Summary of APAC CUSTOMER SERVICE INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Our management's discussion and analysis of financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes thereto appearing elsewhere in this report and our audited consolidated financial statements which appear in Item 8 of Part II of our Annual Report on Form 10-K for the fiscal year ended December 28, 2008. Our management's discussion and analysis contains "forward-looking statements". All forward-looking statements are inherently uncertain as they are based on various expectations and assumptions about future events and are subject to known and unknown risks and uncertainties, and other factors that may cause our actual results, performance, or achievements to be materially different from those expressed or implied by the forward-looking statements. See "Forward Looking Statements and Factors That May Affect Future Results" on page 3 of this Quarterly Report on Form 10-Q and Item 1A in Part II of this Quarterly Report on Form 10-Q.
Overview
We are a leading provider of customer care services and solutions to market leaders in the healthcare, business services, communications, media & publishing, travel & entertainment and financial services industries. Our services are provided through customer care centers staffed with skilled customer service representatives in domestic, off-shore, and client-owned locations. As of September 27, 2009, we operated nine customer care centers in the United States, two of which are client-owned facilities, and four off-shore customer care centers in the Philippines. As of September 27, 2009, our domestic operations consisted of approximately 5,200 workstations and our off-shore operations consisted of approximately 3,600 workstations.
Early in 2008, our Board of Directors selected Michael P. Marrow as President and CEO, bringing 25 years of industry experience to our company. Since joining us, Mr. Marrow has assembled a team of talented mid- and senior-level managers, many of whom have deep experience in running successful outsourced call center operations, as well as senior-level managers with significant turnaround experience. The entire organization, under Mr. Marrow's leadership, has transformed our Company into what we believe to be a more efficient and productive operation, which we believe has returned us to a profitable operating model.
During 2008, we restructured operations resulting in the reduction of overhead costs and headcount, refinanced our debt, and took steps to improve our operating efficiencies. We saw an immediate impact from these and other cost savings initiatives resulting in the Company's profitability on a full year basis for fiscal year 2008. Additionally, our focus on improving our financial performance also resulted in increased gross profit margins, improved cash flow and lower levels of debt in fiscal year 2008.
During 2009, we continued to see a favorable impact from the initiatives launched in 2008 and prior years. Our revenue has grown by approximately 13.2% for the thirty-nine weeks ended September 27, 2009 as compared with the comparable prior year period, driven by expanded services with existing clients and the acquisition of new clients. Cost of services as a percentage of revenue has declined significantly driven by cost savings initiatives. This has resulted in a gross profit margin of approximately 23.2% for the thirty-nine weeks ended September 27, 2009, as compared to approximately 15.6% for the thirty-nine weeks ended September 28, 2008. Net income for the thirty-nine weeks ended September 27, 2009 was $24.9 million, as compared to a net loss of $2.1 million for the same period of 2008. In addition, we paid all outstanding debt in June 2009, allowing us to use our cash generated from operations to fund our capital expenditures to drive further growth.

Table of Contents

Critical Accounting Policies and Estimates The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires us to make estimates and judgments that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Certain of our accounting policies are considered critical, due to the level of subjectivity and judgment necessary in applying these policies and because the impact of these estimates and assumptions on our financial condition and operating performance may be material. On an ongoing basis, we evaluate our estimates and judgments in these areas based on historic experience and other relevant factors. The estimates as of the date of the financial statements reflect our best judgment giving consideration to all currently available facts and circumstances. We believe our estimates and judgments are reasonable, however, actual results and the timing of the recognition of such amounts could differ from those estimates. We have used methodologies that are consistent from year to year in all material respects. We have identified the following accounting policies and estimates that we believe are most critical in the preparation of our condensed consolidated financial statements: accounting for derivatives, allowance for doubtful accounts, accounting for employee benefits, revenue recognition, intangible assets, restructuring charges, accounting for stock-based compensation and income taxes. For details concerning these critical accounting policies and estimates see Item 7 of Part II of our Annual Report on Form 10-K for the fiscal year ended December 28, 2008, under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies and Estimates" and Note 3 to our audited consolidated financial statements which appears in Item 8 of Part II of our Annual Report on Form 10-K for the fiscal year ended December 28, 2008. Any deviation from these policies or estimates could have a material impact on our condensed consolidated financial statements.

