HARTE HANKS INC - Quarter Report: 2007 June (Form 10-Q)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2007

For the transition period from              to             

Commission File Number 1-7120

HARTE-HANKS, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number including area code – 210/829-9000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  Yes    ¨  No

Indicate by check mark whether registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock: $1 par value per share, 72,770,593 shares as of July 31, 2007.

Table of Contents

HARTE-HANKS, INC. AND SUBSIDIARIES

TABLE OF CONTENTS

FORM 10-Q REPORT

June 30, 2007

2

Table of Contents

Item 1. Interim C ondensed Consolidated Financial Statements (Unaudited)

Harte-Hanks, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets (in thousands, except per share and share amounts)

See Notes to Unaudited Condensed Consolidated Financial Statements.

3

Table of Contents

Harte-Hanks, Inc. and Subsidiaries

Consolidated Statements of Operations (in thousands, except per share amounts)

(Unaudited)

See Notes to Unaudited Condensed Consolidated Financial Statements.

4

Table of Contents

Harte-Hanks, Inc. and Subsidiaries

Consolidated Statements of Operations (in thousands, except per share amounts)

(Unaudited)

See Notes to Unaudited Condensed Consolidated Financial Statements.

5

Table of Contents

Harte-Hanks, Inc. and Subsidiaries

Consolidated Statements of Cash Flows (in thousands)

(Unaudited)

See Notes to Unaudited Condensed Consolidated Financial Statements.

6

Table of Contents

Harte-Hanks, Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (in thousands, except per share amounts)

(2007 Unaudited)

See Notes to Unaudited Condensed Consolidated Financial Statements.

7

Table of Contents

Harte-Hanks, Inc. and Subsidiaries

Notes to Unaudited Condensed Consolidated Financial Statements

Note A - Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements include the accounts of Harte-Hanks, Inc. and its subsidiaries (the “Company”). Intercompany transactions and balances have been eliminated.

The statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months and six months ended June 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007. The information included in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis and the consolidated financial statements and notes thereto included in our annual report on Form 10-K for the year ended December 31, 2006.

As used in this report, the terms “Harte-Hanks,” “we,” “us,” or “our” may refer to Harte-Hanks, one or more of its consolidated subsidiaries, or all of them taken as a whole.

Note B - Income Taxes

Our second quarter 2007 income tax provision of $15.3 million was calculated using an effective income tax rate of approximately 40.1%. Our first half 2007 income tax provision of $28.2 million was calculated using an effective income tax rate of approximately 39.5%. Our effective income tax rate is derived by estimating pretax income and income tax expense for the year ending December 31, 2007. The effective income tax rate calculated is higher than the federal statutory rate of 35% due to the addition of state taxes and to certain expenses recorded for financial reporting purposes that are not deductible for federal income tax purposes.

We adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (FIN 48), on January 1, 2007. We did not recognize a change to our unrecognized tax benefits as a result of this adoption. At January 1, 2007, unrecognized tax benefits totaled $11.7 million, of which $1.1 million represents accruals for interest and penalties that were recorded as additional tax expense in accordance with our accounting policy. If recognized, $7.8 million, net of tax, would impact the effective tax rate. There have been no significant changes to these amounts during the quarter or six months ended June 30, 2007.

Harte-Hanks, Inc. and its subsidiaries file income tax returns in the U.S. federal jurisdiction, and various state, local and foreign jurisdictions. With the exception of a few state returns, we are no longer subject to U.S. federal, state, local or non-U.S. income tax examinations by tax authorities for the years prior to 2003. The statute of limitations on the other 2002 tax returns will expire during 2007. An audit of the 2003 U.S. federal return has been completed. We believe that it is reasonably possible that a reduction in our unrecognized tax liabilities in the range of $1.6 million to $1.8 million, net of tax, will occur in the next twelve months related to the statute expiring on various tax returns. If this reduction were to occur, it would decrease the tax expense and effective tax rate for the full year 2007.

8

Table of Contents

Note C – Stock-Based Compensation

We recognized $1.9 million of stock-based compensation during the three months ended June 30, 2007 and 2006. We recognized $3.5 million and $3.7 million of stock-based compensation during the six months ended June 30, 2007 and 2006, respectively. Our annual grant of stock-based awards occurred in the first quarter, which is consistent with the timing of previous annual grants. We did not have any significant stock-based compensation activity in the second quarter of 2007.

