Item 1. BUSINESS
General
Cash Systems, Inc. is a provider of cash access products and related services to the gaming industry. Our products and services provide gaming patrons access to cash through automated teller machine (“ATM”) cash withdrawals, credit and debit card cash advances, and check cashing.
Our predecessor company was organized under the laws of the State of Utah on June 23, 1983, under the name Cameron Resources, Inc. Effective October 3, 1989, Cameron Resources, Inc. merged into Unicom, Inc., a Delaware corporation, for the sole purpose of changing its domicile to the State of Delaware. Unicom, Inc. changed its name to Unistone, Inc. on September 9, 1998.
Pursuant to a Plan of Reorganization and Stock Exchange Agreement dated October 9, 2001 (the “Plan of Reorganization”), Unistone, Inc. acquired all of the outstanding capital stock of Cash Systems, Inc., a Minnesota corporation, in exchange for the issuance of a total of 10,550,000 shares of Unistone Inc.’s common stock. In connection with the Plan of Reorganization, Unistone, Inc. changed its name to Cash Systems, Inc.
Effective February 28, 2006, we acquired certain assets and assumed certain liabilities of Indian Gaming Services, a San Diego-based cash-access provider to the gaming industry and a division of Borrego Springs Bank, N.A. The acquisition provided us with additional ATM, check cashing and credit and debit services to 11 casino facilities. In addition, the acquisition provided us with access to other credit and debit processing opportunities.
Our principal office is located at 7350 Dean Martin Drive, Suite 309, Las Vegas, Nevada. In addition, we have offices in Burnsville, Minnesota and San Diego, California which are used by our call center and technical support staff. We moved our principal office to Las Vegas, Nevada during 2005.
Industry and Products
We provide credit/debit card cash advance (“CCCA”), ATM and check cashing solutions (“Cash Access Services”). These products are the primary means by which casinos make cash available to gaming patrons. We also provide casinos with ancillary services such as on-line reporting, which enhances their ability to monitor player activity and market to gaming patrons. During 2006, our Cash Access Services were used at 135 gaming locations and 25 retail locations nationwide. Revenue generated from our retail customers has accounted for less than 1% of our total revenue in each of the past five years.
Credit Card Cash Advances and POS Debit Card Transactions
Our CCCA products, which are comprised of both “All-In-1 ATMs” and Company kiosks which house point-of-sale (“POS”) terminals, have been installed at 160 locations. Our CCCA products allow gaming patrons to obtain cash from their credit card, or checking account in the case of debit transactions, through the use of our software and equipment.
A gaming patron can initiate a CCCA transaction through one of our “All-In-1 ATMs” or kiosks. The “All-In-1 ATM” or kiosk terminal will prompt the gaming patron to swipe his/her credit or debit card and enter the dollar amount requested. The “All-In-1 ATM” or kiosk terminal will then dial the appropriate bank for an authorization or denial. If authorized, the “All-In-1 ATM” or kiosk terminal will direct the gaming patron to a casino cage. Once at the cage, the gaming patron will present his/her credit/debit card and driver’s license. A cage cashier will swipe the credit/debit card in a Company terminal to obtain information for the transaction initiated at the “All-In-1 ATM” or kiosk terminal. The purpose of the second swipe is for identification purposes only. After finding the approved transaction, the cage terminal will provide the cashier with two options in order to obtain the gaming patron’s address, driver’s license and telephone number, which must be imprinted on each check or voucher. The first option is to swipe the gaming patron’s driver’s license if it contains a magnetic strip. The second option is to manually enter the information into the terminal. After one of these options is selected, a printer attached to the cage terminal will generate a Company check or voucher. The cashier will give the gaming patron cash in the amount requested after he/she signs the Company check or voucher.
Our check or voucher is then deposited by the casino into its account for payment from a Company account and we debit the gaming patron’s credit or debit card. This transaction can be accomplished without the gaming patron using a personal identification number (“PIN”). Gaming patrons pay a service charge typically between 6%-7% for credit card advances and a fixed fee of $1.95 plus 2% for POS debit card withdrawals.
ATM Cash Withdrawals
We offer a full menu of ATM services to casinos and retailers. Through our standard ATMs and our “All-In-1 ATMs,” vault cash for the operation of the ATM can be provided by us or directly by the casino or retailer. We process ATM transactions through ATM networks with which we have licensing agreements. In addition, we provide ATM vault cash, maintenance and armored car service. In an ATM cash withdrawal, a gaming patron directly withdraws funds from his or her bank account by swiping an ATM card through one of our standard ATMs or “All-In-1 ATMs.” Our processor then routes the transaction request through an electronic funds transfer network to the gaming patron’s bank. If the transaction is authorized, the ATM dispenses the cash to the gaming patron. Gaming patrons pay a fixed fee for ATM cash withdrawals.
Check Cashing Solutions
We also offer two check cashing solutions to the gaming industry. First, we provide casinos with full service check cashing. With full service check cashing, we are given space within a casino to operate a check cashing booth. Our employees manage the booth, our cash is used to cash checks, and we retain customer fees from check cashing. Gaming patrons pay a service charge based on the amount of the transaction for our check cashing services. At December 31, 2006, there were approximately 19 casinos utilizing our full service check cashing services. Second, we self-guarantee checks via internal check cashing technology as well as provide check guarantee services with the assistance of third party providers and check verification services.
Joint Venture and Cashclub Product
In April 2006, the Company entered into a joint venture agreement with Bally Technologies, Inc. and Scotch Twist, Inc. (“Joint Venture”). Through the Joint Venture, the Company anticipates developing products that allow customers to fund player accounts using credit and debit cards tied to a players club card, such that the players club card can be used in place of a credit or debit card to effectuate transactions within a casino for gaming, dining, retail purchases, and lodging under a license to a portfolio of patents from Scotch Twist. If and when this cashless product is developed, Bally Technologies and Cash Systems will work together to market and sell the product, initially for use exclusively with Bally’s hardware and software interface and accounting systems, and will allocate the fees generated from the use of the jointly developed products among the Joint Venture partners. We do not anticipate that the development costs related to the Joint Venture will be material to us.
As an initial step in the development of the Joint Venture’s cashless product and to test gaming patron acceptance of a players club card, in October 2006, the Company commenced beta testing of the cashclub™ product, which enables cash access through the use of a players club card at an ATM or Kiosk. Initial beta testing may be ended soon. We are working with the card associations to ensure that the cashclub™ product and process will comply with the card association rules prior to full deployment into the marketplace. We do not expect the revenues from the cashclub™ product in the beta phase to be material to the Company. Prior to implementation of the Joint Venture’s cashless product, we will work with the card associations to ensure that the cashless product and process will comply with the card association rules. At this time, we can give no assurance that we will be able to implement the cashless product in a manner that will comply with the cash association rules.
The Company incurred research and development costs relating to the development of its Joint Venture product. For the years ended December 31, 2006, 2005, and 2004, the Company expensed $91,207, $0, and $0, which is included in other general and administrative expenses on the consolidated statement of operations.
The Casino Gaming Market
Casino gaming in the United States has expanded significantly in recent years. There are now 47 states offering some form of legalized gaming including casinos, racinos, pari-mutuel wagering, lotteries and the like. The growth in the gaming industry has resulted from the legalization of gaming in additional jurisdictions and the opening of new casinos in existing markets, as well as from an overall increase in gaming activity. There are approximately 900 casinos in the United States, comprised of tribal owned casinos and commercially operated casinos. We do not believe that the number of states which permit gaming on Native American land will increase significantly in the future. Future growth is expected to result principally from increased gaming in jurisdictions which currently permit casino gaming. The overall trend is towards gaming as a form of entertainment.
The expansion of casino gaming has generated a corresponding demand for ancillary services, including cash access services in casinos. While a few casino operators provide such services directly, the vast majority of casinos’ cash access services are provided by third party vendors pursuant to contracts with the casino operator, with typical contract terms of three to five years. We believe that the principal objective of casino operators in providing or arranging for such services is to promote gaming activity by making funds available to gaming patrons on a convenient basis. The outsourcing of these services provides the gaming patron with easy access to funds and provides an additional profit center for the casinos through the sharing of fees collected from gaming patrons.