Table of Contents

Results of Operations
The following table sets forth selected information about our results of
operations for the thirteen and thirty-nine weeks ended September 27, 2009 and
September 28, 2008, respectively. Certain additional components of cost of
services have been included as we believe they would enhance an understanding of
our results of operations. All amounts in the table below are presented in
thousands.

                                                              Thirteen Weeks Ended                                     Thirty-Nine Weeks Ended
                                               September 27,       September 28,       Fav (Unfav)       September 27,       September 28,       Fav (Unfav)
                                                   2009                2008             % Change             2009                2008             % Change

Net Revenue                                   $        68,360     $        59,243              15.4 %   $       207,648     $       183,470              13.2 %

Cost of Services:
Direct labor                                           37,648              34,239             (10.0 )           110,168             106,218              (3.7 )
Other facility expenses                                16,547              14,933             (10.8 )            49,361              48,678              (1.4 )

Total cost of services                                 54,195              49,172             (10.2 )           159,529             154,896              (3.0 )

Percentage of revenue                                    79.3 %              83.0 %               -                76.8 %              84.4 %               -


Gross profit                                           14,165              10,071              40.7              48,119              28,574              68.4
Gross profit margin                                      20.7 %              17.0 %               -                23.2 %              15.6 %               -

Operating Expenses:
Selling, general & administrative expenses              7,518               7,187              (4.6 )            22,868              23,582               3.0
Restructuring and other charges (reversals)                (9 )               616             101.5                 (58 )             3,394             101.7

Total operating expenses                                7,509               7,803               3.8              22,810              26,976              15.4

Operating income                                        6,656               2,268             193.5              25,309               1,598                 *
Other income                                              (15 )              (129 )           (88.4 )               (45 )              (303 )           (85.1 )
Interest (income) expense, net                            (60 )               359             116.7                 (18 )             3,954             100.5

Income (loss) before income taxes                       6,731               2,038             230.3              25,372              (2,053 )               *
Income tax expense                                        143                  33            (333.3 )               429                  33                 *

Net income (loss)                             $         6,588     $         2,005             228.6 %   $        24,943     $        (2,086 )               *

* Means that the percentage change is not meaningful

Non-GAAP Financial Measures
To supplement our Condensed Consolidated Financial Statements presented in accordance with GAAP, we present EBITDA, which is defined as a non-GAAP financial measure. The presentation of this non-GAAP financial measure is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. The items excluded from this non-GAAP financial measure are significant components of our financial statements and must be considered in performing a comprehensive analysis of our overall financial results.
We believe this non-GAAP financial measure provides meaningful supplemental information and is useful in understanding our results of operations and analyzing trends because it excludes certain charges such as interest, taxes, depreciation and amortization expenses that are not part of our ordinary business operations.
EBITDA is a measure used by our lenders, investors and analysts to evaluate our financial performance and our ability to pay interest and repay debt. This measure is also indicative of our ability to fund the capital investments necessary for our continued growth. We use this measure, together with our GAAP financial metrics, to assess our financial performance, allocate resources, measure our performance against debt covenants and evaluate our overall progress towards meeting our long-term financial objectives.

Table of Contents

We believe that this non-GAAP financial measure is useful to investors and analysts in allowing for greater transparency with respect to the supplemental information used by us in our financial and operational decision making. In addition, we believe investors, analysts and lenders benefit from referring to EBITDA when assessing our performance and expectations of our future performance. However, this information should not be used as a substitute for our GAAP financial information; rather it should be used in conjunction with financial statement information contained in our condensed consolidated financial statements presented in accordance with GAAP.
We use a consistent method for computation of EBITDA. Our calculation of EBITDA may not be consistent with calculations of similar measures used by other companies. The accompanying notes have more details on the GAAP financial measure that is most directly comparable to our non-GAAP financial measure and the related reconciliation between these financial measures.