Note D - Earnings Per Share

Basic earnings per share is computed on the basis of the weighted number of shares of the common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and nonvested shares.

A reconciliation of basic and diluted earnings per share (EPS) is as follows:

2.4 million and 2.0 million anti-dilutive market price options have been excluded from the calculation of shares used in the diluted EPS calculation for the three months ended June 30, 2007 and 2006, respectively.

9

Table of Contents

2.3 million and 1.9 million anti-dilutive market price options have been excluded from the calculation of shares used in the diluted EPS calculation for the six months ended June 30, 2007 and 2006, respectively.

Note E – Business Segments

Harte-Hanks is a highly focused targeted media company with operations in two segments – Direct Marketing and Shoppers.

10

Table of Contents

Information about the operations of Harte-Hanks in our two different business segments follows:

Note F – Components of Net Periodic Pension Benefit Cost

Prior to January 1, 1999, we maintained a defined benefit pension plan for which most of our employees were eligible. In conjunction with significant enhancements to our 401(k) plan, we elected to freeze benefits under this defined benefit pension plan as of December 31, 1998.

11

Table of Contents

In 1994, we adopted a non-qualified, supplemental pension plan covering certain employees, which provides for incremental pension payments so that total pension payments equal those amounts that would have been payable from our principal pension plan if it were not for limitations imposed by income tax regulation. The benefits under this supplemental pension plan will continue to accrue as if the principal pension plan had not been frozen.

Net pension cost for both plans included the following components:

We made a $5.0 million contribution to our frozen pension plan in May 2007 in order to obtain the Pension Benefit Guaranty Corporation full funding limit exemption. We are not required to make and do not intend to make any additional contributions to either pension plan for the remainder of 2007 other than to the extent needed to cover benefit payments related to the unfunded plan. As a result of the $5.0 million contribution, our expected return on plan assets for 2007 increased $0.3 million. This is expected to decrease our net periodic benefit cost in the second half of the year by approximately $0.2 million.

12

Table of Contents

Note G – Comprehensive Income

Comprehensive income for a period encompasses net income and all other changes in equity other than from transactions with our stockholders. Our comprehensive income was as follows:

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Cautionary Note Regarding Forward-Looking Statements

This report and, in particular, this Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) contain “forward-looking statements” within the meaning of the federal securities laws. All such statements are qualified by this cautionary note, which is provided pursuant to the safe harbor provisions of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may also be included in our other public filings, press releases, our website and oral and written presentations by management. Statements other than historical facts are forward-looking and may be identified by words such as “may,” “will,” “expects,” “believes,” “anticipates,” “plans,” “estimates,” “seeks,” “could,” “intends,” or words of similar meaning. Examples include statements regarding (1) our strategies and initiatives, (2) our financial outlook, including adjustments to our cost structure and other actions designed to improve our financial performance, (3) our expectations for our businesses and for the industries in which we operate, (4) competitive factors, (5) acquisition and development plans, (6) our stock repurchase program, (7) expectations regarding pending legal proceedings, and (8) other statements regarding future events, conditions or outcomes. These forward-looking statements are based on current information, expectations and estimates and involve risks, uncertainties, assumptions and other factors that are difficult to predict and that could cause actual results to vary materially from what is expressed in or indicated by the forward-looking statements. In that event, our business, financial condition, results of operations or liquidity could be materially adversely affected and investors in our securities could lose part or all of their investments. Some of these risks, uncertainties, assumptions and other factors can be found in our filings with the Securities and Exchange Commission, including the factors discussed under “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year

13

Table of Contents

ended December 31, 2006 (2006 Form 10-K) and any updates thereto in our Forms 10-Q. The forward-looking statements included in this report and those included in our other public filings, press releases, our website and oral and written presentations by management are made only as of the respective dates thereof, and we undertake no obligation to update publicly any forward-looking statement in this report or in other documents, our website or oral statements for any reason, even if new information becomes available or other events occur in the future.

Overview

The following MD&A section is intended to help the reader understand the results of operations and financial condition of Harte-Hanks, Inc. (Harte-Hanks). This section is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes to the financial statements contained elsewhere in this report and our MD&A section, financial statements and accompanying notes to financial statements in our 2006 Form 10-K. Our 2006 Form 10-K contains a discussion of other matters not included herein, such as disclosures regarding critical accounting policies and estimates, and contractual obligations.

