Deluxe Paper Payment Systems provides check printing services to financial services companies and markets checks and business forms directly to households and small businesses. Deluxe Payment Protection Systems provides payment protection, collections and risk management services to financial institutions and retailers. Deluxe Electronic Payment Systems provides electronic funds transfer processing and software services to the financial and retail industries. Deluxe Direct Response, which was sold in 1998, provided direct marketing, customer database management and related services to the financial industry and other businesses. Deluxe Government Services provides electronic benefits transfer services to state governments. Deluxe Direct, which was sold in 1998, primarily sold greeting cards, stationery and specialty paper products through direct mail. All segments operate primarily in the United States. Deluxe Electronic Payment Systems also has international operations. In analyzing the results of the segments, corporate expenses are allocated to the segments as a fixed percentage of segment revenues.This allocation includes expenses for support functions such as human resources, information services and finance. Charges for certain corporate liabilities are not allocated to the segments.

The restructuring charges were related to the Company’s initiatives to reduce its SG&A expenses, discontinue production of the Deluxe Direct Response segment’s direct mail products, and close four additional financial institution check printing plants.

The losses on long-term contracts and relationships of the Deluxe Government Services segment resulted from a continuing strong economy, record low unemployment and welfare reform.These factors reduced the transaction volumes and expected future revenues of this business well below original expectations. Additionally, this business has experienced actual and expected future telecommunications, installation, help desk and other costs that have been significantly higher than originally anticipated, resulting in expected future losses on its exist-ing electronic benefits transfer contracts and relationships.

These charges are reflected throughout the 1998 consolidated statement of income according to the nature of the charge, with $47.1 million in cost of sales expense, $22 million in SG&A expense and $1.1 million in other income.

During 1996, the Company announced its plans to divest three businesses within its Deluxe Direct segment. One of these businesses was sold in 1997 and the remaining two were sold in 1998. Additionally, the Company determined that it would divest the international unit of its Deluxe Electronic Payment Systems segment. In 1997, the Company recorded a pretax impairment charge of $99 million to write these businesses down to their estimated fair values less costs to sell. The sale of the Deluxe Direct businesses was completed in December 1998. In January 1999, the Company determined that the international unit of Deluxe Electronic Payment Systems maintained a continuing strategic importance within the segment and it is no longer held for sale.This determination is not expected to have a significant impact on the Company’s operating results or financial position.

The special charge in 1997 included restructuring charges of $24.5 million.These charges included additional costs associated with the Company’s 1996 plan for closing 21 financial institution check printing plants, severance related to implementing process improvements in the post-press phase of check production, implementing a new order processing and customer service system, and reducing support functions at corporate operations and other businesses. As of December 31, 1998, the production functions at all 21 plants were closed.The front-end operations of three of the plants remain open and are expected to close in 1999. In 1999, the new order processing and customer service system and the improved post-press production process are expected to be substantially completed.

During 1997, a judgment was entered against Deluxe Electronic Payment Systems, Inc. (DEPS), in the U.S. District Court for the Western District of Pennsylvania.The case, which related to the Deluxe Government Services business, was brought against DEPS by Mellon Bank in connection with a potential bid to provide electronic benefits transfer services for the Southern Alliance of States. In September 1997, the Company recorded a pretax charge of $40 million to reserve for this judgment and other related costs. In 1998, Mellon’s motion for prejudgment interest was denied by the district court and the Company reversed $4.2 million of the $40 million liability.This reversal is reflected in other income in the 1998 consolidated statement of income.The Company’s appeal of this judgment was denied by the Third Circuit Court of Appeals in January 1999, and the Company paid $32.2 million to Mellon in February 1999.The Company is reviewing whether a further appeal is warranted.

These charges are reflected throughout the 1997 consolidated statement of income according to the nature of the charge, with $82.9 million in goodwill impairment charge, $7.7 million in cost of sales expense, $39.6 million in SG&A expense and $49.8 million in other expense.