Our business currently is concentrated in the casino industry and we contemplate that our operations will continue to be focused on operations in casinos and other gaming locations. Although not anticipated, we would be adversely affected by a decline in the popularity of gaming, a reduction in the rate of expansion of casino gaming, changes in laws or regulations affecting casinos and related operations, or other adverse changes in the gaming industry.
Increased competition has prompted casino operators to seek innovative ways to attract gaming patrons and increase the frequency of return visits. We believe that efficient and confidential access to cash for gaming patrons contributes to increased gaming volume. Credit/debit card cash advances, ATMs and check cashing are the three primary methods used by casinos to provide gaming patrons with quick and efficient access to cash. Virtually all casinos in the United States currently offer at least one of these services on their premises.
Customers
We presently provide our Cash Access Services to a combination of commercial and Native American owned casinos across the United States and Caribbean countries, as well as to vendors who themselves contract directly with casinos for such services. During 2006, approximately 60% of the casinos serviced are with Native American tribal operated casinos and the remaining are with commercially operated casinos.
We provide our Cash Access Services pursuant to agreements with the operators of the host casinos or vendors, as described above. Such agreements typically have initial terms of three to five years, with renewal clauses. In most of the agreements, either party may cancel the agreement for “cause” if a breach is not cured within thirty days. In addition, some of the agreements are terminable upon 30 days advance notice, and some become nonexclusive or terminable by the operator of the host casino or vendor in the event that we fail to satisfy specific covenants, such as covenants relating to our ongoing product development. We rely on these agreements to govern the overall relationships with the casinos and promote superior customer service and strong personal relationships to generate the renewals of such agreements. We continue to enhance our technology to provide ever improving products and service to our customers. However, there can be no assurance that these agreements will be renewed after their initial or renewal terms.
Regulation
Gaming Regulation
Many states require companies engaged in the business of providing cash access services or transmitting funds to obtain licenses from regulatory agencies. Certain states require companies to post bonds or other collateral to secure their obligations to their customers in those states. State and Tribal agencies have extensive discretion to deny or revoke licenses. We have obtained the necessary licenses and bonds to do business with the casinos where we currently operate and will be subject to similar licensing requirements as we expand our operations into other jurisdictions.
As part of our application for licenses and permits, members of our Board of Directors, our officers, key employees and stockholders holding five percent or more of our stock must submit to a personal background check. This process can be time consuming and intrusive. If an individual is unwilling to provide this background information or is unsatisfactory to a licensing authority, we must have a mechanism for making the necessary changes in management or stock ownership before beginning the application process.
In order to address this issue, our Bylaws provide that no person may become the beneficial owner of five percent or more of any class or series of our capital stock unless that person agrees in writing to:
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provide to the relevant gaming authorities such information about himself or herself as the authorities may require;
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respond to written or oral questions that the gaming authorities may propound; and
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consent to the performance of any background check that the gaming authorities may require, including the investigation of any criminal record.
If a holder of five percent or more of our capital stock does not agree to these requirements, we may redeem all or a portion of
that stockholder’s shares by paying fair market value for the shares after giving the holder 30 days’ notice of such redemption. The redemption price may be paid, at the discretion of our Board of Directors, in cash or securities having a fair market value equal to the value of the capital stock being redeemed. Management believes that this procedure will give us flexibility to ensure compliance with gaming regulations of the jurisdictions in which we may seek gaming licenses.
While there can be no assurance that we will be able to do so, we anticipate that we will be able to obtain and maintain the licenses necessary for the conduct of our business.
Many suppliers to Native American Tribal operated casinos are subject to the rules and regulations of the local Tribal Gaming Commission. These Tribal Gaming Commissions have authority to regulate all aspects of casino operations, including vendor selection and licensing. We have obtained the necessary licenses or approvals from the appropriate Tribal Gaming Commissions where we operate. However, failure to maintain compliance with all requirements of a Tribal Gaming Commission may result in the loss of our license and subsequently the loss of our contracts with the applicable Tribal casino. While there can be no assurance that we will be able to do so, we anticipate that we will be able to obtain and maintain the licenses and approvals necessary for the conduct of our business.
Our business may also be affected by state and federal regulations governing the gaming industry in general. Changes in the approach to regulation of casino gaming could affect the number of new gaming establishments in which we may provide Cash Access Services.
Financial Services Regulation
Anti-Money Laundering. The USA PATRIOT Act of 2001 and its implementing federal regulations require us to establish and maintain an anti-money laundering program. Our anti-money laundering program includes: (1) internal policies, procedures, and controls designated to identify and report money laundering; (2) a designated compliance officer; (3) an ongoing employee training program; and (4) an independent audit function to test the program. We are in the process of augmenting our anti-money laundering program and will perform independent testing to evaluate the effectiveness of the program in 2007.
In addition, the cash access services that we provide are subject to recordkeeping and reporting obligations under the Bank Secrecy Act (“BSA”). For example, in gaming establishments where we staff and operate satellite cashiers or booths, and are the direct provider of our cash access services to gaming patrons, we are required to file on a timely basis a Suspicious Activity Report (“SAR”) with the U.S. Treasury Department’s Financial Crimes Enforcement Network of any suspicious transaction relevant to a possible violation of law or regulation. A SAR must be filed when a business knows, suspects, or has reason to suspect that a transaction or pattern of transactions: involves funds derived from illegal activity; is intended or conducted in order to hide or disguise such funds so as to evade or violate any federal law or regulation, such as federal BSA reporting requirements; serves no business or apparent lawful purpose; or is intended to facilitate criminal activity. In gaming establishments where we staff and operate satellite cashiers or booths, we are also required to file a Currency Transaction Report (“CTR”) of each deposit, withdrawal, exchange of currency or other payment or transfer by, through, or to us which involves a transaction in currency of more than $10,000 in a single day.
Following the events of September 11, 2001, the United States and other governments have imposed and are considering a variety of new regulations focused on the detection and prevention of money laundering and money transmitting to or from terrorists and other criminals. Compliance with these new regulations may impact our business operations or increase our costs.
Fund Transfers. Our POS debit card transactions and ATM services are subject to the Electronic Fund Transfer Act, which provides gaming patrons with certain rights, including the right to dispute unauthorized transfers, incorrect transfers to and from their accounts, computational errors, the receipt of an incorrect amount of money, and transfers that are incorrectly identified on a receipt or statement. We have implemented the necessary policies and procedures in order to comply with the regulatory requirements for fund transfers.
Privacy Regulations. We gather non-public, personally-identifiable financial information from gaming patrons who use our Cash Access Services, such as names, addresses, telephone numbers, bank and credit card account numbers, Social Security numbers and income, credit histories and transaction information. The Gramm-Leach-Bliley Act requires us to safeguard and protect the privacy of such non-public personal information. Also, the Gramm-Leach-Bliley Act requires us to make disclosures to gaming patrons regarding our privacy and information sharing policies and give patrons the opportunity to prevent us from releasing information about them to unaffiliated third parties in certain situations. In addition to the federal Gramm-Leach-Bliley Act privacy regulations, we are subject to state privacy regulations. Certain state privacy regulations impose more stringent limitations on access and use of personal information. We continue to implement policies and programs, as well as adapt our business practices, in order to comply with applicable state privacy laws and regulations.
ATM Operations. Our ATM services are subject to applicable regulations in each jurisdiction in which we operate ATMs. These regulations require, among other things, that we register with the regulators as an operator of ATMs, that we provide gaming patrons with notices of the transaction fees assessed upon use of our ATMs, that our transaction fees do not exceed designated maximums, that we offer gaming patrons a means of resolving disputes with us, and that we comply with prescribed safety and security requirements.