Harte-Hanks is a worldwide, direct and targeted marketing company that provides direct marketing services and shopper advertising opportunities to a wide range of local, regional, national and international consumer and business-to-business marketers. We manage our operations through two operating segments: Direct Marketing and Shoppers.

Harte-Hanks Direct Marketing improves the return on its clients’ marketing investment by increasing their prospect and customer value – a process of “customer optimization” – organized around five strategic considerations:

We utilize various capabilities and technologies to enable our clients to identify, reach, influence and nurture their customers. The services and products offered by Direct Marketing are tailored to specific industries or markets. Our direct marketing business services various vertical markets including retail, high-tech/telecom, financial services, pharmaceutical/healthcare, and a wide range of selected markets. Depending on the needs of our clients, our direct marketing capabilities are provided in an integrated approach through more than 30 facilities worldwide, more than 10 of which are located outside of the United States. Each of these centers possesses some specialization and is linked with others to support the needs of our clients. Revenues from the Direct Marketing segment represented approximately 60% of our total revenue for the three months ended June 30, 2007.

Harte-Hanks Shoppers is North America’s largest owner, operator and distributor of shopper publications, based on weekly circulation and revenues. Shoppers are weekly advertising publications delivered free by Standard Mail to households and businesses in a particular geographic area. Shoppers offer advertisers a targeted, cost-effective, local advertising system, with virtually 100% penetration in their area of distribution. Shoppers are particularly effective in large markets with high media fragmentation in which major metropolitan newspapers generally have low penetration. As of June 30, 2007, our shoppers are zoned into more than 1,000 separate editions with circulation of approximately 13 million each week in California and Florida. Our Shoppers segment also provides advertising services online through our websites, ThePennySaverUSA.com and TheFlyer.com. Revenues from the Shoppers segment represented approximately 40% of our total revenue for the

14

Table of Contents

three months ended June 30, 2007.

We derive revenues from the sale of direct marketing services and shopper advertising services. As a worldwide business, direct marketing is affected by, among other things, general national and international economic trends. Our shoppers operate in local markets and are largely affected by the strength of the local economies in California and Florida.

Our overall strategy is based on seven key elements:

Our principal expense items are labor, postage and transportation.

Results of Operations

Operating results were as follows:

2^nd Quarter 2007 vs. 2^nd Quarter 2006

Revenues

Consolidated revenues decreased 2.8%, to $290.1 million, and operating income decreased 19.3% to $41.6 million in the second quarter of 2007 when compared to the second quarter of 2006. Our overall results reflect decreased revenues of 7.1% from our Shoppers segment, partially offset by increased revenues of 0.4% from our Direct Marketing segment. The revenue performance from Shoppers was the result of decreased sales in established markets, primarily attributable to the challenging real estate and associated financing markets in the California and Florida geographies in which we operate, and the discontinuation of commercial printing operations in our Tampa facility. Direct Marketing comparisons were affected by $7.0 million of revenue recognized in the second quarter of 2006 relating to a contract termination fee received from one of our customers in the financial vertical. Excluding revenues from this contract termination, Direct Marketing’s second quarter 2007 revenues would have been up $7.7 million, or 4.6%, and consolidated revenues would have been down less than 1% compared to the second quarter of 2006.

15

Table of Contents

Operating Expenses

Overall operating expenses increased 0.7%, to $248.6 million, in the second quarter of 2007 compared to the second quarter of 2006. This increase includes approximately $1 million of costs recognized in our Shoppers segment related to the shut down of approximately 600,000 of unprofitable circulation at the end of June 2007, and approximately $1 million of costs recognized in our Direct Marketing segment as part of an initiative to reduce fixed costs and headcount. For the quarter, Direct Marketing operating expenses increased 3.4% while Shoppers operating expenses decreased 3.0% and general corporate expense decreased 6.2%. Direct Marketing’s results were impacted by $2.4 million of operating expense recognized in the second quarter of 2006 as a result of the contract termination discussed above.

Net Income/Earnings Per Share

Net income decreased 24.2%, to $22.9 million, and diluted earnings per share decreased 16.2%, to $0.31 per share, in the second quarter of 2007 when compared to the second quarter of 2006. The decrease in net income was a result of decreased operating income, increased interest expense and a higher effective tax rate in the second quarter of 2007 when compared to the second quarter of 2006.