These charges are reflected throughout the 1996 consolidated statement of income according to the nature of the charge, with $111.9 million in goodwill impairment charge, $39.2 million in cost of sales expense, $24.6 million in SG&A expense and a $33.4 million gain in other income.

Deluxe Payment Protection Systems’ sales increased 11.9% to $215.7 million, reflecting volume increases in the collections business and in account inquiry services provided to financial institutions. Deluxe Electronic Payment Systems’ sales increased 12.2% to $130.9 million, because of new customers and increased transaction volumes. Deluxe Government Services’ sales increased 63.1% to $44 million, reflecting new customers and increased activity for existing customers. Offsetting the increases in these segments were decreases in other segments. Deluxe Paper Payment Systems’ sales decreased .6% to $1,279.8 million, primarily because of lower volume in financial institution check printing resulting from lost customers. This decrease was partially offset by increased volume for the direct mail check business and new pricing strategies within the financial institution market. Deluxe Direct Response’s sales decreased 18.1% to $43.4 million, because of lost customers, price decreases for its direct mail products and the sale of Deluxe Card Services in the third quarter of 1998. Deluxe Direct’s sales decreased 10.7% to $223.9 million, mostly because of business divestitures. Additionally, lower catalog circulation caused volume to decline in the remaining businesses.

In 1997, the Company’s net sales decreased 3% from 1996. Revenues lost due to divestitures within the Deluxe Direct segment were partially offset by increased sales for all other segments. Excluding businesses divested in both years, the Company’s consolidated net sales increased 1.2% from 1996.

Deluxe Direct’s sales decreased 35.2% to $250.8 million in 1997, as a result of actions initiated in 1996 to increase its profitability. These included sales of businesses, reduced catalog circulation and elimination of unprofitable product lines. Additionally, response rates for the direct mail businesses declined from 1996. The decrease within this segment was offset by increases in all other segments. Deluxe Paper Payment Systems’ sales increased 1.1% to $1,288.2 million in 1997, reflecting increased volume for financial institution and direct mail check offerings. However, competitive pricing pressures on financial institution check printing products partially offset volume increases. Deluxe Payment Protection Systems’ sales increased 30.5% to $192.8 million, primarily because of higher collection service volume and increased account verification inquiries from financial institutions. Deluxe Electronic Payment Systems’ sales increased 6.9% to $116.6 million, primarily from increased volume in financial institution ATM processing. Deluxe Direct Response’s sales increased 5.9% to $53 million, because of acquisitions in 1996 and 1997. Deluxe Government Services’ sales increased 29.1% to $27 million, because of new customers and increased volume for existing customers.

Deluxe Paper Payment Systems’ gross margin increased to 63.1% in 1998 from 60.7% in 1997. The slight sales decrease was more than offset by cost savings realized from closing financial institution check printing plants and other efficiency improvements. Deluxe Electronic Payment Systems’ margin increased to 28.1% in 1998 from 25.6% in 1997, because of increased transaction volumes and reduced employee benefit costs achieved from revising its employee benefit and incentive compensation programs. Deluxe Government Services’ margin improved from negative 9.9% in 1997 to negative 2.4% in 1998, reflecting increased volume and the accrual of future contract and relationship losses in the third quarter of 1998. These margin increases were offset by decreases in other segments. Deluxe Payment Protection Systems’ margin decreased to 43.8% in 1998 from 47.7% in 1997. Revenue growth was more than offset by increased information services and other infrastructure costs, reflecting the Company’s investment in this segment. Deluxe Direct Response’s margin decreased to 27.0% in 1998 from 29.6% in 1997, because of decreased volume and lower prices for direct mail products, without a corresponding decrease in costs. Deluxe Direct’s margin decreased to 52.5% in 1998 from 53.3% in 1997, reflecting the divestiture of a higher margin business in late 1997.

