433 ) (9.7 )% Selling and marketing 6,940 6,355 585 9.2 % Depreciation and amortization 7,314 6,711 603 9.0 % Total costs and expenses 137,784 136,593 1,191 0.9 % Loss from continuing operations before other income and income taxes (7,614 ) (6,369 ) (1,245 ) (19.6 )% Other income 82 451 (369 ) (81.8 )% Loss from continuing operations before income taxes (7,532 ) (5,918 ) (1,614 ) (27.3 )% Income tax (benefit) provision (100 ) 30 (130 ) * Loss from continuing operations (7,432 ) (5,948 ) (1,484 ) (25.0 )% Income (loss) from discontinued operations, net 219 (245 ) 464 * Net loss $ (7,213 ) $ (6,193 ) $ (1,020 ) (16.5 )% * Not meaningful COMPARISON-FISCAL 2011 TO 2010 Revenues (Continuing Operations) The following table compares the revenues generated by our Continuing Operations during fiscal years 2011 and 2010: Year ended September 30, Variance (in thousands, except percentages) 2011 2010 $ % Revenues Payment Solutions $ 128,644 $ 127,223 $ 1,421 1.1 % VSA 1,526 3,001 (1,475 ) (49.2 )% Total $ 130,170 $ 130,224 $ (54 ) - Payment Solutions Revenues: During fiscal 2011, we processed 7.3% more transactions than in fiscal 2010, representing 5.7% more dollars processed.

The lower growth in dollars processed, as compared with growth in transactions, was due primarily to an increase in transactions from Customers with lower average dollar size per transaction. Furthermore, the economic environment also caused the average payment size to decline. The combination of increased transactions processed, with lower average payment size resulted in minimal revenue growth in fiscal 2011.

Additionally, we experienced an 11.8% decrease in transactions processed for utility Clients, versus the previous year, primarily because many of the large utilities that became Official Payments Clients when ChoicePay was acquired did not renew their contracts. The majority of other Client types experienced increases in transactions processed, ranging from 8.1% to 18.0% during fiscal 2011 as compared to fiscal 2010.

VSA Revenues: Consistent with the plan to wind down our VSA operation, revenue decreased for fiscal 2011 when compared to fiscal 2010, as a result of contract completions.

Direct Costs (Continuing Operations) The following table provides a year-over-year comparison of direct costs incurred by our Continuing Operations during fiscal 2011 and 2010: 23-------------------------------------------------------------------------------- Back to table of contents Year ended September 30, Variance (in thousands, except percentages) 2011 2010 $ % Direct costs Payment Solutions: Discount fees $ 94,925 $ 90,853 $ 4,072 4.5 % Other costs 5,583 6,197 (614 ) (10.0 )% Total Payment Solutions 100,508 97,050 3,458 3.6 % VSA 256 1,278 (1,022 ) (80.0 )% Total $ 100,764 $ 98,328 $ 2,436 2.5 % Payment Solutions Direct Costs: A 7.3% increase in transaction volume during fiscal 2011 was the primary cause of the 4.5% increase in discount fees over fiscal 2010. Further contributing to the increase in discount fees were the fluctuation in payment methods used by Customers as well as an increase in discount fees charged by one of the payment networks. In addition, during fiscal 2010 we recognized a one-time reduction in cost of $0.3 million from settlement funds received related to payment card processing fees.

The decrease in other direct costs was primarily attributable to a $0.3 million decrease in telephony costs as a result of our efforts to improve efficiencies in our telephony structure. We also benefited from a $0.1 million decrease in labor and labor-related expenses, which includes temporary labor, primarily due to efforts to more efficiently staff our customer service department during the income tax season. In addition, we benefited from $0.2 million in reduced non-capitalized equipment purchases, software maintenance and other miscellaneous costs. Offsetting these decreases was $0.1 million in one-time expense associated with integration costs for certain higher education Clients.