As discussed above, in the second quarter of 2007 we began an initiative to reduce fixed costs and headcount in both of our businesses. We plan to take additional steps in the second half of the year in both businesses to further align our cost structure with the current revenue environment and we will recognize additional costs in the second half of 2007 as we continue this initiative. For the full year 2007, we anticipate that these costs will exceed the overall benefit we will experience as a result of this initiative.

First Half 2007 vs. First Half 2006

Revenues

Consolidated revenues decreased 0.6%, to $573.2 million, and operating income decreased 14.7% to $77.7 million in the first half of 2007 when compared to the first half of 2006. The revenue performance from Shoppers was the result of decreased sales in established markets, primarily attributable to the challenging real estate and associated financing markets in the California and Florida geographies in which we operate, and the discontinuation of commercial printing operations in our Tampa facility. Direct Marketing comparisons were affected by $7.0 million of revenue recognized in the second quarter of 2006 relating to a contract termination fee described above. Excluding revenues from this contract termination, Direct Marketing’s first half 2007 revenues would have been up $14.5 million, or 4.4%, and consolidated revenues would have been up 0.6% compared to the first half of 2006.

Operating Expenses

Overall operating expenses increased 2.0%, to $495.5 million, in the first half of 2007 compared to the first half of 2006. This increase includes approximately $1 million of costs recognized in our Shoppers segment related to the shut down of approximately 600,000 of unprofitable circulation at the end of June 2007, and approximately $1 million of costs recognized in our Direct Marketing segment as part of an initiative to reduce fixed costs and headcount. Direct Marketing operating expenses increased 4.1% and general corporate expense increased 1.9%, while Shoppers operating expenses decreased 1.1%. Direct Marketing’s results were impacted by $2.4 million of operating expense recognized in the second quarter of 2006 as a result of the contract termination discussed above.

Net Income/Earnings Per Share

Net income decreased 19.9%, to $43.2 million, and diluted earnings per share decreased 12.3%, to $0.57 per share, in the first half of 2007 when compared to the first half of 2006. The decrease in net income was a result of decreased operating income, increased interest expense and a higher effective tax rate in the first half of 2007 when compared to the first half of 2006.

16

Table of Contents

Direct Marketing

Direct Marketing operating results were as follows:

2^nd Quarter 2007 vs. 2^nd Quarter 2006

Revenues

Direct Marketing revenues increased $0.7 million, or 0.4%, in the second quarter of 2007 compared to the second quarter of 2006. These year-over-year comparisons were affected by $7.0 million of revenue recognized in the second quarter of 2006 relating to a contract termination fee received from one of our customers in the financial vertical. Excluding revenues from this contract termination, second quarter 2007 revenues would have been up $7.7 million, or 4.6%, compared to the second quarter of 2006. Our high tech/telecom vertical, which was helped by our September 2006 acquisition of Aberdeen Group, Inc. (Aberdeen), was up double digits and our select vertical grew in the high single digits. Our pharma/healthcare vertical was up in the mid-single digits, while our retail vertical was flat in the quarter. Excluding the 2006 impact of the contract termination fee, our financial vertical was down in the high single digits. Revenues from our vertical markets are impacted by, among other things, the economic fundamentals of each industry, various market factors, including the demand for services by our clients, and the financial condition of and budgets available to specific clients. Revenues for Direct Marketing are affected by a number of factors, including general national and international economic trends.

From a service offering perspective, Direct Marketing experienced increased revenues from telesales, market research and analytics, and internet services. Partially offsetting these increases were declines in revenues from print and data and database processing.

The acquisitions of StepDot Software GmbH in June 2006, Global Address in July 2006 and Aberdeen in September 2006 also positively affected our revenues in the second quarter of 2007 compared to the second quarter of 2006. The sale of a print operation in October 2006 negatively affected our revenues in the second quarter of 2007 compared to the second quarter of 2006.

Future revenues will depend on, among other factors, how successful we are at growing business with existing clients, acquiring new clients, meeting client demands, and the strength of the national and international economies. We believe that we will benefit from marketing and advertising expenditures being moved from other advertising media to the targeted media space, the results of which can be more effectively tracked, enabling measurement of the return on marketing investment. Standard postage rates increased in January of 2006 and again in May of 2007. Postage rates influence the demand for our Direct Marketing services even though the cost of mailings is borne by our clients and is not directly reflected in our revenues or expenses. While we do not expect the postal rate increases to have a significant impact on our Direct Marketing business, there is no assurance that future postal increases will not have an adverse impact on us.

