The Company continues to pursue revenue growth through five primary sources: internal growth, which consists primarily of increased transaction processing for existing clients; sales of ancillary products and enhanced services to existing clients; the addition of new clients in existing service areas; expansion into adjacent markets where FDC can provide similar information processing services to new client groups; and acquisitions. FDC continues to consider acquisition opportunities as well as other forms of business combinations and divestitures. Acquisitions supplement FDC's internal efforts to access new markets and client groups, while divestitures are contemplated for business units lacking sufficient growth prospects or for units not enhancing the Company's transaction processing competencies. However, no assurance can be given with respect to the timing, likelihood or the financial or business effect of any possible transaction.

Strategic Transactions and Developments

The Company formed First Data Solutions in 1996 from its information management businesses to enhance current product and service offerings to the Company's existing and potential clients. Subsequent product expansion occurred through the Company's acquisition of Donnelley Marketing, Inc., a consumer information and direct marketing firm, in September 1996 and a public record information business in June 1996. These business combinations were accounted for as purchases, and their results have been included from the effective dates of each acquisition. In addition, the Company introduced the U$A Value Exchange product which offers its merchant base the opportunity for targeted promotional programs to the cardholders of FDC's issuing bank clients.

During 1996, FDC implemented a number of additional alliance programs with bank clients. The alliances are designed to preserve each bank's existing merchant relationships while allowing both FDC and the bank to share in profit opportunities with respect to the existing merchant business of both FDC and the bank, namely in the form of cost efficiencies and expanded product offerings. The structure of the alliances varies depending on the needs of each bank client and FDC, as well as applicable tax, regulatory and other considerations; however, each alliance involves the bank and FDC contributing some of their merchant contracts, cash or a combination thereof. Additionally, cost efficiencies and product offerings have benefited the alliances in generating new merchant business.

In the fourth quarter, the Company also entered into several agreements enhancing its merchant processing area, the most significant being with Wal-Mart and Chase Manhattan Bank ("Chase"). The Company entered into a 10-year agreement with Wal-Mart to process all of their electronic payments. In addition, use of the Company's check acceptance product, which is currently used by certain Wal-Mart locations, will be expanded. The Company entered into an agreement with Chase to form an alliance which initially will focus principally on national level merchants. This venture is expected to become operational in the first quarter of 1997.

In the payment instruments area, the Company acquired the remaining outside interest in the Western Union Mexican money transfer business. During 1996, the Company also acquired two fleet service operations which offers the trucking industry various types of payment products. These acquisitions offered an adjacent market for the Company's payment services.

The Company continues to scrutinize its businesses and their related fit into FDC's long-term plans. During the past few years, FDC completed the sale of several business units: the Company's MoneyGram operations as discussed above, the Company's health systems business in June 1995 and its cable billing services and hotel reservations businesses in November 1994. In February 1997, the Company completed the sale of its GENEX subsidiary. GENEX was a division of the Company's health care administration services area and performed workers' compensation cost containment and management services. The remainder of the health care administration services area has experienced a decline in business levels over the past year as FDC has shifted away from government-related and other low margin products, and focused on data processing and information management related to employee claims and the resulting payment, including completing the development of a new claims administration processing system, ACT3, for which the Company has incurred capitalized software development costs of $53.9 million at December 31, 1996. ACT3 has been in development for several years. This development is entering the critical period of operational implementation and planned roll-out to many existing customers as well as new clients.

During the 1996 third quarter, the Company's Board of Directors declared a two-for-one stock split, effected in the form of a stock dividend, distributed on November 15, 1996 to shareholders of record on November 1, 1996. Accordingly, all earnings (loss) per common share amounts and related share amounts have been retroactively restated in the accompanying consolidated financial statements and in this discussion and analysis.

Results of Operations

1996 Compared with 1995

A substantial portion of the Company's operating revenues is generated from payment and other transactions occurring entirely within the United States. Transactions outside the United States arise principally within the Company's card services operation in the United Kingdom, and from non-bank money transfers settled outside the United States, but originating and processed within the United States. Both of these international transaction volume sources had double digit growth in 1996.

The Company derives revenues in its primary service areas based principally on the number of accounts or transactions processed, a percentage of dollar volume processed, or on a combination thereof. Lesser amounts of revenue are generated from foreign currency exchange on money transfer transactions and from sharing in investment earnings on fiduciary funds. These payment instrument investment revenues from fiduciary funds (before commissions to certain selling agents) increased from $244.0 million in 1995 to $285.9 million in 1996. The overall growth of FDC is demonstrated by the following key indicators (along with the percentage growth compared to 1995): 153 million card accounts on file at December 31, 1996 (+26%), 5.9 billion merchant transactions (+33%) and 458 million payment instrument transactions, excluding MoneyGram money transfers (+14%).

Operating expenses increased 18% to $3.1 billion from $2.6 billion in 1995. The percentage increase was less than the operating revenue percentage increase for the year, reversing the 1995 trend when operating expenses for the year rose at a rate of four percentage points higher than operating revenue growth. This reversal was primarily due to high growth in certain business areas which have a lower ratio of operating expenses to revenue than the overall Company average and the benefits of integration activities which have slowed the rate of growth in operating expenses. These positive benefits were somewhat offset by the continued impact of signing certain new business and renewing larger customers at lower rates and the impact of a FFMC health care acquisition in October 1995 (prior to FFMC's merger with the Company), which has relatively higher operating expenses compared with its revenues.

Selling, general and administrative expenses increased to $724.7 million, up 10% from $660.3 million in 1995. The increase is principally associated with the Company's efforts to attract customers and increase business levels by devoting resources and expenditures to marketing and advertising programs for the Company's businesses, including its alliance programs with banks for its merchant processing services. General and administrative increases for the year, which were primarily driven by the merchant processing business and certain acquisitions, were substantially offset by synergy savings from the merger with FFMC.

Interest expense increased modestly despite increased borrowing levels, principally due to reduced costs related to assumed pension obligations in connection with the Western Union acquisition (which has been classified as interest expense as it is a suspended plan for which service credits are no longer being earned by participants). In addition, the Company is currently experiencing lower rates due to the short-term rate environment and use of its commercial paper program.

Earnings comparisons between 1996 and 1995 are significantly impacted by merger, integration and impairment amounts. The 1996 merger, integration and impairment amount consists of a $46.0 million gain on the sale of the Company's MoneyGram operation through an initial public offering of 100% of its common stock. This divestiture was ordered by the FTC as part of the FFMC merger. In addition, the 1996 amount includes $32.5 million of integration and impairment charges. These items, net, increased after tax income by $8.3 million ($0.02 per share). The 1995 $645.7 million merger, integration and impairment charge included $221.7 million in direct costs of the FFMC merger, primarily payments pursuant to preexisting change in control agreements with FFMC management. As a result of the FFMC merger, the Company conducted a strategic reevaluation of its businesses, reviewing overall trends and developments in relation to its business investments and industry concentrations. In addition to identifying duplicate and overlapping operations, this process identified certain insignificant business lines for disposition or discontinuance and highlighted other business lines and customer relationships which had diminished future value. As a result, the Company recorded restructuring and integration costs of $121.2 million and impairment charges of $283.6 million. The impairment charge included a $114.7 million write-off of ENVOY goodwill caused by the subsequent agreements that added CES and NaBANCO to FDC's operations. These additions caused the Company to not pursue the business plans driving the assumptions used to originally value ENVOY in August 1994 when the agreement to acquire ENVOY was executed. Finally, the charge included a $19.2 million expense related to the prepayment of certain long-term borrowings. After considering tax benefits of only $105.8 million due to the nondeductibility of certain items, the 1995 charge reduced after tax earnings by $539.9 million ($1.21 per share). For a more complete description of these charges, see Note 2 to the consolidated financial statements.

Excluding merger, integration and impairment amounts and the 1995 second quarter impact of the divestiture of the health systems business (which produced a pretax gain of $68.9 mil-lion and offsetting income taxes of $67.7 million), pretax income for the year was $1,018.3 million, up 37% from 1995's $744.4 million. Pretax margins, as a percentage of total revenues, increased to 20.6% in 1996 from 18.1% in 1995. This margin improvement indicates the ongoing realization of synergies, cost containment efforts and operating efficiencies. In addition, margin improvements were experienced in the merchant processing area due to the increased number of alliances accounted for under the equity method and in the payment instruments area due to strong transaction growth in high margin products. These improvements were partially offset by a decline in margin in the Company's health care administration business.

FDC's effective income tax rate of 38.3% in 1996 decreased from 38.9% in 1995 (excluding the impact of the 1995 merger, integration and impairment charge and the health systems divestiture discussed above) due to increased earnings from nontaxable investments of settlement assets, partially offset by an increase in state taxes as a larger percentage of business was conducted in states with higher tax rates than the Company's prior average rate.

After tax earnings increased from a net loss of $84.2 million in 1995 to a net income of $636.5 million in 1996. Excluding merger, integration and impairment amounts in both years, after tax earnings increased 38% to $628.2 million in 1996 from $455.7 million in 1995. Earnings per common share (again excluding the above amounts in both years) increased 32% to $1.35 in 1996 compared with $1.02 per share in 1995. The lower percentage increase in per share earnings compared with after tax earnings results principally from the issuance of common stock during 1995 to complete business combinations.