Check Cashing. In jurisdictions in which we serve as a check casher, we are subject to the state licensing requirements and regulations governing check cashing activities. Generally, these regulations require us to obtain a license from the state’s banking regulators to operate as a check casher. Some states also impose restrictions on this activity such as restrictions on the amounts of service fees that may be imposed on the cashing of certain types of checks, requirements as to records that must be kept with respect to dishonored checks, and requirements as to the contents of receipts that must be delivered to gaming patrons at the time a check is cashed.
Network and Card Association Regulation. In addition to the governmental regulation described above, some of our services are also subject to rules promulgated by various payment networks, electronic fund transfer networks, and card associations.
Competition
The casino cash access business is highly competitive, and there is no assurance that we will be able to compete effectively long-
term. We have focused to a large extent on providing our services to the gaming industry. In our market, we compete primarily with Global Cash Access, Inc., Global Payments, Inc., and Fidelity National Information Services (formerly Certegy, Inc.) and financial institutions such as U.S. Bancorp and other regional and local banks that operate ATM machines on the premises of gaming establishments. We face potential competition from gaming establishments that may choose to operate Cash Access Services on their own behalf rather than outsource to us. Of our three primary competitors, Global Cash Access, Inc. is the only one that focuses primarily in the same markets in which we focus. It is possible that these current and/or new competitors may provide the same services that we provide, and have greater financial resources than we have. If we face significant competition, it may have a material adverse effect on our business, financial condition and results of operations.
In addition, more well-capitalized competitors may begin to offer competitive technology and services. Therefore, due to the short-term agreements described above, there is no assurance that we will be able to continue to grow our market share or even maintain our existing market share if our competitors begin offering products and services more comparable to those offered by us.
Proprietary Rights
We use technology in operating our business, and our success depends on developing and protecting our intellectual property. We rely on copyright, patent, trademark and trade secret laws, as well as the terms of license agreements with third parties, to protect our intellectual property. We also rely on other confidentiality and contractual agreements and arrangements with our employees, affiliates, business partners and customers to establish and protect our intellectual property and similar proprietary rights. These legal protections and arrangements afford only limited protection of our proprietary rights, and there is no assurance that our competitors will not independently develop or license products, services, or capabilities that are substantially equivalent or superior to ours. We have received one patent and have applied for nine additional patents for our developed intellectual property, and we expect to apply for additional patents as an ongoing practice. No assurances can be made as whether the patents will be granted or if they will provide financial benefit to us in the future.
Dependence on Major Customer
During the years ended December 31, 2006, 2005 and 2004, The Seminole Tribe of Florida accounted for more than 10% of our total revenues. The Seminole Tribe of Florida accounted for 27%, 29%, and 31% of total revenues for the years ended December 31, 2006, 2005, and 2004, respectively. We contract with The Seminole Tribe of Florida through a third party affiliated with The Seminole Tribe of Florida. We have provided Cash Access Services to The Seminole Tribe of Florida since November 2001 and have renewed our contract with the third party affiliated with The Seminole Tribe of Florida effective December 2006.
Employees
Our executive offices are based in Las Vegas, Nevada, where we currently employ 34 people; our satellite offices in Burnsville, Minnesota and San Diego, California employ 33 and 13 people, respectively; we employ approximately 289 people in total including employees at our check cashing booths.
Available Information
We make available, free of charge, on the Investor Relations section of our Web site (http://www.cashsystemsinc.com), our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, Section 16 reports and any amendments to those reports as soon as reasonably practicable after such reports or amendments are electronically filed with or furnished to the SEC.
Item 1A.
Item 1A. RISK FACTORS
Our business faces significant risks. These risks include those described below and may include additional risks and uncertainties not presently known by us or that we currently deem immaterial. Our financial condition, results of operations and business prospects could be materially and adversely affected by any of these risks, and the trading price of our common stock could decline. These risks should be read in conjunction with the other information contained in this Annual Report on Form 10-K.
Risks Related to Our Business
Competition in the market for cash access products and services is intense, and if we are unable to compete effectively, we could face price reductions and decreased demand for our services.
Some of our current and potential competitors have a number of significant advantages over us, including:
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commission structures that are more beneficial to gaming establishments than ours;
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longer operating histories;
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pre-existing relationships with potential customers; and
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significantly greater financial, marketing and other resources, which allow them to respond more quickly to new or changing opportunities.
In addition, some of our current and potential competitors have greater name recognition and marketing power. Furthermore, some of our current competitors have established, and in the future potential competitors may establish, cooperative relationships with each other or with third parties or adopt aggressive pricing policies to gain market share.
As a result of the intense competition in this industry, we could encounter significant pricing pressures and lose customers. These pricing pressures could result in significantly lower average service charges for our Cash Access Services or higher commissions payable to gaming establishments. We may not be able to offset the effects of any service charge reductions with an increase in the number of customers, cost reductions or otherwise. In addition, the gaming industry is always subject to market consolidation, which could result in increased pricing pressure and additional competition. To the extent that competitive pressures in the future force us to reduce our pricing to establish or maintain relationships with gaming establishments, our revenues could decline.
We have operating losses in consecutive years.
We have incurred net losses of $11.9 million and $3.8 million for the years ended December 31, 2006 and 2005, respectively. Losses are likely to continue unless we are able to increase our overall gross margins through negotiation of more favorable renewal and new customer contracts, increase revenues through normal growth channels including organic and new product-based growth, and decrease overall expenses. We have built an infrastructure to scale to these types of margin and revenue increases, but can not provide any assurance that growth or cost savings objectives will be achieved. If we are unable to negotiate more favorable contracts, meet revenue growth objectives, or sufficiently control costs, it may have a material adverse effect on our business, financial condition, and results of operations.
The cash access industry is subject to change, and we must keep pace with the changes to successfully compete.
The demand for our products and services is affected by changing technology, evolving industry standards and the introduction of new products and services. Cash access services are based on existing financial services and payment methods, which are also continually evolving. Our future success will depend, in part, upon our ability to successfully develop and introduce new cash access services based on emerging financial services and payment methods, which may, for example, be based on stored value cards, Internet-based payment methods or the use of portable consumer devices such as personal digital assistants and cellular telephones, and to enhance our existing products and services on a timely basis to respond to changes in patron preferences and industry standards. We cannot be sure that the products, services or technologies that we choose to develop will achieve market acceptance or obtain any necessary regulatory approval or that products, services or technologies that we choose not to develop will not threaten our market position. If we are unable, for technological or other reasons, to develop new products or services, enhance or sell existing products or services in a timely and cost-effective manner in response to technological or market changes, our business, financial condition and results of operations may be materially adversely affected.
The loss of our sponsorship into the Visa U.S.A., Visa International and MasterCard card associations could have a material adverse effect on our business.
We cannot provide cash access services involving VISA cards and MasterCard cards in the United States without sponsorship into the Visa U.S.A. and MasterCard card associations. Harris Bank and BankFirst currently sponsor us into the card associations. In the event we lose our sponsorship by Harris Bank and BankFirst into the card associations, we would need to obtain sponsorship into the card associations through another member of the card associations that is capable of supporting our transaction volume. We may not be able to obtain alternate sponsorship. Our inability to obtain alternate sponsorship on favorable terms or at all would have a material adverse effect on our business and operating results.
Because of our dependence on certain customers, the loss of a top customer could have a material adverse effect on our revenues and profitability.
During each of the years ended December 31, 2006, 2005 and 2004, The Seminole Tribe of Florida accounted for more than 10% of our total revenues. The Seminole Tribe of Florida accounted for 27%, 29%, and 31% of total revenues for the year ended December 31, 2006, 2005, and 2004, respectively. We contract with The Seminole Tribe of Florida through a third party affiliated with The Seminole Tribe of Florida. We have provided Cash Access Services to The Seminole Tribe of Florida since November 2001 and have renewed our contract with the third party affiliated with The Seminole Tribe of Florida effective December 2006. There can be no assurance that this contract will be renewed after its term expires. In addition, loss or financial hardship experienced by, or a substantial decrease in revenues from The Seminole Tribe of Florida or any of our other top customers could have a material adverse effect on our business, financial condition and results of operations. Consolidation among operators of gaming establishments may also result in the loss of a top customer to the extent that customers of ours are acquired by our competitors’ customers.
If we are unable to maintain our current customers on terms that are favorable to us, our business, financial condition and operating results may suffer a material adverse effect.
We enter into contracts with our gaming establishment customers to provide our cash access products and related services. Most of our contracts have a term ranging from three to five years in duration and provide that we are the only provider of cash access products to these establishments during the term of the contract. In most of the contracts, either party may cancel the agreement for “cause” if a breach is not cured within thirty days. In addition, some of the contracts are terminable upon 30 days advance notice and some either become nonexclusive or terminable by our gaming establishment customers in the event that we fail to satisfy specific covenants set forth in the contracts, such as covenants related to our ongoing product development. We are typically required to renegotiate the terms of our customer contracts upon their expiration, and in some circumstances we may be forced to modify the terms of our contracts before they expire. Assuming constant transaction volume, increases in commissions or other incentives paid to gaming establishments would reduce our operating results. We may not succeed in renewing these contracts when they expire, which would result in a complete loss of revenue from that customer.
An unexpectedly high level of chargebacks could adversely affect our business.
When gaming patrons use our Cash Access Services, we either dispense cash or produce a negotiable instrument that can be endorsed and exchanged for cash. If a completed cash access transaction is subsequently disputed by a cardholder or accountholder and if we are unsuccessful in establishing the validity of the transaction, the transaction becomes a chargeback and we may not be able to collect payment for such transaction. If, in the future, we incur an unexpectedly high level of chargebacks, we may suffer a material adverse effect to our business, financial condition or results of operations.
If we are unable to protect our intellectual property, we may lose a valuable competitive advantage or be forced to incur costly litigation to protect our rights.
We use technology in operating our business, and our success depends on developing and protecting our intellectual property. We rely on copyright, patent, trademark and trade secret laws, as well as the terms of license agreements with third parties, to protect our intellectual property. We also rely on other confidentiality and contractual agreements and arrangements with our employees, affiliates, business partners and customers to establish and protect our intellectual property and similar proprietary rights. We have been issued a patent for system and method for performing a quasi-cash transaction, U.S. Patent No. 6,951,302. At the same time, our products may not be patentable in their entirety or at all. For example, although we currently have eight inventions that are the subject of patent applications pending in the United States Patent and Trademark Office, we can provide no assurance that these applications will become issued patents. If they do not become issued patents, our competitors would not be prevented from using these inventions.
We also license various technology and intellectual property rights from third parties. We rely heavily on third parties to maintain and protect these technology and intellectual property rights. If our licensors or business partners fail to protect their intellectual property rights in technology that we license and we are unable to protect these rights, the value of our licenses may
diminish significantly. It is possible that third parties may copy or otherwise obtain and use our information and proprietary technology without authorization or otherwise infringe on our intellectual property rights. In addition, we may not be able to deter current and former employees, consultants, and other parties from breaching confidentiality agreements and misappropriating proprietary information. If we are unable to adequately protect our technology or our exclusively licensed rights, or if we are unable to continue to obtain or maintain licenses for technology from third parties, it could have a material adverse effect on the value of our intellectual property, similar proprietary rights, our reputation, and our results of operations.
In the future, we may have to rely on litigation to enforce our intellectual property rights and contractual rights. In addition, we may face claims of infringement that could interfere with our ability to use technology or other intellectual property rights that are material to our business operations. If litigation that we initiate is unsuccessful, we may not be able to protect the value of some of our intellectual property. In the event a claim of infringement against us is successful, we may be required to pay royalties or license fees to continue to use technology or other intellectual property rights that we had been using or we may be unable to obtain necessary licenses from third parties at a reasonable cost or within a reasonable time. Any litigation of this type, whether successful or unsuccessful, could result in substantial costs to us and diversions of our resources. Although we believe that our intellectual property rights are sufficient to allow us to conduct our business without incurring liability to third parties, our products and services may infringe on the intellectual property rights of third parties and our intellectual property rights may not have the value we believe them to have.
Our products and services are complex, depend on a myriad of complex networks and technologies and may be subject to software or hardware errors or failures that could lead to an increase in our costs, reduce our revenues or damage our reputation.
Our products and services, and the networks and third-party services upon which our products and services are based, are complex and may contain undetected errors or may suffer unexpected failures. The computer networks that we rely upon in providing our products and services are vulnerable to computer viruses, physical or electronic break-ins and similar disruptions, which could lead to interruptions, delays, loss of data, public release of confidential data and the inability to complete gaming patron transactions. The occurrence of these errors or failures, disruptions or unauthorized access could adversely affect our sales to customers, diminish the use of our cash access products and services by gaming patrons, cause us to incur significant repair costs, result in our liability, divert the attention of our development personnel from product development efforts, and cause us to lose credibility with current or prospective customers or gaming patrons.
We have formed relationships with and rely heavily on the services and technology of a number of third-party companies and consultants to operate our systems and ensure the integrity of our technology. Although we do not anticipate severing relations with any of these parties, any of these providers may cease providing these services or technology in an efficient, cost-effective manner, or altogether, or be unable to adequately expand their services to meet our needs. In the event of an interruption in, or the cessation of, services or technology by an existing third-party provider, we may not be able to make alternative arrangements for the supply of the services or technology that are critical to the operation of our business and this could have a material adverse effect on our business.
Changes in interchange rates may affect our costs of revenues.
We pay credit card associations interchange fees for services they provide in settling transactions routed through their networks. In addition, we pay fees to participate in various ATM or debit networks. The amounts of these interchange fees are fixed by the card associations and networks in their sole discretion, and are subject to increase in their discretion from time to time. Many of our contracts enable us to pass through to our customers the amount of any increase in interchange or processing fees, but competitive pressures might prevent us from doing so. To the extent that we are unable to pass through to our customers the amount of any increase in interchange or processing fees, our costs of revenues would increase and our net income would decrease, assuming no change in transaction volumes. Any such decrease in net income could have a material adverse effect on our financial condition and results of operations.
We are subject to extensive rules and regulations of card associations, including MasterCard International and Visa U.S.A.
A significant portion of our cash access services are processed as transactions subject to the extensive rules and regulations of the two leading card associations, MasterCard International and Visa U.S.A. From time to time, we receive correspondence from these card associations regarding our compliance with their rules and regulations. In the ordinary course of our business, we engage in discussions with our sponsoring bank and/or the card associations regarding our compliance with their rules and regulations. The rules and regulations of the card associations may not always expressly address some of the contexts and settings in which we process cash access transactions, or do so in a manner subject to varying interpretations. From time to time we also face technical compliance issues, e.g. the format of data submission files. We expect to continue to face and resolve issues such as these in the ordinary course of business, which we do not believe will result in a material adverse impact on our operations. The card associations modify their rules and regulations from time to time. In the event that the card associations or our sponsoring bank determine that the manner in which we process certain card transactions is not in continued compliance with existing rules and regulations, or if the card associations adopt new rules or regulations that prohibit or restrict the manner in which we process certain card transactions, we may be forced to modify the manner in which we operate which may increase our costs, or cease processing certain types of cash access transactions altogether, either of which could have a material negative impact on our business. As an example of the card associations amending their regulations, we are now required to comply with the Payment Card Industry (PCI) Data Security Standard. Although, we have developed and implemented a detailed plan for the PCI Data Security Standard and found to be in compliance, we may be subject to substantial penalties and fines if we do not maintain compliance with this standard.
We also process transactions involving the use of the Discover Card. The rules and regulations of the proprietary credit card network that services this card present risks to us that are similar to those posed by the rules and regulations of MasterCard International and Visa U.S.A.
We are subject to regulatory and political risk associated with the majority of our customers being Native American, Sovereign Nations.
For the year ended December 31, 2006, approximately 60% of the casinos that we serviced are Native American owned
casinos. The Tribes are sovereign nations which may determine their own rules, regulations and dispute processes. The only limitation on the Tribal jurisdiction is the Gaming Compact, adopted by the particular state within which the Tribe’s casino is located, which the Tribe has signed to authorize the opening of its casino. Our contracts with the Tribal casinos are subject to approval by the Tribal Council, the political governing body of the Tribe, and the Tribal Gaming Commission. Any change in the make-up of the Tribal Council membership, due to elections, resignations, or other means may result in a termination or non-renewal of our contract or license, or both. The Tribal Gaming Commissions have authority to regulate all aspects of casino operations, including vendor selection and licensing. Failure to maintain compliance with all requirements of the Tribal Gaming Commission may result in the loss of our license and subsequently the loss of the contract.
We are subject to the performance of third-parties whom we contract through as vendors to some Tribal casinos.
Some of our Tribal contracts are with other vendors who themselves contract directly with the Tribal casinos for Cash Access Services. The loss of the contract by these third parties, for any reason, may result in our loss of the contract.
Our joint development activities may result in products that are not commercially successful or that are not available in a timely fashion.
We have engaged in joint development projects with third parties in the past, including our Joint Venture with Bally Technologies, Inc. and Scotch Twist, Inc., and we expect to continue doing so in the future. Joint developments can magnify several risks for us, including the loss of control over development of aspects of the jointly developed products and over the timing of product availability. Accordingly, we face increased risk that joint development activities will result in products that are not commercially successful or that are not available in a timely fashion.
In addition to joint development activities, from time to time we consider acquiring additional technologies, products and intellectual property. We periodically enter into discussions with third parties regarding such potential acquisitions. We cannot assure you that we will enter into any such acquisition agreements in the near future or at all. We have no present understanding or agreements with respect to any acquisitions.
We depend on our key personnel.
We are highly dependent on the involvement of Michael Rumbolz, our Chief Executive Officer, and other members of our senior management team. All of our executive officers have separate employment and non-compete agreements with us. The loss of Mr. Rumbolz or other members of our senior management team would have a material adverse effect on our business.
Our success depends to a significant degree upon the performance and continued service of key managers involved in the development and marketing of our products and services to gaming establishments. Our future success depends upon our ability to attract, train and retain such personnel. We may need to increase the number of key managers as we further develop our products and services and as we penetrate other geographic markets. Our ability to enter into contracts with gaming establishments depends in large part on the relationships that our key managers have formed with management-level personnel of gaming establishments. Competition for individuals with such relationships is intense, and we cannot be certain that we will be successful in recruiting and retaining such personnel. In addition, employees may leave our company and subsequently compete with us. Our sales efforts are particularly hampered by the defection of personnel with long-standing relationships with management-level personnel of gaming establishments.
Our senior secured convertible notes contain financial and other restrictive covenants that limit our ability to engage in activities that may be in our long-term best interests.
Our senior secured convertible notes contain financial and other restrictive covenants that limit our ability to engage in activities that may be in our long-term best interests. These restrictions include, among other things, limits on our ability to make investments, pay dividends, incur debt, sell assets, or merge with or acquire another entity. Our failure to comply with those covenants could result in an event of default which, if not cured or waived, could result in the acceleration of our debt.
If we are obligated for any reason to repay our outstanding senior secured convertible notes, we would be required to deplete our working capital and/or raise additional funds. If we are unable to repay our senior secured convertible notes, the holders of these notes would be entitled to foreclose on substantially all of our assets which secure the repayment of such notes.
On October 10, 2006, we issued and sold $20.0 million in aggregate principal amount of senior secured convertible notes. These notes are due and payable on October 10, 2011, unless sooner converted into shares of our common stock. Upon the occurrence of an event of default or change of control, we could be required to repay these notes prior to maturity at a premium equal to up to 120% of the principal amount outstanding, together with accrued interest on the outstanding principal balance of these notes. If we are obligated for any reason to repay these notes in full, we would be required to use our limited working capital and/or raise additional funds. If we are unable to repay these notes, together with the applicable redemption premium, when required, the holders of these notes could foreclose on substantially all of our assets which secure the repayment of such notes.
Effective internal and disclosure controls are necessary for us to provide reliable financial reports and effectively prevent fraud and to operate successfully as a public company. If we cannot provide reliable financial reports or prevent fraud, our reputation and operating results would be harmed.
We have discovered a material weakness in our internal controls as defined under standards adopted by the Public Company Accounting Oversight Board, or PCAOB, that require remediation. Under the PCAOB standards, a “material weakness” is a significant deficiency or combination of significant deficiencies that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. A “significant deficiency” is a control deficiency or combination of control deficiencies, that adversely affect a company’s ability to initiate, authorize, record, process, or report external financial data reliably in accordance with generally accepted accounting principles such that there is a more than remote likelihood that a misstatement of a company’s annual or interim financial statements that is more than inconsequential will not be prevented or detected.
As a result of the material weakness we have identified in our internal controls, we also identified certain deficiencies in some of our disclosure controls and procedures that we believe require remediation. We cannot be certain that our efforts to improve our internal and disclosure controls will be successful or that we will be able to maintain adequate controls over our financial processes and reporting in the future. Any failure to maintain effective controls or timely effect any necessary improvement of our internal and disclosure controls could harm operating results or cause us to fail to meet our reporting obligations, which could affect our ability to remain listed with NASDAQ. Ineffective internal and disclosure controls could also cause investors to lose confidence in our reported financial information, which would likely have a negative effect on the trading price of our securities.
Risks Related to the Industry
Economic downturns, a decline in the popularity of gaming or changes in the demographic profile of gaming patrons could reduce the number of gaming patrons that use our services or the amounts of cash that they access using our services.
The strength and profitability of our business depends on consumer demand for gaming. During periods of economic contraction, our revenues may decrease while some of our costs remain fixed, resulting in decreased earnings. This is because the gaming activities in connection with which we provide our cash access services are discretionary leisure activity expenditures and participation in leisure activities may decline during economic downturns because consumers have less disposable income. Even an uncertain economic outlook may adversely affect consumer spending in gaming operations, as consumers spend less in anticipation of a potential economic downturn. Reductions in tourism could also have a material adverse effect on our business, financial condition and results of operations.
Changes in consumer preferences or discretionary consumer spending could harm our business. Gaming competes with other leisure activities as a form of consumer entertainment, and may lose relative popularity as new leisure activities arise or as other existing leisure activities become more popular. The popularity of gaming is also influenced by the social acceptance of gaming, which is dictated by prevailing social mores. To the extent that the popularity of gaming declines as a result of either of these factors, the demand for our cash access services may decline and our business may be harmed.
Aside from the general popularity of gaming, the demographic profile of gaming patrons changes over time. The gaming habits and use of cash access services varies with the demographic profile of gaming patrons. For example, a local gaming patron may visit a gaming establishment regularly but limit his or her play to the amount of cash that he or she brings to the gaming establishment. In contrast, a vacationing gaming patron that visits the gaming establishment infrequently may play much larger amounts and have a greater need to use cash access services. To the extent that the demographic profile of gaming patrons either narrows or migrates towards gaming patrons who use cash access services less frequently or for lesser amounts of cash, the demand for our cash access services may decline and our business may be harmed.
We are subject to extensive governmental gaming regulation.
We are subject to a variety of regulations in the jurisdictions in which we operate. Regulatory authorities at the federal, state, local and Native American Tribal Council levels have broad powers with respect to the licensing of gaming-related activities and may revoke, suspend, condition or limit our licenses, impose substantial fines and take other actions, any one of which could have a material adverse effect on our business, financial condition and results of operations. With a majority of our customers being Native American Tribal gaming operations we are subject to regulatory and contractual approval by Tribal authorities. As sovereign nations, the Tribal customers have broad powers and significant discretion regarding termination or renewal of the licenses and contracts. Any disputes arising regarding a license or contract must be resolved through the Tribal judicial system. We cannot assure you that any new gaming license or related approval that may be required in the future will be granted, or that our existing licenses will not be revoked, suspended or limited or will be renewed. If additional gaming-related regulations are adopted in a jurisdiction in which we operate, such regulations could impose restrictions or costs that could have a material adverse effect on our business. From time to time, various proposals are introduced in the legislatures of some of the jurisdictions in which we have existing or planned operations that, if enacted, could adversely affect the tax, regulatory, operational or other aspects of the gaming industry and our company. Legislation of this type may be enacted in the future.
Members of our board of directors, corporate officers, management team and the beneficial owners of five percent or more of our outstanding equity interests generally must also be approved by certain state or Tribal regulatory authorities. If the regulatory authorities were to find a person occupying any such position unsuitable, we would be required to sever our relationship with that person. Certain public issuances of securities and certain other transactions by us also require the approval of certain regulatory authorities.
In addition, certain new products and services that we may develop cannot be offered in the absence of regulatory approval of the product or licensing of us, or both. For example, our cashless gaming product must have approval and cannot be used at any location until we receive approval from the appropriate authority in such location. These approvals could require that we and our officers, directors or beneficial owners obtain a license or be found suitable and that the product be approved after testing and review. We cannot assure you that we will obtain any such approvals in the future.
In most jurisdictions in which we do business, we must obtain a non-gaming supplier’s or vendor’s license, qualification or approval. The obtaining of these licenses, qualifications or approvals and the regulations imposed on non-gaming suppliers and vendors are typically less stringent than for gaming-related suppliers and vendors. In some jurisdictions in which we do business, we must obtain a gaming-related supplier’s or vendor’s license, qualification or approval. If we must obtain a gaming-related supplier’s or vendor’s license, qualification or approval because of the introduction of new products (such as products related to cashless gaming) or because of a change in the laws or regulations, or interpretation thereof, our business could be materially adversely affected. This increased regulation of business could include, but is not limited to: requiring the licensure or finding of suitability of any equity owner, officer, director or key employee of the Company; the termination or disassociation with any equity owner, officer, director or key employee that fails to file an application or to obtain a license or finding of suitability; the submission of detailed financial and operating reports; submission of reports of material loans, leases and financing; and requiring regulatory approval of certain commercial transactions such as the transfer or pledge of equity interests in the Company.
Many of the financial services that we provide are subject to extensive rules and regulations.
All of our cash access services are subject to the privacy provisions of state and federal law, including the Gramm-Leach-Bliley Act. Our POS debit card transactions and ATM withdrawal services are subject to the Electronic Fund Transfer Act. Our ATM services are subject to the applicable regulations in each jurisdiction in which we operate ATMs. Our ATM services may also be subject to local regulations relating to the imposition of daily limits on the amounts that may be withdrawn from ATM machines, the location of ATM machines and our ability to surcharge cardholders who use our ATM machines. The cash access services we provide are subject to recordkeeping and reporting obligations under the Bank Secrecy Act and the USA PATRIOT Act of 2001. In gaming establishments where we provide our cash access services directly to gaming patrons at satellite cashiers or booths that we staff and operate, we are required to file CTRs or SARs on a timely basis. If we fail to file these CTRs or SARs on a timely basis or if we are found to be noncompliant in any way with these laws, we could be subject to substantial civil and criminal penalties. In jurisdictions in which we serve as a check casher, we are subject to the applicable state licensing requirements and regulations governing check cashing activities and deferred deposit service providers.
In the event that any regulatory authority determines that the manner in which we provide cash access services is not in compliance with existing rules and regulations, or the regulatory authorities adopt new rules or regulations that prohibit or restrict the manner in which we provide cash access services, we may be forced to modify the manner in which we operate, or stop processing certain types of cash access transactions altogether. We may also be required to pay substantial penalties and fines if we fail to comply with applicable rules and regulations. For example, if we fail to file CTRs or SARs on a timely basis or if we are found to be noncompliant in any way with either the Bank Secrecy Act or the USA PATRIOT Act of 2001, we could be subject to substantial civil and criminal penalties. In addition, our failure to comply with applicable rules and regulations could subject us to private litigation. Any such actions could have a material adverse effect on our business, financial condition and operating results.
Following the events of September 11, 2001, the United States and other governments have imposed and are considering a variety of new regulations focused on the detection and prevention of money laundering and money transmitting to or from terrorists and other criminals. Compliance with these new regulations may impact our business operations or increase our costs. Finally, as we develop new products and services, we may become subject to additional regulations.
Being a public company may strain our resources, divert management’s attention and affect our ability to attract and retain qualified directors.
As a public company, we are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act, the Sarbanes-Oxley Act of 2002, or SOX, and the rules and regulations of The NASDAQ Global Market. We have been subject to the Exchange Act since 2001 and provisions of SOX since 2005, as a result of the change in ownership control. The requirements of these rules and regulations have increased our accounting, legal and financial compliance costs, made some activities more difficult, time-consuming or costly and have placed significant strain on our personnel, systems and resources. The Exchange Act requires, among other things, that we file annual, quarterly and current reports with respect to our business and financial condition. SOX requires, among other things, that we maintain effective disclosure controls and procedures and internal control over financial reporting. In order to maintain and improve the effectiveness of our disclosure controls and procedures and internal control over financial reporting, significant resources and management oversight will be required. As a result, management’s attention may be diverted from other business concerns, which could have a material adverse effect on our business, financial condition and operating results.
Item 1B.
Item 1B. UNRESOLVED STAFF COMMENTS
None.
Item 2.
Item 2. PROPERTIES
The following table sets forth the location, principal use and size of each of our facilities:
We lease our Las Vegas, Nevada facility pursuant to a lease agreement, the term of which expires in July 2010, our San Diego facility pursuant to a lease agreement, the term of which expires in June 2008 and our Burnsville, Minnesota facility pursuant to a lease agreement, the term of which expires in June 2007. In addition to these facilities, we occupy space within certain casinos pursuant to financial services agreements in order to provide full service check cashing. The casino receives commissions based on the transactions that we process at the casino, but no direct lease payments are made for the space provided. Our employees manage the booth, but the casino operator maintains ownership of the facility. The existing locations are sufficient for the Company’s needs at present and will be assessed on an ongoing basis.
Item 3.
Item 3. LEGAL PROCEEDINGS
We are involved in various claims and lawsuits arising in the normal course of business. We do not expect any of these claims, individually or in the aggregate, to have a material adverse effect on our consolidated financial position or results of operations.
Item. 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of 2006.
PART II
Item 5.
Item 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
On December 23, 2005, our Board of Directors approved a resolution authorizing and directing our officers to withdraw the listing of our common stock from the American Stock Exchange (“AMEX”) and to list such common stock on the NASDAQ National Market. Our common stock ceased trading on AMEX after the close of market on January 5, 2006, and began trading on the NASDAQ National Market on January 6, 2006 under the symbol “CKNN.” On July 1, 2006, the NASDAQ National Market was renamed the NASDAQ Global Market. Our common stock was traded on AMEX from January 6, 2004 through January 5, 2006 under the symbol “CKN,” and on the OTC Bulletin Board from March 15, 2001 through December 31, 2003 under the symbol “CSHS.”
The following table shows the range of high and low sales prices (based on daily closing price) for our common stock for the periods indicated.
Holders
The number of direct record holders of our common stock as of March 12, 2007 was approximately 150. This does not include an indeterminate number of stockholders who may hold their shares in “street name,” estimated to amount to approximately 350 at March 12, 2007 based upon information provided to us by our stock transfer agent, American Registrar & Transfer Co.
Dividends
We have never paid cash dividends on our common stock and do not intend to do so in the foreseeable future. We currently intend to retain our earnings for the operation and expansion of our business. In addition, our Senior Secured Convertible Notes prohibit our payment of dividends without the prior written consent of the holders of the Notes representing not less than two-thirds of the aggregate principal amount of the then outstanding Notes.
Stock Performance Graph
The following graph compares the performance of an investment in the Company’s common stock from December 31, 2002 through December 31, 2006, assuming $100 was invested on December 31, 2002, with the reinvestment of all dividends, as if such amounts had been invested in: (i) our common stock; (ii) the stocks included in the S&P Small Cap 600 Index; (iii) the stocks included in the Nasdaq U.S. Index; and (iv) the stocks included in the Dow Jones U.S. Gambling Index. No cash dividends have been declared on the Company’s common stock since the stock commenced trading. The comparisons in this graph are not intended to forecast or be indicative of possible future performance of the Company’s common stock.
Total Return To Shareholders
(Includes reinvestment of dividends)
Comparison of Cumulative Total Return
Issuer Repurchases of Equity Securities
In January 2005, our Board of Directors authorized the repurchase of up to 1,000,000 shares of our common stock as part of the Company’s overall strategy to prudently allocate resources to enhance shareholder value. This stock repurchase program does not have an expiration date. The Company did not repurchase any shares of its common stock during the years ended December 31, 2006 and 2005. At December 31, 2006, the Company had authority to repurchase 1,000,000 shares of its common stock pursuant to this stock repurchase program.
Recent Sales of Unregistered Securities
During 2006, a total of 30,000 warrants having an exercise price of $1.50 were exercised on a “cashless” or “net exercise” basis (based on the average market price of the Company’s common stock prior to exercise) resulting in the issuance of 24,050 shares. In addition, during 2006, a total of 15,625 warrants were exercised for cash of $23,438 at a weighted average exercise price of $1.50 per share. The issuance of the Company’s common stock was effected as a private placement pursuant to an exemption from the registration requirements under Section 4(2) of the Securities Act of 1933, as amended, and Regulation D promulgated thereunder.
Item 6.
Item 6. SELECTED FINANCIAL DATA
The Selected Financial Data presented below has been derived from our audited Consolidated Financial Statements for the years indicated and should be read in conjunction with the Consolidated Financial Statements and related notes set forth elsewhere herein and Item 7.
Item 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion is intended to help the reader understand our results of operations and financial condition and is provided as a supplement to, and should be read in conjunction with, our financial statements, the accompanying notes to financial statements, and the other information included or incorporated by reference herein.
Overview
The Company provides credit/debit card cash advance (“CCCA”), ATM and check cashing solutions (“Cash Access Services”) to casinos, a majority of which are owned and operated by Native American tribes. These products are the primary means by which casinos make cash available to gaming patrons. The Company also provides casinos with ancillary services such as on-line reporting, which enhances their ability to monitor player activity and market to gaming patrons. With our February 28, 2006 acquisition of Indian Gaming Services, the Company added 11 casinos as customers and obtained access to other credit and debit processing opportunities.
Credit Card Cash Advances and POS Debit Card Transactions
Our CCCA products, which are comprised of both “All-In-1 ATMs” and Company kiosks which house point-of-sale (“POS”) terminals, have been installed at 135 gaming and 25 retail locations. Our CCCA products allow gaming patrons to obtain cash from their credit card, or checking account in the case of debit transactions, through the use of our software and equipment.
A gaming patron can initiate a CCCA transaction through one of our “All-In-1 ATMs” or kiosks. The “All-In-1 ATM” or kiosk terminal will prompt the gaming patron to swipe his/her credit or debit card and enter the dollar amount requested. The “All-In-1 ATM” or kiosk terminal will then dial the appropriate bank for an authorization or denial. If authorized, the “All-In-1 ATM” or kiosk
terminal will direct the gaming patron to a casino cage. Once at the cage, the gaming patron will present his/her credit/debit card and driver’s license. A cage cashier will swipe the credit/debit card in a Company terminal to obtain information for the transaction initiated at the “All-In-1 ATM” or kiosk terminal. The purpose of the second swipe is for identification purposes only. After finding the approved transaction, the cage terminal will provide the cashier with two options in order to obtain the gaming patron’s address, driver’s license and telephone number, which must be imprinted on each check or voucher. The first option is to swipe the gaming patron’s driver’s license if it contains a magnetic strip. The second option is to manually enter the information into the terminal. After one of these options is selected, a printer attached to the cage terminal will generate a Company check or voucher. The cashier will give the gaming patron cash in the amount requested after he/she signs the Company check or voucher.
Our check or voucher is then deposited by the casino into its account for payment from a Company account and we debit the gaming patron’s credit or debit card. This transaction can be accomplished without the gaming patron using a personal identification number (“PIN”). Gaming patrons pay a service charge typically between 6%-7% for credit card advances and a fixed fee of $1.95 plus 2% for POS debit card withdrawals.
ATM Cash Withdrawals
The Company offers a full menu of ATM services to casinos and retailers. Through the Company’s standard ATMs and our “All-In-1 ATMs,” vault cash for the operation of the ATM can be provided by the Company or directly by the casino or retailer. The Company processes ATM transactions through ATM networks with which the Company has licensing agreements. In addition, the Company provides ATM vault cash, maintenance and armored car service. In an ATM cash withdrawal, a gaming patron directly withdraws funds from his or her bank account by swiping an ATM card through one of the Company’s standard ATMs or “All-In-1 ATMs.” The Company’s processor then routes the transaction request through an electronic funds transfer network to the gaming patron’s bank. If the transaction is authorized, the ATM dispenses the cash to the gaming patron. Gaming patrons pay a fixed fee for ATM cash withdrawals.
Check Cashing Solutions
The Company also offers two check cashing solutions to the gaming industry. First, the Company provides casinos with full service check cashing. With full service check cashing, the Company is given space within a casino to operate a check cashing booth. The Company’s employees manage the booth, the Company’s cash is used to cash checks, and the Company retains customer fees from check cashing. Gaming patrons pay a service charge based on the amount of the transaction for our check cashing services. At December 31, 2006, there were 19 casinos utilizing our full service check cashing services. Second, we self-guarantee checks via internal check cashing technology as well as provide check guarantee services with the assistance of third party providers and check verification services.
Joint Venture and Cashclub Product
In April 2006, the Company entered into a joint venture agreement with Bally Technologies, Inc. and Scotch Twist, Inc. (“Joint Venture”). Through the Joint Venture, the Company anticipates developing products that allow customers to fund player accounts using credit and debit cards tied to a players club card, such that the player’s club card can be used in place of a credit or debit card to effectuate transactions within a casino for gaming, dining, retail purchases, and lodging under a license to a portfolio of patents from Scotch Twist. If and when this cashless product is developed, Bally Technologies and Cash Systems will work together to market and sell the product, initially for use exclusively with Bally’s hardware and software interface and accounting systems, and will allocate the fees generated from the use of the jointly developed products among the Joint Venture partners. We do not anticipate that the development costs related to the Joint Venture will be material to us.
As an initial step in the development of the Joint Venture’s cashless product and to test gaming patron acceptance of a players club card, in October 2006, the Company commenced beta testing of the cashclub™ product, which enables cash access through the use of a players club card at an ATM or Kiosk. Initial beta testing may be ended soon. We are working with the card associations to ensure that the cashclub™ product and process will comply with the card association rules prior to full deployment into the marketplace. We do not expect the revenues from the cashclub™ product in the beta phase to be material to the Company. Prior to implementation of the Joint Venture’s cashless product, we will work with the card associations to ensure that the cashless product and process will comply with the card association rules. At this time, we can give no assurance that we will be able to implement the cashless product in a manner that will comply with the cash association rules.
The Company incurred research and development costs relating to the development of its Joint Venture product. For the years ended December 31, 2006, 2005, and 2004, the Company expensed $91,207, $0, and $0, which is included in other general and administrative expenses on the consolidated statement of operations.