Operating Expenses

Operating expenses increased $4.9 million, or 3.4%, in the second quarter of 2007 compared to the second quarter of 2006. These results were affected by $2.4 million of operating expense recognized in the second quarter of 2006 as a result of the contract termination discussed above. Excluding the expenses related to the contract termination, operating expense increased $7.3 million, or 5.1%. These results were also affected by approximately $1 million of costs, primarily severance and lease termination costs, recognized towards the end of

17

Table of Contents

the second quarter of 2007 as part of an initiative to reduce fixed costs and headcount. Labor costs increased $5.2 million, or 7.1%, in the second quarter of 2007 compared to the second quarter of 2006 due to severance and higher payrolls and temporary labor due to more labor intensive revenues. This increase was partially offset by lower incentive compensation. Production and distribution costs decreased $3.4 million, or 6.3%, due to lower logistics-related transportation costs and less expense related to printing materials. This decrease was partially offset by costs associated with the early termination of a lease as part of the cost cutting initiative. The shift in revenues from high production cost, less labor intensive work done at our divested print facility to more labor intensive, lower production cost work done at Aberdeen also contributed to the changes in labor and production and distribution costs. General and administrative expense increased $2.6 million, or 22.5%, due primarily to increased employee expenses including travel, recruiting and training, and increased bad debt expense due to timing. Depreciation and amortization expense increased $0.5 million, or 7.5%, due to additional intangible amortization related to 2006 acquisitions, primarily Aberdeen, and additional depreciation of assets related to our facility in Manila.

Direct Marketing’s largest cost components are labor, outsourced costs and transportation costs. Each of these costs is variable and tends to fluctuate with revenues and the demand for our direct marketing services.

First Half 2007 vs. First Half 2006

Revenues

Direct Marketing revenues increased $7.5 million, or 2.2%, in the first half of 2007 compared to the first half of 2006. These year-over-year comparisons were affected by $7.0 million of revenue recognized in the second quarter of 2006 relating to the contract termination discussed above. Excluding revenues from this contract termination, first half 2007 revenues would have been up $14.5 million, or 4.4%, compared to the first half of 2006. Our high tech/telecom vertical, which was helped by our September 2006 acquisition of Aberdeen, was up double digits and our select vertical grew in the high single digits. Our retail vertical was up slightly, while our pharma/healthcare vertical was down slightly in the first half. Excluding impact of the contract termination fee, our financial vertical was down in the mid-single digits.

From a service offering perspective, Direct Marketing experienced increased revenues from telesales, market research and analytics, software programming and fulfillment. Partially offsetting these increases were declines in revenues from print and data and database processing.

The acquisitions of StepDot Software GmbH in June 2006, Global Address in July 2006 and Aberdeen in September 2006 positively affected our revenues in the first half of 2007 compared to the first half of 2006. The sale of a print operation in October 2006 negatively affected our revenues in the first half of 2007 compared to the first half of 2006.

Operating Expenses

Operating expenses increased $11.7 million, or 4.1%, in the first half of 2007 compared to the first half of 2006. These results were affected by $2.4 million of operating expense recognized in the second quarter of 2006 as a result of the contract termination discussed above. Excluding the expenses related to the contract termination, operating expense increased $14.1 million, or 4.9%. The results were also affected by approximately $1 million of costs, primarily severance and lease termination costs, recognized towards the end of the second quarter of 2007 as part of an initiative to reduce fixed costs and headcount. Labor costs increased $12.7 million, or 8.7%, in the first half of 2007 compared to the first half of 2006 due to severance and higher payrolls and temporary labor due to the relative increase in revenues from more labor intensive service lines. Production and distribution costs decreased $6.8 million, or 6.3%, due to lower logistics-related transportation costs and less expense related to printing materials. This decrease was partially offset by costs associated with the early termination of a lease as part of the cost cutting initiative. The shift in revenues from high production cost, less labor intensive work done at our divested print facility to more labor intensive, lower production cost work done at Aberdeen also

18

Table of Contents

contributed to the changes in labor and production and distribution costs. General and administrative expense increased $3.9 million, or 16.7%, due primarily to increased employee expenses including travel, recruiting and training, and bad debt expense due to timing. Depreciation and amortization expense increased $1.9 million, or 15.7%, due to additional intangible amortization related to 2006 acquisitions, primarily Aberdeen, and additional depreciation of assets related to our facility in Manila.

Shoppers

Shoppers operating results were as follows: