June 8th, 2006

A Funky Merger

Looking through the latest 10Q for Fidelity National Information Services (FIS) we were reminded of the roundabout way the company came into being.

Fidelity National Information Services, Inc. (“FIS” or the “Company”) is a leading provider of technology solutions, processing services, and information-based services to the financial services industry. The Company’s formation began in early 2004 and was substantially completed on March 8, 2005, when all the entities, assets and liabilities that are included in these Consolidated and Combined Financial Statements were organized under one legal entity. The formation was accomplished through the contribution of entities and operating assets and liabilities to a newly formed subsidiary of Fidelity National Financial, Inc. and subsidiaries (“FNF”). The Consolidated and Combined Financial Statements included herein reflect the historical financial position, results of operations and cash flows of the businesses included in the formation. On February 1, 2006, the Company completed the Merger with Certegy, Inc. (the “Merger”) (note 4) which was accounted for as a reverse acquisition and purchase accounting was applied to the acquired assets and assumed liabilities of Certegy. The results of operations are only included since the acquisition date.
As a result of the Merger, each outstanding share of FIS common stock was exchanged for 0.6396 shares of common stock of Certegy, which has a par value of $0.01 per share. All share and per share amounts disclosed in these financial statements and footnotes for periods prior to February 1, 2006 are presented as converted by the exchange ratio used in the Merger.
The parent company, until recently, was a subsidiary of Fidelity National Financial, a bank. FNF had been considering a spin-off or sale but wanted to avoid a taxable event. Meanwhile, Certegy was a publicly traded company already. By merging with Certegy, management took the subsidiary public.
The merits of the merger appear real. Each company had strengths where the other was weak. However, the details of the merger all appear to be the result of some regulatory, tax or accounting consideration rather than the merits themselves. For example, when a public company issues stock in connection with a merger, typically it is the issuing company’s history (in this case Certegy) that is retained. With this merger, all historic data is restated to reflect the FNF subsidiary, as though the publicly traded Certegy never existed. Anyone who was a legacy shareholder suddenly has no idea of what the past financials appear to be.
Prior to March 9, 2005, the historical financial statements of the Company were presented on a combined basis. Beginning March 9, 2005, after all the assets and liabilities of the Company were formally contributed to the holding company, the historical financial statements of the Company have been presented on a consolidated basis for financial reporting purposes. The accompanying unaudited Consolidated and Combined Financial Statements include those assets, liabilities, revenues, and expenses directly attributable to FIS’s operations and, prior to March 9, 2005, allocations of certain FNF corporate assets, liabilities and expenses to FIS.
Other details also seem a bit contrived:
Under the terms of the merger agreement, the Company was merged into a wholly owned subsidiary of Certegy in a tax-free merger, and all of the Company’s outstanding stock was converted into Certegy common stock. As a result of the Merger:

• The Company’s pre-merger shareholders owned approximately 67.4% of the Company’s outstanding common stock immediately after the Merger; while Certegy’s pre-merger shareholders owned approximately 32.6%,
In connection with the Merger, Certegy amended its articles of incorporation to increase the number of authorized shares of capital stock from 400 million shares to 800 million shares, with 600 million shares being designated as common stock and 200 million shares being designated as preferred stock. Additionally, Certegy amended its stock incentive plan to increase the total number of shares of common stock available for issuance under the current stock incentive plan by an additional 6 million shares, and to increase the limits on the number of options, restricted shares, and other awards that may be granted to any individual in any calendar year. These changes were approved by Certegy’s shareholders on January 26, 2006.
As part of the Merger transaction, Certegy declared a $3.75 per share special cash dividend that was paid to Certegy’s pre-merger shareholders. This dividend, totaling $236.6 million, was paid by Certegy at the consummation of the Merger.
Generally accepted accounting principles in the U.S. require that one of the two companies in the transaction be designated as the acquirer for accounting purposes. The Company has been designated as the accounting acquirer because immediately after the Merger its shareholders held more than 50% of the common stock of the Company. As a result, the Merger has been accounted for as a reverse acquisition under the purchase method of accounting. Under this accounting treatment, the Company will be considered the acquiring entity and Certegy will be considered the acquired entity for financial reporting purposes. The financial statements of the combined company after the Merger reflect the Company’s financial results on a historical basis and include the results of operations of Certegy from February 1, 2006.
We see that the basis for the merger accounting stems from its shareholders owning more than 50 percent of the combined company. In fact, FNF itself owns more than half and controls both the stock and the board of directors. Yet this is only the case because Certegy paid its pre-merger shareholders a special dividend. Had they not shed their asset (cash) the pre-merger Certegy would have been large enough to prevent outright control by FNF. Typically an acquiror pays a hefty premium to gain control. In this case, it was the acquiree that issued the shares and the only payment was made by the acquiree to its shareholders. Quite a cheap path to a controlling position.
But wait… there’s more.
Also, the Merger triggered the performance criteria relating to FIS’s performance stock option grant made in March 2005 and these awards vested when the trading value of the Company’s stock remained above $31.27 for 45 consecutive trading days following the Merger. As a result, the Company recorded a charge of $24.1 million in the first quarter of 2006 and will record an additional $0.4 million in the second quarter of 2006 relating to these options that became fully vested on April 7, 2006.