In 1997, Deluxe Paper Payment Systems’ margins increased to 60.7% from 58.5% in 1996. The competitive pricing pressures experienced by financial institution check printing were more than offset by improved product mix and production efficiencies and by reduced costs from revising the employee benefits program. Deluxe Electronic Payment Systems’ margins increased to 25.6% in 1997 from 19.4% in 1996, primarily because of decreased consulting expenses and cost containment. Deluxe Direct’s margins increased to 53.3% in 1997 from 48.4% in 1996, reflecting better cost control and inventory management in the direct mail businesses and the sale of businesses with poorer margins. These margin increases were offset by decreases in other segments. Deluxe Payment Protection Systems’ margin decreased to 47.7% from 49.8% in 1996, because of increased costs related to the growth of the collections business. Deluxe Direct Response’s margin decreased to 29.6% from 33.6% in 1996, reflecting the acquisition of lower margin businesses in 1996 and 1997. Deluxe Government Services’ margin decreased from a loss of 5.8% in 1996 to a loss of 9.9% in 1997, primarily because of increased costs for telecommunications, interchange fees and help desk.

In 1997, the Company’s SG&A expenses were flat compared to expenses in 1996. Excluding the reorganization and other special charges discussed above, SG&A expenses in 1997 decreased $14.6 million, or 1.9%. Deluxe Electronic Payment Systems’ SG&A expenses were flat compared to expenses in 1996. The Deluxe Direct segment’s SG&A expenses decreased 36.4% from 1996, mainly because the assets of the businesses held for sale were no longer depreciated and amortized. This segment also had reduced catalog costs resulting from lower paper costs and simplified designs. These SG&A expense reductions were partially offset by increases in other segments. Deluxe Paper Payment Systems’ SG&A expenses increased 5.9%. Financial institution check printing SG&A expenses increased because of increased customer service call center volume and duplicate costs from maintaining an old customer service system as a new system was implemented. Although call center volume increased on an annual basis, it decreased in the fourth quarter of 1997, compared to the fourth quarter of 1996. During this time, the Company began charging financial institution customers for placing orders via telephone as opposed to electronic channels. Deluxe Payment Protection Systems’ SG&A expenses increased 31.6%, reflecting increased infrastructure costs and selling expenses related to the growth of the collections business. Deluxe Direct Response’s SG&A expenses increased 115.3% from 1996, because of acquisitions in 1996 and 1997. Deluxe Government Services’ SG&A expenses increased 26.7%, because of increased employee compensation expense.

1997 net income decreased to $44.7 million from $65.5 million in 1996. The primary reason for the decrease was the higher amount of reorganization and other special charges discussed above. With the charges and their related tax effects removed, the Company’s net income was $175.6 million in 1997 and $156 million in 1996.

Purchases of property, plant and equipment, and intangibles required cash outlays of $121.3 million in 1998, compared to $109.5 million in 1997 and $92 million in 1996. The Company anticipates capital expenditures of approximately $130 million in 1999. The 1998 expenditures and anticipated 1999 expenditures relate to information technology systems upgrades and replacement, productivity improvements and new product development.

The Company has uncommitted bank lines of credit of $145 million available at variable interest rates. No amounts were drawn on those lines during 1998. The average amount drawn on those lines during 1997 was $3.1 million at a weighted average interest rate of 6.47%. There was no outstanding balance at December 31, 1998 or 1997 on these lines of credit. The Company also has in place a $150 million committed line of credit available for borrowing and as support for commercial paper. As of December 31, 1998 and 1997, the Company had no commercial paper outstanding and no indebtedness outstanding under its committed line of credit. Additionally, the Company has a shelf registration in place to issue up to $300 million in medium-term notes. Such notes could be used for general corporate purposes, including working capital, capital expenditures, possible acquisitions, and repayment or repurchase of outstanding indebtedness and other securities of the Company. As of December 31, 1998 and 1997, no such notes were issued or outstanding.