                                                            Thirteen Weeks Ended (1)                                   Thirty-Nine Weeks Ended
                                              September 27,        September 28,       Fav (Unfav)       September 27,       September 28,       Fav (Unfav)
                                                  2009                 2008             % Change             2009                2008             % Change
                                                                         (Dollars in thousands except statistical data and notes)

EBITDA (2)                                   $         9,600      $         5,214              84.1 %   $        34,065     $        11,140             205.8 %

Statistical information:
Number of customer care centers:
Domestic                                                   9                    9                                     9                   9
Off-shore                                                  4                    3                                     4                   3

Total                                                     13                   12                                    13                  12


Number of workstations, end of period:
Domestic                                               5,174                4,486                                 5,174               4,486
Off-shore                                              3,647                3,275                                 3,647               3,275

Total                                                  8,821                7,761                                 8,821               7,761

Notes to Non-GAAP Financial Measures

(1) We operate on a thirteen-week fiscal quarter that ends on the Sunday closest to September 30.

(2) We define EBITDA as net income
(loss) plus income tax expense (benefit), depreciation and amortization, and interest expense.

EBITDA is a measure used by our lenders, investors and analysts to evaluate our financial performance and our ability to pay interest and repay debt. This measure is also indicative of our ability to fund the capital investments necessary for our continued growth. We use this measure, together with our GAAP financial metrics, to assess our financial performance, allocate resources, measure our performance against debt covenants and evaluate our overall progress towards meeting our long-term financial objectives.
EBITDA is not intended to be considered in isolation or used as a substitute for net income (loss) or cash flow from operations data presented in accordance with GAAP or as a measure of liquidity. The items excluded from EBITDA are significant components of our statements of operations and must be considered in performing a comprehensive assessment of our overall financial results.

Table of Contents

EBITDA can be reconciled to net income (loss), which we believe to be the most directly comparable financial measure calculated and presented in accordance with GAAP, as follows:

                                                 Thirteen Weeks Ended                      Thirty-Nine Weeks Ended
                                          September 27,         September 28,        September 27,         September 28,
                                              2009                  2008                 2009                  2008
                                                                      (Dollars in thousands)

Net income (loss)                        $         6,588       $         2,005      $        24,943       $        (2,086 )

Interest (income) expense, net                       (60 )                 359                  (18 )               3,954
Income tax expense                                   143                    33                  429                    33
Depreciation and amortization                      2,929                 2,817                8,711                 9,239

EBITDA                                   $         9,600       $         5,214      $        34,065       $        11,140