Don’t want to expense the options? Write them off in one shot and investors will ignore them. Early vesting is also a nice reward to employees. And while you’re at it, grant a few million more and vest them right away:

Through the Merger with Certegy, the Company assumed the Certegy Inc. Stock Incentive Plan that provides for the issuance of qualified and non-qualified stock options to officers and other key employees at exercise prices not less than market on the date of grant. All options and awards outstanding prior to the Merger under the Certegy Plan were fully vested as of the Merger date. As part of the Merger, the Certegy shareholders approved amendments to the plan and approved an additional 6 million shares to be made available under the plan. During the period from February 1, 2006 through March 31, 2006, the Company has granted 1,852,500 options under this plan. There were 5,417,183 options outstanding under this plan at March 31, 2006.

Have a title insurance business that may be impacted by the housing slowdown (See Stewart Enterprises – STC)? No problem. With control of the newly merged company you can shed it easily by merging everything else into the new FIS.

On April 27, 2006 FNF announced that its Board of Directors approved pursuing a plan for the elimination of its holding company structure, which would result in the transfer of certain of FNF’s assets and liabilities to FNT and the distribution of FNF’s ownership stakes in FNT to FNF shareholders. Following the distribution of its FNT shares, FNF would merge into FIS and FNF stockholders would receive FIS stock for their FNF shares. Under the plan, after the transaction is complete, FNT, which will consist of FNF’s current specialty insurance and Sedgwick business lines in addition to its current title insurance business, will be renamed Fidelity National Financial (“New FNF”) and will trade under the symbol FNF. FNT and FIS have established special committees of their respective boards of directors to evaluate and negotiate a formal proposal if and when made by FNF. Current FNF Chairman and CEO William P. Foley, II, would assume the same positions in the New FNF and serve as executive Chairman of FIS, and other key members of FNF senior management would also agree to continue their involvement in both New FNF and FIS in executive capacities, pursuant to employment agreements. Completion of the transaction will be subject to a number of conditions, including but not limited to: preparation of a proposal for the transactions and negotiation of definitive agreements; approval of the boards of directors and shareholders of each of FNF, FNT and FIS; the receipt of a private letter ruling from the Internal Revenue Service; the clearance of proxy statements and registration statements by the SEC; the receipt of all necessary regulatory approvals for the transfer of FNF’s specialty insurance operations to FNT and for the spin-off of FNF ownership in FNT; the receipt of necessary approvals under credit agreements of FNF, FNT and FIS and any other material agreements; and any other conditions set forth in the definitive agreements for the transactions, once completed.

You have to have smart people to maneuver through all of these contortions, and FNF did:

The minority equity interest sale was accomplished through FIS selling a 25% interest in its common stock to an investment group consisting of Thomas H. Lee Partners, or THL, Texas Pacific Group, or TPG, Evercore METC Capital Partners II, L.P. and Banc of America Capital Investors, L.P. FIS issued a total of 32 million shares (adjusted for Certegy Merger) of its common stock to the investment group for a total purchase price of $500 million.

Note: As we said earlier, there are strong reasons for the merger to have happened and we are not questioning the wisdom of the merger itself. We are not suggesting any of the activities are underhanded. The merger details were disclosed in advance and scrutinized (at least theoretically) by regulators and shareholders alike. We also do not guarantee that our interpretation of these details (not the details themselves, which were included in a regulatory filing, but our interpretation) is accurate. Quite frankly we got dizzy reading the 10Q, and we are no strangers to reading them. So if you know better than we do, please elaborate in the comments. We would love to understand this thing.

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Topics: Fidelity National Information Systems (FIS), Forensic Accounting, Software and Programming, Stock Market, Technology | RSS

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