Cash dividends totaled $119.7 million in 1998, compared to $121.3 million in 1997 and $122 million in 1996. Dividend payments were 82.3% of earnings in 1998, 271.6% in 1997 and 186.3% in 1996. In December 1996, the Company’s board of directors amended the Company’s stock repurchase plan to permit the repurchase of up to 10 million shares of Deluxe common stock. The board also approved the repurchase of up to 5 million of the 10 million approved common shares. Through December 31, 1998, the Company has repurchased 3.5 million shares under this plan. As of March 1999, the Company has repurchased all of the 5 million shares approved by the board under the plan.

The Company is using a multiphase approach in conducting its year 2000 remediation efforts. These phases are: assessment; analysis and formulation of remediation strategy; solution implementation; testing; and certification using internally developed criteria. The Company has divided its internal readiness review between "mission critical" systems and equipment and its other assets. The project is organized around nine types of computerized assets: internally developed applications; product-to-market software and systems; third-party purchased software; data centers; networks; environmental systems; purchased hardware (including embedded chip and desktop equipment); third-party assessment; and external interfaces. During 1997, the Company assessed and prioritized all affected areas, defined appropriate resolution strategies and began execution of those strategies. The compliance strategies included renovation, replacement and retirement of systems and equipment.

As of February 1999, the overall project is approximately 91% complete and approximately 98% complete for mission critical areas. All mission critical components are expected to complete the certification process by the end of March 1999. Also, during 1999, the project focus will shift toward completing customer and vendor testing and contingency execution.

As part of its year 2000 review, the Company has also assessed the readiness of the embedded chip equipment in its facilities. This assessment included all plant manufacturing equipment, HVAC systems, building security systems, personal computers and other office equipment such as printers, faxes and copy machines. The most frequent method of achieving compliance in this area is replacing non-compliant systems and equipment. This effort was approximately 94% complete as of February 1999 and is scheduled for completion by September 1999.

Another area of focus for the Company is the year 2000 readiness of its significant suppliers and customers, both from the standpoint of technology and product and service provision. These external organizations have been contacted and have provided responses to year 2000 assessment requests. Site visits and action plans are being developed as appropriate, based on the importance of the organizations to the Company’s ability to provide products and services. This category was 98% complete as of February 1999, with completion expected at the end of March 1999.

operations may be at risk, as would customer information interfaces and the provision of products and services. The risk is increased by the potential for the Company to fall out of compliance with policies set by the Federal Financial Institution Examination Council, National Credit Union Agency and other federal and regional regulatory bodies.

The Company believes that with the planned modifications to existing systems and the replacement or retirement of other systems, the year 2000 compliance issue will be resolved in a timely manner and will not pose significant operational problems for the Company. The Company has prioritized its renovation efforts to focus first on its mission critical internal systems and the Company believes it is on schedule to complete this component of its remediation efforts before the relevant year 2000 failure dates are reached. In addition to the planned modifications, replacements and retirements, the Company has developed risk mitigation processes and is creating contingency plans in an effort to limit the inherent risk of the year 2000 issue. Manual fall-back processes and procedures are being identified and put in place, particularly in cases where vendor equipment or services begin to demonstrate the potential to be unavailable. The Company is also preparing plans to deploy internal teams to repair problems as they arise when the next century begins. Ongoing audit reviews are scheduled during the latter part of 1999 and into 2000 to ensure that compliance control processes continue to be used. In addition, the Company is enhancing its existing business resumption plans and intends to look to its existing liability insurance programs to mitigate its loss exposure if operational problems do arise.

The Company operates internationally, and so it is subject to potentially adverse movements in foreign currency rate changes. The Company does not enter into foreign exchange forward contracts to reduce its exposure to foreign currency rate changes on intercompany foreign currency denominated balance sheet positions. Historically, the effect of movements in the exchange rates have not been material to the consolidated operating results of the Company.

Having completed a divestiture program begun in 1996 and having taken steps to improve the profitability of its ongoing businesses while investing in its infrastructure, the Company is now positioned for growth. Its improved cash position, low debt and available financing create the opportunity to enhance products and services through internal developments, external alliances, partnerships and acquisitions that are within its strategic focus.