Table of Contents

Comparison of Results of Operations for the Thirteen Weeks Ended September 27, 2009 and September 28, 2008
Net revenue increased 15.4% to $68.4 million for the thirteen weeks ended September 27, 2009, as compared to $59.2 million for the thirteen weeks ended September 28, 2008. The increase in revenue is primarily driven by growth with existing and new clients of $11.6 million in the communications vertical, $0.9 million in the healthcare vertical, excluding the seasonal Medicare Part D program, $0.6 million in the media & publishing vertical and $0.4 million in the financial services vertical. This was partially offset by the decline in revenue of $1.8 million in the business services vertical, $1.1 million from the seasonal Medicare Part D program, $0.8 million in the travel & entertainment vertical, $0.4 million from the exit of a retail client in 2008 and $0.2 million of other services.
Cost of services increased $5.0 million, or 10.2%, to $54.2 million for the thirteen weeks ended September 27, 2009, from $49.2 million for the thirteen weeks ended September 28, 2008. Direct labor increased $3.4 million, or 10.0%, primarily driven by higher volume in the domestic communications vertical and higher volume offshore, partly offset by lower wage rates and employee benefits, both domestically and offshore, and lower volume in the business services vertical. Facility and other costs increased $1.6 million, or 10.8%, primarily due to $1.9 million of increased facility costs related to growth and expansion domestically and from the build-out of our fourth facility in the Philippines, partially offset by $0.3 million of other continued cost savings initiatives. Cost of services as a percentage of revenue declined to 79.3% for the thirteen weeks ended September 27, 2009 from 83.0% for the thirteen weeks ended September 28, 2008, primarily driven by lower wage rates and employee benefits. Gross profit increased $4.1 million, or 40.7%, to $14.2 million for the thirteen weeks ended September 27, 2009, as compared to $10.1 million for the thirteen weeks ended September 28, 2008, primarily due to an increase in domestic and off-shore volume and lower wages and employee benefits, partially offset by increased facility and other costs associated with growth and expansion domestically and off-shore. Gross profit margin increased to 20.7% for the thirteen weeks ended September 27, 2009 from 17.0% for the thirteen weeks ended September 28, 2008 due to a decline in wage rates and employee benefits both domestically and off-shore.
Selling, general and administrative expenses were $7.5 million for the thirteen weeks ended September 27, 2009 as compared to $7.2 million for the thirteen weeks ended September 28, 2008. The $0.3 million increase is primarily due to $0.7 million increase in compensation and benefits primarily related to incentive compensation, a $0.3 million increase in professional fees and a $0.2 million increase in employee recruiting and relocation costs, partially offset by a $0.6 million reduction in bad debt expense driven by the collection of previously provided reserves from a 2008 client bankruptcy, and a $0.3 million reduction in rent and other facility charges resulting from the relocation of our corporate office.
Restructuring and other charges reflected a recovery of less than $0.1 million for the thirteen weeks ended September 27, 2009, as compared to a charge of $0.6 million for the thirteen weeks ended September 28, 2008 and were primarily related to adjustments in severance charges and retirement obligations recorded in fiscal year 2008, offset by the reversal of the remaining reserve for property taxes associated with the 2006 restructuring initiative. Restructuring and other charges of $0.6 million for the thirteen weeks ended September 28, 2008 included $0.6 million of severance charges related to changes in our executive team and further reductions in our operations and administrative headcount and $0.1 million in additional restructuring charges associated with our 2005 restructuring initiative, partially offset by the reversal of the remaining $0.1 million reserve associated with the 2007 restructuring initiative. For more information regarding restructuring and other charges, see Note 9 of our condensed consolidated financial statements appearing elsewhere in this Quarterly Report on Form 10-Q.
Operating income was $6.7 million for the thirteen weeks ended September 27, 2009, as compared to $2.3 million for the thirteen weeks ended September 28, 2008. The $4.4 million improvement was the result of a $4.1 million increase in gross profit and a $0.6 million decrease in restructuring and other charges, partially offset by a $0.3 million increase in selling, general and administrative expenses as noted above.
Net interest income was less than $0.1 million for the thirteen weeks ended September 27, 2009 and was primarily related to $0.2 million from the amortization of points on forward contracts, partially offset by $0.1 million of fees and interest associated with borrowings under the Revolving Loan Facility with PNC. Interest expense was $0.4 million for the thirteen weeks ended September 28, 2008 and was primarily related to interest associated with borrowings under the Revolving Loan Facility with PNC.