VSA Direct Costs: Product and material costs decreased $0.5 million during fiscal 2011 compared to fiscal 2010. The completion of several projects meant that certain software maintenance contracts did not have to be renewed, resulting in a $0.2 million reduction in expense. The remaining $0.3 million in reduced expenses was related to labor and labor-related expenses, telephony costs and other office expenses, consistent with the reduction in contracts to service.

General and Administrative (Continuing Operations) The following table compares general and administrative (G&A) costs incurred during fiscal 2011 and 2010: Year ended September 30, Variance (in thousands, except percentages) 2011 2010 $ % General and administrative Payment Solutions $ 22,761 $ 24,821 $ (2,060 ) (8.3 )% VSA 5 378 (373 ) (98.7 )% Total $ 22,766 $ 25,199 $ (2,433 ) (9.7 )% Payment Solutions General and Administrative: Several factors contributed to the overall decrease in G&A expenses during fiscal 2011. Share-based payment expense decreased $1.3 million when comparing fiscal 2011 to 2010. During fiscal 2011, we reversed $1.5 million in share-based payment expense related to Restricted Stock Units, (RSUs) granted to a former CEO. RSU vesting conditions were not satisfied and we reversed the expense that had been previously recognized. Two factors contributed to a $0.2 million increase to share-based payment expense in fiscal 2011: (1) we granted every employee options to purchase shares of our stock, which led to an increase in the total number of shares vesting and the associated expense, and (2) fiscal 2010 benefitted from significant credits to share-based payment expense due to our Performance Stock Units, (PSUs), as well as a declining stock price.

During fiscal 2010 we recorded nearly $1.5 million in severance expense related to the departure of a former CEO and former COO. During fiscal 2011, we recorded approximately $0.5 million in severance expense related to the departure of our former CFO and the severance expense related to the transition of our corporate office to Norcross, Georgia. This resulted in a $1.0 million net expense reduction in fiscal 2011 over the prior year. Fiscal 2011 management incentive plan expense was $0.8 million less than in fiscal 2010 because we did not meet our fiscal 2011 performance goals.

24-------------------------------------------------------------------------------- Back to table of contents Our legal expenses decreased $0.9 million in fiscal 2011 versus fiscal 2010, primarily due to one-time legal costs incurred during fiscal 2010 related to corporate governance matters and our annual meeting and proxy statement. Our facilities related costs decreased $0.6 million in fiscal 2011 over fiscal 2010 due to a full year benefit of reduced rent expense for our Reston office as well as the absence of restructuring costs related to our San Ramon, California, Tulsa, Oklahoma and Auburn, Alabama office consolidations. During fiscal 2011 we increased our collection efforts on accounts receivable and as a result we re-evaluated our estimate for bad debts which resulted in a $0.5 million decrease in bad debt expense in fiscal 2011 versus fiscal 2010.

Further contributing to the overall reduction in G&A expenses in fiscal 2011 versus fiscal 2010 were: a $0.4 million reduction in telephony costs as a result of reduced pricing agreements placed into effect late in fiscal 2010; a $0.2 million reduction in recruiting expense as a result of expenses incurred in fiscal 2010 for our CEO search; and $0.1 million in reduced travel and travel-related expenses.

Primarily offsetting these decreases was an increase in labor and labor-related costs of $2.3 million in fiscal 2011 versus fiscal 2010, a result of additional positions added at the senior executive level, the addition of software developers, a decrease in internally developed software projects that capitalize labor, and an increase in maintenance work on existing platforms. In addition, our outside consultant and services labor costs increased $0.7 million in fiscal 2011 versus fiscal 2010. Our software and equipment purchases and maintenance agreements increased $0.4 million in fiscal 2011 versus fiscal 2010, consistent with previously discussed network upgrade initiatives. Finally, our money transmitter license and fee expense increased $0.3 million primarily attributable to obtaining licenses in several new states.

VSA General and Administrative: The decrease in fiscal 2011 for VSA G&A expenses relates primarily to an adjustment to bad debt expense in fiscal 2011 relating to a Pension contract payment received that had been fully reserved.