1995 Compared with 1994

Expenses (excluding 1995's merger, integration and impairment charge of $645.7 million) increased 37%, slightly higher than the rate of increase of operating revenues. Operating expenses increased by 39% primarily due to outlays to expand its facilities and increase staffing to grow the Company's infrastructure. Selling, general and administrative expenses grew at a lesser rate of 22%. Accordingly, income before income taxes (excluding the 1995 merger, integration and impairment charge and the impact of the divestiture of the health systems business as previously discussed) increased 22% to $744.4 million in 1995 compared with $611.3 million in 1994. The Company's pretax margin on total revenues of 18.1% in 1995 was down from 19.8% in 1994 due to the Company's infrastructure expenses incurred and the impact of pricing for larger clients in 1995.

FDC's effective income tax rate of 150.2% in 1995 increased from 41.1% in 1994 principally from the nondeductibility of a large portion of the merger, integration and impairment charge. Excluding the impact of the charge on 1995's rate, the Company's effective income tax rate increased 2.9% in 1995 to 44.0%, primarily from the impact of $67.7 million in taxes (a 98.3% tax rate) on the gain from the sale of the Company's health systems business. Excluding the 1995 health systems divestiture, FDC's effective rate in 1995 of 38.9% decreased from 41.1% in 1994 due primarily to increased earnings from nontaxable investments of settlement assets.

After tax earnings decreased from $360.3 million in 1994 to a net loss of $84.2 million in 1995 as a result of the merger, integration and impairment charge, which impacted per share amounts in a similar manner. Excluding the impact of the charge, after tax earnings increased 26% to $455.7 million from $360.3 million in 1994. Earnings per common share (again excluding the 1995 merger, integration and impairment charge) increased 20% to $1.02 in 1995 compared with $0.85 per share in 1994.

Economic Fluctuations

Portions of the Company's business are seasonal. FDC's revenues and earnings are favorably affected by increased card and check volume during the holiday shopping period in the fourth quarter and, to a lesser extent, during the back-to-school buying period in the third quarter. Higher money transfer volume during the summer months in FDC's payment instruments area also affects revenues and earnings.

Although FDC cannot precisely determine the impact of inflation on its operations, the Company has not been significantly affected by inflation. For the most part, the Company has looked to operating efficiencies from scale and technology, as well as decreases in technology and communication costs to offset increased costs of employee compensation and other operating expenses. In addition, a portion of FDC's service revenues are based on a percentage of dollar volume processed, partially insulating operating margins on these services from the effects of inflation.

Forward Looking Statement

All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.

Important factors upon which the Company's forward looking statements are premised include the following:

• Continued growth at rates approximating recent levels for card-based payment transactions, consumer money transfer transactions, and other product markets.
• Successful implementation of the ACT3 health care claims administration processing system into the Company's existing customer base as well as overall market appeal for the service.
• Successful implementation and achievement of expected growth of the U$A Value Exchange program and other information product initiatives.
• Absence of consolidation among client financial institutions or other client groups which has a significant impact on FDC client relationships.
• Successful management of pricing pressures through cost efficiencies.
• No imposition of a Value Added Tax on third-party credit card processing services by the European Community, which could put credit card processing outsourcers at a competitive disadvantage to in-house solutions in the European Community.
• No unanticipated changes in laws, regulations, credit card association rules or other industry standards affecting FDC's businesses which require significant product redevelopment efforts or render products obsolete.
• No dispositions of significant businesses, which could have a short-term dilutive impact if other appropriate investment opportunities are not immediately available.
• Continuation of the existing interest rate environment, avoiding increases in agent fees related to a portion of the Company's payments instruments business and in the Company's short-term borrowing costs.
• Absence of significant changes in retail foreign exchange spreads on retail money transfer transactions, particularly between the United States and Mexico.
• No significant increase in the cost of maintaining a role for FDC's credit card processing, merchant processing and money transfer businesses in connection with new payment technologies being developed.
• Successfully managing the potential both for patent protection and patent liability in the context of rapidly developing legal framework for expansive software patent protection.

Variations from these assumptions or failure to achieve these objectives could cause actual results to differ from those projected in the forward looking statement. Due to the uncertainties inherent in forward looking statements, readers are urged not to place undue reliance on these statements. In addition, FDC undertakes no obligation to update or revise forward looking statements to reflect changed assumptions, the occurrence of unanticipated events, or changes to projections over time.

Capital Resources and Liquidity

Cash flow from operations in 1996 exceeded the comparable 1995 amount by $344.7 million. Due to the 1995 merger, integration and impairment charge not using a large amount of cash, this increase is significantly different than the increase in net income between the two periods.

FDC reinvests cash in its existing businesses primarily to expand its processing capabilities through property and equipment additions and to establish customer processing relationships through initial contract payments and costs for conversion and systems development. These cash outlays totaled $670.8 million in 1996 compared with $466.7 million in the prior year. This increase is primarily due to the Company's expansion of its overall processing capacity to continue to meet growing transaction volumes and the conversion of new customers onto the Company's processing systems. The Company expects that these outlays will be slightly lower in 1997 due to 1996 investment in the Company's processing systems. In 1997, the Company also expects to expense approximately $30 million of expenditures in connection with preparing its processing systems to handle the year 2000 issues.

Overall, FDC's operating cash flow in 1996 exceeded its non-acquisition investing activities by $383.0 million. The Company also received cash of $211.9 million during 1996 relating to dispositions, which is primarily attributable to the December 1996 divestiture of MoneyGram, proceeds from the formation of joint ventures in furtherance of FDC's bank alliance program and the sale of a retail credit card receivables portfolio. This cash contributed to funds utilized for acquisitions and treasury stock purchases. During 1996, the Company invested $495.5 million of cash in several acquisitions and ongoing investments in the bank alliance program. A $162 million payment was made in the 1996 first quarter to purchase the remaining interest in a joint venture relating to Western Union's money transfer services between the U.S. and Mexico. In the third quarter, a $188.9 million payment was made to purchase Donnelley Marketing, Inc., a consumer information and direct marketing firm. The remainder consists principally of payments relating to the Company's alliance programs with bank clients involving merchant business, and two acquisitions which expanded the Company's markets and service offerings in its payment instruments business.

The Company's financing activities include net borrowings, share repurchases and dividend payments. Net cash provided by financing activities was $11.0 million in 1996, as compared to $480.0 million in 1995. The significant decline is due to lower net borrowings ($114.6 million in 1996 versus $501.6 million in 1995) and higher net share repurchase activity.

During 1996, the Company issued $350 million in Medium-Term Notes (with maturities ranging from two to five years), reducing its dependence on short-term borrowings. The proceeds from these notes were used to reduce outstanding commercial paper, which declined from $689.3 million at December 31, 1995 to $441.1 million at December 31, 1996. Also, the Company obtained $250 million in uncommitted bank lines from several financial institutions during 1996, under which $34.8 million was outstanding at December 31, 1996.

The Company made cash outlays totaling $254.9 million in 1996 to buy back shares of its common stock which were reissued primarily in connection with the Company's stock compensation plans. Proceeds from option exercises and related tax benefits of $177.5 million partially offset these outlays. In addition, FDC continued its pattern of paying quarterly cash dividends of $0.015 per share to the Company's common stockholders, resulting in cash outlays totaling $26.2 million and $13.8 million in 1996 and 1995, respectively. Following the November 1996 stock split, the Company increased the fourth quarter 1996 dividend to $0.02 per share which was paid in January 1997.

As an integral part of FDC's information processing services for payment transactions, FDC receives funds from instruments sold in advance of settlement with payment recipients. These funds (referred to as "settlement assets" on FDC's consolidated balance sheets) are not utilized to support the Company's operations. However, the Company does have the opportunity to earn income from investing a portion of these funds. The Company maintains a portion of its settlement assets in highly liquid investments (classified as cash equivalents within settlement assets) to fund settlement obligations.

The Company uses conventional interest rate swap and cap agreements (off-balance sheet) to partially hedge specific exposures related to certain commission expenses of its payment instruments business which are tied to short-term variable rates. The impact of these instruments is not material to the Company's overall financial position or results of operations. A more detailed description of these financial instruments is contained in Note 7 to the consolidated financial statements.

At December 31, 1996, the Company held cash and cash equivalents of $271.7 million, an increase of 18% over 1995's $231.0 million. These amounts include $70.0 million related to required investments in connection with the Company's merchant card settlement operations, additional amounts used to support the operations of certain business units, and the remainder available for general corporate purposes. Also, FDC has available short-term borrowing capability of $774.1 million at December 31, 1996 under the Company's commercial paper program and through its uncommitted credit lines. In addition, at December 31, 1996, the Company had an outstanding shelf registration statement providing for the future issuance of debt and equity securities up to $250 million in the aggregate.

The Company believes that its current level of cash and borrowing capability along with future cash flows from operations are sufficient to meet the needs of its existing businesses. However, to achieve its objectives, the Company may, when necessary, supplement its available cash resources by seeking funds in the equity or debt markets. To provide additional flexibility, the Company anticipates expanding its existing commercial paper program to $1.5 billion and has been authorized by its board of directors to file an additional $750 million shelf registration.