Table of Contents

EBITDA was $9.6 million for the thirteen weeks ended September 27, 2009, an increase of $4.4 million, as compared to $5.2 million for the thirteen weeks ended September 28, 2008. The increase was primarily due to a $4.1 million increase in gross profit, a $0.6 million decrease in restructuring and other charges, partially offset by a $0.3 million increase in selling, general and administrative expenses as noted above. More information concerning this non-GAAP financial measure, including the definition of EBITDA and a reconciliation of this measure to the most directly comparable financial measure calculated and presented in accordance with GAAP, can be found under the heading "Non-GAAP Financial Measures" and the accompanying notes thereto appearing elsewhere in this Management's Discussion and Analysis of Financial Condition and Results of Operations.
The income tax expense for the thirteen weeks ended September 27, 2009 was $0.1 million. This is driven by a gross income and earned tax of 5% on a portion of our Philippine financial results and domestic state income taxes. The U.S. federal tax provision is fully offset by the utilization of net operating loss carryforwards and work opportunity tax credits. This resulted in a 2.1% effective income tax rate for the thirteen weeks ended September 27, 2009. The tax provision associated with the income before taxes for the thirteen weeks ended September 28, 2008 of less than $0.1 million resulted from the utilization of net operating loss carryforwards. The effective income tax rate for the thirteen weeks ended September 28, 2008 was 1.6% due to the provision for state income taxes.
Net income increased $4.6 million to $6.6 million for the thirteen weeks ended September 27, 2009, as compared to $2.0 million for the thirteen weeks ended September 28, 2008.
Comparison of Results of Operations for the Thirty-nine Weeks Ended September 27, 2009 and September 28, 2008 Net revenue increased 13.2% to $207.6 million for the thirty-nine weeks ended September 27, 2009, as compared to $183.5 million for the thirty-nine weeks ended September 28, 2008. The increase in revenue of $24.1 million is primarily driven by growth with existing and new clients of $29.9 million in the communications vertical, $10.3 million in the healthcare vertical, excluding the seasonal Medicare Part D program, $1.5 million in the media & publishing vertical and $0.4 million in the financial services vertical. This was partially offset by the decline in revenue of $9.5 million from the seasonal Medicare Part D program, $3.2 million in the business services vertical, $2.9 million due to the exit of a retail client in 2008, $0.8 million in the travel & entertainment vertical and $1.6 million of other services.
Cost of services increased $4.6 million, or 3.0%, to $159.5 million for the thirty-nine weeks ended September 27, 2009, as compared to $154.9 million for the thirty-nine weeks ended September 28, 2008. Direct labor increased $3.9 million, or 3.7%, primarily driven by higher volume in the domestic communications vertical and higher volume off-shore, partially offset by lower wage rates and employee benefits and improved efficiencies both domestically and off-shore. Total facility and other costs increased $0.7 million, or 1.4%, primarily due to $3.2 million increase in facility costs associated with domestic expansion and the build-out of our fourth facility in the Philippines and a $0.6 million increase in telecommunication costs associated with increased volumes off-shore, partially offset by a $2.5 million decrease in facility and other costs associated with continued cost savings initiatives both domestically and offshore and $0.6 million of reduced information technology costs resulting from the 2008 workforce reduction. Cost of services as a percentage of revenue declined to 76.8% for the thirty-nine weeks ended September 27, 2009 from 84.4% for the thirty-nine weeks ended September 28, 2008, primarily driven by lower wages and employee benefits, increased labor efficiencies and the leveraging of fixed costs.
Gross profit increased $19.5 million, or 68.4%, to $48.1 million for the thirty-nine weeks ended September 27, 2009, as compared to $28.6 million for the thirty-nine weeks ended September 28, 2008, primarily due to higher volume domestically and off-shore and lower wage rates and employee benefits and improved efficiencies both domestically and off-shore. Gross profit margin increased to 23.2% for the thirty-nine weeks ended September 27, 2009 from 15.6% for the thirty-nine weeks ended September 28, 2008 due to efficiencies in cost of services as noted above.
Selling, general and administrative expenses were $22.9 million for the thirty-nine weeks ended September 27, 2009, a decrease of $0.7 million from $23.6 million for the thirty-nine weeks ended September 28, 2008. The decrease is primarily due to a $0.8 million reduction in bad debt expense related to the specific reserves recorded in 2008 in the publishing vertical and a recovery of a portion of these reserves recognized in 2009, a $0.7 million decrease in rent and other facility charges resulting from the relocation of our corporate office, a $0.6 million reduction in salaries and wages and $0.1 million of other cost savings obtained through continued efforts to control expenses, partially offset by a $1.1 million increase in incentive compensation and a $0.4 million increase in professional fees.

Table of Contents

Restructuring and other charges decreased $3.5 million to a recovery of $0.1 million for the thirty-nine weeks ended September 27, 2009, as compared to a charge of $3.4 million for the thirty-nine weeks ended September 28, 2008 and were primarily related to adjustments in severance charges and retirement obligations recorded in fiscal year 2008 and the reversal of the remaining reserve for property taxes associated with the 2006 restructuring initiative. During the thirty-nine weeks ended September 28, 2008, we recorded charges of . . .