Selling and Marketing (Continuing Operations) The following table provides a year-over-year comparison of selling and marketing costs incurred during fiscal 2011 and 2010: Year ended September 30, Variance (in thousands, except percentages) 2011 2010 $ % Selling and marketing Payment Solutions $ 6,940 $ 6,355 $ 585 9.2 % VSA - - - - Total $ 6,940 $ 6,355 $ 585 9.2 % Payment Solutions Selling and Marketing: Advertising expense increased $0.6 million in fiscal 2011 versus fiscal 2010, a result of a strategic initiative to expand marketing campaigns to more markets. We also incurred $0.1 million in severance expense in fiscal 2011 versus fiscal 2010 as a result of the departure of several employees in our sales group. Furthermore, our share-based payment expense increased $0.1 million year-over-year due to an increase in the number of options which had been granted. Our sales commission expense increased $0.1 million year-over-year, as a result of the structure of our fiscal 2011 commission plan. Offsetting these increases is a decrease in marketing research of $0.2 million and a $0.1 million decrease in labor and labor-related expenses, including consultants and outside services.

Depreciation and Amortization (Continuing Operations) The following table provides a year-over-year comparison of depreciation and amortization costs incurred during fiscal years 2011 and 2010: 25-------------------------------------------------------------------------------- Back to table of contents Year ended September 30, Variance (in thousands, except percentages) 2011 2010 $ % Depreciation and amortization Payment Solutions $ 7,314 $ 5,625 $ 1,689 30.1 % VSA - 1,086 (1,086 ) (100.0 )% Total $ 7,314 $ 6,711 $ 142 9.0 % During the fourth quarter of fiscal 2010 we placed several internally developed software projects into service with a three year useful life, resulting in a full year of depreciation expense recorded during fiscal 2011. This was the primary reason for the increase in depreciation and amortization expense for Payment Solutions. We did not incur any depreciation or amortization expense for our VSA operation during fiscal 2011, consistent with our plan to wind down the VSA business.

Other Income (Continuing Operations) Interest income, net: Fiscal 2011 interest income decreased $0.3 million compared to fiscal 2010, attributable to both a decrease in the size of our investment portfolio and decreases in interest rates. Due to current market conditions, we elected to sell the municipal bonds we then owned and invest the proceeds in money market accounts, treasury bills, discount notes and commercial paper - often at lower interest rates than were being paid by the municipal bonds.

Income Tax Provision (Continuing Operations) We reported an income tax benefit from continuing operations of $100,000 for fiscal 2011, as compared to fiscal 2010, in which we recorded a provision of $30,000. The provision for income taxes represents state tax obligations incurred by our Payment Solutions operations and an intra-period tax allocation between continuing and discontinued operations. Our Consolidated Statements of Operations for fiscal 2011 and 2010 do not reflect a federal tax provision because of offsetting adjustments to our deferred tax asset valuation allowance.

LIQUIDITY AND CAPITAL RESOURCES At September 30, 2012 we had $39.1 million in cash and cash equivalents compared with $39.8 million at September 30, 2011. The decline in cash and cash equivalents is primarily associated with the acquisition of network-related infrastructure and spending on internally developed software.

As discussed in Note 5-Customer Concentration and Risk and Note 9-Commitments and Contingencies our Consolidated Balance Sheets include settlements receivable and payable. We had $39.1 million in cash and cash equivalents at September 30, 2012. We had $15.3 million of settlements receivable at September 30, 2012 which we collected within two days of the fiscal year end as settlements from credit card companies and banks. We had $17.0 million of settlements payable and $5.6 million of accrued discount fees as of September 30, 2012 that we had not yet distributed to clients due to the timing of bank transactions.

In July 2011 we committed $8.3 million to upgrade our infrastructure, which included the purchase of hardware, software and professional services. The project commenced in August 2011 and was completed and put into service in September 2012.

We believe we have sufficient liquidity to meet currently anticipated needs, including capital expenditures, working capital investments, and acquisitions for the next twelve months. We expect to generate cash flows from operating activities over the long term; however, we may experience significant fluctuations from quarter to quarter as a result of the timing of billing and collections, and the related settlement of funds. To the extent that our existing capital resources are insufficient to meet our capital requirements, we would have to raise additional funds. There can be no assurance that such additional funding, if necessary, would be available on favorable terms, if at all. Currently, we do not have any short or long-term debt.

26-------------------------------------------------------------------------------- Back to table of contents Net Cash from Continuing Operations-Operating Activities. During fiscal 2012, our operating activities from Continuing Operations generated $4.1 million of cash. This reflects a net loss of $6.0 million from Continuing Operations and $10.1 million of non-cash items in net income. Changes in working capital generated $0.9 million of cash during fiscal 2012.

Net Cash from Continuing Operations-Investing Activities. Net cash used by our investing activities from Continuing Operations for fiscal 2012 was $4.7 million. The purchase of equipment and software to support our Payment Solutions operations, including internally developed software used $4.6 million of cash and payment for the ChoicePay earn-out used $0.1 million of cash.

Net Cash from Continuing Operations-Financing Activities. Net cash used in our financing activities from Continuing Operations for fiscal 2012 was $0.03 million, reflecting $34,000 of capital lease obligations cash use.

Net Cash from Discontinued Operations-Operating Activities. During fiscal 2012, our operating activities from Discontinued Operations used $14,000 of cash for miscellaneous legal expenses.

Net Cash from Discontinued Operations-Investing Activities. During fiscal 2012, there was no cash generated or used by investing activities from discontinued operations. During fiscal 2011 investing activities from discontinued operations provided $0.4 million of cash as a result of an earn-out payment, net of taxes, from the sale of our former GBPO business.

CRITICAL ACCOUNTING POLICIES Our discussion and analysis of our financial condition and results of operations is based on our Consolidated Financial Statements, which have been prepared in accordance with US GAAP. Note 2-Summary of Significant Accounting and Reporting Policies of our Notes to Consolidated Financial Statements contains a summary of our significant accounting policies, many of which require the use of estimates and assumptions. We believe that of our significant policies, the following are the most noteworthy because they are based upon estimates and assumptions that require complex subjective judgments by management, which can have a material effect on our reported results. Changes in these estimates or assumptions could materially affect our financial condition and results of operations. Actual results could differ materially from management's estimates.

Revenue Recognition Electronic payment processing revenue: Electronic payment processing and fee income is derived from the electronic processing of credit and debit card transactions that are captured and authorized through third-party networks. We charge a convenience fee for these processing services which is either a percentage of the dollar amount of each transaction or a flat fee per transaction. Certain Clients are charged miscellaneous fees, including fees for handling charge-backs or returns, monthly minimum fees, statement fees and fees for other miscellaneous services. Revenues derived from the electronic processing of credit and debit card transactions are reported gross of amounts paid to sponsor banks in the form of discount fees. We recognize the revenue in the month in which the service is provided.

VSA revenue: VSA revenue is primarily derived from annual recurring service fees for the use of the service and related support services. Customer set-up fees are billed upon service initiation and are recognized as revenue over the estimated customer relationship period of 2.5 years. Payment for VSA and related services is generally received one month to one year in advance. Deferred revenues are recognized for customer payments for services in advance of the performance of services for the customer.

Goodwill and Intangible Assets Acquired goodwill and intangible assets are initially recorded at fair value and tested for impairment at least annually or more frequently if events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. All of our goodwill and intangible assets are included in our Payment Solutions reporting unit. Goodwill is evaluated for possible impairment by comparing the fair value of a 27-------------------------------------------------------------------------------- Back to table of contents reporting unit with its carrying value, including the goodwill assigned to that reporting unit. Fair value of the reporting unit is estimated using a combination of income-based and market-based valuation methodologies. Under the income approach, forecasted cash flows of a reporting unit are discounted to a present value using a discount rate commensurate with the risks of those cash flows. Under the market approach, the fair value of a reporting unit is estimated based on trading multiples of a group of comparable public companies and from values implied by recent merger and acquisition transactions involving comparable companies. An impairment charge is recorded if the carrying value of the Payment Solutions reporting unit exceeds its implied fair value. We performed our annual impairment test of the carrying value of our goodwill for fiscal 2012 during our fourth quarter; this is consistent with the historic timing of our annual goodwill impairment review. Based on our assessment as of September 30, 2012, we concluded that the fair value of the Payment Solutions reporting unit exceeded its carrying value by at least 50%. Significant assumptions inherent in the valuation methodologies employed include, but are not limited to, projected business results, growth rates and discount rates. These assumptions are based primarily on our historical results and expectations for future operations. Our assumptions do not include the potential impacts of alternative payment methods Customers might begin to use, significant changes in the overall economy or loss of significant Clients, each of which would likely decrease our estimated fair value and potentially cause us to record an impairment of our recorded goodwill.

At September 30, 2012, the carrying value of goodwill was approximately $17.6 million.

In addition to our annual goodwill impairment review, we also perform periodic reviews of the carrying values of our other intangible assets. These intangible assets consist primarily of acquired core technology and acquired customer related assets. In evaluating potential impairment of these assets we specifically consider whether any indicators of impairment are present, including: · whether there has been a significant adverse change in the business climate that affects the value of an asset; · whether there has been a significant change in the extent or manner in which an asset is used; and · whether there is an expectation that the asset will be sold or disposed of before the end of its originally estimated useful life.

If indicators of impairment are present, an estimate of the undiscounted cash flows that the specific asset is expected to generate must be made to ensure that the carrying value of the asset can be recovered. These estimates involve significant subjectivity. At September 30, 2012, the carrying value of our intangible assets, excluding goodwill, was approximately $1.1 million. As a result of our fiscal 2012 impairment review, we concluded that none of these assets was impaired.

Income Taxes We account for income taxes by recognizing deferred tax assets and liabilities, which are recorded to reflect the future tax consequences attributable to the effects of differences between the carrying amounts of existing assets and liabilities for financial reporting and for income tax purposes. Judgments are required in determining the amount and probability of future taxable income, which in turn is critical to a determination of whether a valuation reserve against the deferred tax asset is appropriate.

We also account for the recognition and measurement of tax benefits associated with uncertain tax positions. This requires evaluations of individual tax positions to determine whether any part of that position can be recognized or continue to be recognized in the financial statements. An uncertain tax position exists if it is unclear how a transaction will be treated under tax law. As of September 30, 2012 and 2011, we had no unrecognized tax benefits.

Share-Based Compensation Under the provisions of ASC 718, share-based compensation cost for stock option awards is estimated at the grant date based on the award's fair value as calculated by the Black-Scholes option-pricing formula and is recognized as expense ratably over the requisite service period. We recognize share -based 28-------------------------------------------------------------------------------- Back to table of contents compensation costs for only those shares that are expected to vest. The impact of forfeitures that may occur prior to vesting is estimated and considered in the amount of expense recognized. Forfeiture estimates are revised in subsequent periods when actual forfeitures differ from those estimates. The Black-Scholes option-pricing formula requires various highly judgmental assumptions including volatility and expected option life. If any of the assumptions used in the Black-Scholes model change significantly, share-based compensation expense may differ materially for future awards from that recorded for existing awards.

RECENT ACCOUNTING STANDARDS FASB ASU 2011-04. In May 2011, the FASB issued FASB ASU 2011-04, which clarifies some existing concepts, eliminates wording differences between US GAAP and International Financial Reporting Standards, or IFRS, and changes some of the principles and disclosures of fair value measurement to achieve convergence between US GAAP and IFRS. ASU 2011-04 also expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. We adopted this ASU effective January 1, 2012. The initial adoption of this ASU did not have a material impact on our financial position or results of operations.

FASB ASU 2011-08. In September 2011, the FASB issued FASB ASU 2011-08, which allows entities testing for impairment of goodwill the option of performing a qualitative assessment before calculating the fair value of a reporting unit in step 1 of the goodwill impairment test. If, after assessing the totality of events or circumstances, an entity determines it is more likely than not that the fair value of a reporting unit is more than its carrying amount, then performing the two-step impairment test is unnecessary. However, if an entity concludes otherwise, then it is required to perform the first step of the two-step impairment test. We will adopt this ASU effective October 1, 2012. We do not believe the adoption of this ASU will have a material impact on our financial position or results of operations.

FASB ASU 2011-11. In December 2011, the FASB issued FASB ASU 2011-11, which requires entities to disclose information about offsetting and related arrangements to enable users of financial statements to understand the effect of those arrangements on an entity's financial position. The amendments require enhanced disclosures about financial instruments and derivative instruments that are either (i) offset in accordance with current literature or (ii) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with current literature. ASU 2011-11 is effective for fiscal years, and interim periods within those years, beginning on or after January 1, 2013. This standard will become effective for us beginning October 2013. The disclosures required by ASU 2011-11 will be applied retrospectively for all comparative periods presented. We are currently evaluating the impact of ASU 2011-11.

FASB ASU 2012-02. In July 2012 the FASB issued FASB ASU 2012-02 regarding the testing of indefinite-lived intangible assets for impairment. An entity will have an option not to calculate annually the fair value of an indefinite-lived intangible asset if the entity determines that it is not more likely than not that the asset is impaired. This standard permits an entity to assess qualitative factors when testing indefinite-lived intangible assets for impairment results in guidance that is similar to the goodwill impairment testing guidance. This is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. We do not believe the adoption of this standard will have any impact on our financial statements or results of operations.

OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS OFF-BALANCE SHEET ARRANGEMENTS We do not have any off-balance sheet arrangements under Item 303 of Regulation S-K.

29-------------------------------------------------------------------------------- Back to table of contents INDEMNIFICATION AGREEMENTS Our Certificate of Incorporation obligates us to indemnify our directors and officers against all expenses, judgments, fines and amounts paid in settlement for which such persons become liable as a result of acting in any capacity on behalf of Official Payments, if the director or officer met the standard of conduct specified in the Certificate, and subject to the limitations specified in the Certificate. In addition, we have indemnification agreements with certain of our directors and officers, which supplement the indemnification obligations in our Certificate. These agreements generally obligate us to indemnify the indemnitees' against expenses incurred because of their status as a director or officer, if the indemnitee met the standard of conduct specified in the agreement, and subject to the limitations specified in the agreement.

EMPLOYMENT AGREEMENTS As of September 30, 2012, we had employment and change of control agreements with several key employees. If certain termination or change of control events were to occur under these contracts as of September 30, 2012, we could be required to pay up to $3.9 million.

CONTRACTUAL OBLIGATIONS We have contractual obligations to make future payments on lease agreements, which have remaining terms that extend beyond five years. During fiscal 2012, we entered into a lease agreement for space in Great Falls, Virginia to house some of our legal team. This lease agreement ends in fiscal 2014.

Additionally, in the normal course of business, we enter into contractual arrangements whereby we commit to future purchases of products or services from unaffiliated parties. Purchase obligations are legally binding arrangements whereby we agree to purchase products or services with a specific minimum quantity defined at a fixed minimum or variable price over a specified period of time. The following table presents our expected payments for contractual obligations that were outstanding at September 30, 2012. All of our contractual obligations expire by 2018.

(in thousands) Total 2013 2014-2015 2016-2017 Thereafter Capital lease obligations $ - $ - (equipment) (1) $ 29 $ 23 $ 6 Operating lease obligations: Facilities leases 4,645 1,056 1,709 1,445 435 Equipment leases 11 6 5 - - Purchase obligations: Subcontractor - - - - - Purchase order 425 425 - - -Total contractual obligations $ 5,110 $ 1,510 $ 1,720 $ 1,445 $ 435 (1) Includes interest payments of $3.

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