Internal Transaction Processing
In the past, the Company’s CCCA, POS Debit Card and ATM transactions were settled with its network payers through third party processing providers. In May 2006, the Company beta-tested its own internal processing switch at its Florida based properties. As of December 31, 2006, with the exception of a few minor properties, all CCCA and POS Debit Card transactions are processed through an internal Company-owned switch. For ATM transactions, over 75% of the Company’s ATM devices were converted to the new switch as of year end. The new internal processing switch enables the Company to eliminate third party processing costs by settling transactions directly with its network payers.
Due to the change to internal processing, a one to three day timing lag exists between the time the advance occurs and the Company is reimbursed. The effect of this change has been reflected in the Company’s consolidated balance sheets as settlements due from credit card and ATM processors as well as the associated payables due to customer accounts which are reflected in other accrued expenses.
Results of Operations
The following table presents, for the fiscal years indicated, selected items from the Consolidated Statements of Income expressed as a percentage of total sales and service fees and the year-to-year percentage changes in the dollar amounts of those items.
2006 Compared With 2005
Revenues for the year ended December 31, 2006 were $96.0 million compared to $63.2 million for the same period in 2005. The $32.8 million increase or a 52% increase in 2006 revenues over 2005 revenues, is due to the continued expansion of products and services to additional gaming operations and includes the accretive effect of acquiring IGS during the first quarter of 2006. IGS contributed $16.2 million of revenue during 2006. The volume of transaction dollars processed through our Cash Access Services during the year ended December 31, 2006 was $2,920.3 million compared to $1,983.1 million during the same period in 2005. We expand and win business relationships based on the Company’s focus on technology and superior service and expect to be successful in our bids to win new contracts as well as expand offerings under existing contracts.
Commissions, processing costs, check cashing costs and armored car services increased by approximately $25.3 million which was directly related to the Company’s revenue growth from new locations and increased transaction volume at existing locations as we expanded our services.
Total operating expenses for the year ended December 31, 2006 were $102.1 million compared to $68.9 million for 2005. The $33.2 million, or 48% increase in operating expenses over the comparable period in 2005, was due primarily to the increased amount of transactions and expansion of our business to additional locations. $3.1 million of operating expenses were attributable to IGS.
Payroll and related costs also increased by nearly $2.4 million as headcount increased by 40 employees mostly relating to an increase in the number of booth operations personnel as well as the addition of higher paid technical engineers required for our new product development. The IGS acquisition contributed $0.9 million to the increase.
Management and the Board of Directors made a concerted effort to correct a material weakness in our system of internal controls identified in the prior year. We increased payroll costs in the finance and accounting departments this past year in order to enhance our internal control processes and technical expertise. The company hired an experienced compliance director to ensure that our internal controls were in place and to test there operating effectiveness throughout the year. Management plans to continue its efforts in this area going forward.
Other General and Administrative expenses increased by $3.8 million over prior year. IGS contributed $0.5 million to the year over year increase. The company expensed through write-offs or increased reserves a significant amount for transaction exceptions, chargebacks and discrepancies with the bank.
We expect revenues to continue to increase in 2007 over 2006 which should result in a decrease in operating expenses as a percentage of revenues. The company plans to do this through the expansion of product offerings and technology applications which will make the overall operation more cost effective. As part of the new product offerings and technology applications, we continue to explore cashless gaming through internal development and alliances with other parties as well as progress towards complete implementation and utilization of our new internal processing switch.
Interest expense increased by approximately $2.9 million due to the increased amount of vault cash required to fund our ATMs, increased borrowing on our line of credit for a majority of the year, higher interest rates, interest related to the Senior Secured Convertible Notes in the fourth quarter, debt issuance costs, and amortization of the original issuance discount in connection with the Senior Secured Convertible Notes. The Company expects to be able to better leverage its operating costs in the future through the expansion of product offerings and technology applications.
Management recorded a full valuation allowance for deferred tax assets of $6.1 million for the year ended December 31, 2006 as management determined that it was more likely than not the deferred tax assets would not be realized as of December 31, 2006. The valuation was offset by a benefit of income taxes recorded during 2006 of $3.7 million resulting in expense of $2.4 million for the year ended December 31, 2006 (see Note 15).
On a fully diluted basis, after-tax net loss of ($11,888,228) for the year ended December 31, 2006 was 12% of sales or ($0.68) per diluted common share, as compared to a net loss of ($3,765,474) which was 6.0% of sales or ($0.23) per diluted common share for the same prior year period.
2005 Compared With 2004
Revenues for the year ended December 31, 2005 were $63.2 million compared to $48.4 million for the same period in 2004. The 30.5% increase in 2005 revenues is due primarily to the addition of three new customers and the continued expansion of products and services to gaming operations. Our ability to expand and win business relationships is based on our focus on technology and superior service. We expect to be successful in our bids to win new contracts and to expand offerings under existing contracts.
Operating expenses for the year ended December 31, 2005 were $68.9 million compared to $44.6 million for 2004. The 54.4% increase in operating expenses was primarily due to the increased commissions, credit card processing costs as a direct result of an increase in revenues from the new customers added in 2005. It also includes unusual write-offs of $2.7 million that relate to bad debt, and other receivable write-offs.
We also incurred significant costs associated with compliance with SOX. Approximately $2.4 million of costs were directly attributable to SOX compliance, including costs for consultants, travel, overtime and testing of controls. Throughout 2005, we retained consultants to assist in developing the necessary internal controls to satisfy the requirements of SOX and to provide us with the tools to properly manage and control the operation of our business. We anticipate that the need for SOX consultants will be reduced during 2006, as more of the internal control process is maintained internally, as a result of the increase in personnel, software and accounting system infrastructure that we implemented during 2005.
There was a significant increase in payroll during 2005, due to our focus on building the internal infrastructure. The increase in personnel reflected in the increased payroll expense is part of our plan to establish sufficient infrastructure to enable us to grow on a going forward basis and is part of our plan to for managing SOX compliance more efficiently and effectively in the future. We also implemented during 2005 a new accounting system to better manage our internal control systems. Implementation of the new accounting system required substantial personnel time and effort which is reflected as part of the increase in payroll.
On November 14, 2005, our Board of Directors approved the accelerated vesting of all unvested stock options granted under the Stock Option Plan of 2001 and the Equity Incentive Plan of 2005. As a result of the vesting acceleration, options to purchase
1,205,000 shares of our common stock became exercisable immediately, and we recognized an expense in the fourth quarter of 2005 of approximately $156,000 after tax. Based on changes to the accounting rules relating to the expensing of stock options that became effective on January 1, 2006, we estimate that accelerating the vesting of the options will eliminate pre-tax compensation expenses of approximately $3.2 million, $1.6 million, and $0, which otherwise would have been recognized in our statements of income for the years ending December 31, 2006, 2007, and 2008, respectively. Our Board of Directors determined that the decision to accelerate the vesting of the options was in the best interests of our stockholders as it will reduce our reported compensation expense in future periods.
Interest expense for the year ended December 31, 2005 increased to $0.6 million from $0.3 million for the year ended December 31, 2004 primarily due to our increased use of cash supplied pursuant to our vault cash agreement with Fidelity Bank to meet the normal operating requirements of certain of our ATMs.
We expect to reduce our operating costs in the future as a percentage of revenues through the expansion of product offerings and technology applications which will make the overall operations more cost effective. As part of the new product offerings and technology applications, we continue to explore cashless gaming through internal development and alliances with other parties.
Income before income taxes was a loss of $6.1 million compared to profit of $3.5 million for 2004. This substantial change in operating results was due to the factors described above. While we increased revenues, our expenses increased substantially more due to the increase in payroll, SOX compliance, unusual and infrequent write-offs, increased commissions, processing costs and check-cashing costs related to the increased revenues. On a fully diluted basis, after-tax net income of ($3.8 million) for 2005 was (6.0)% of sales or ($0.23) per share, as compared to net income of $2.2 million which was 4.5% of sales of $0.14 per share for the prior fiscal year.
Liquidity and Capital Resources
At December 31, 2006, we had cash of $24.9 million compared to $25.8 million at December 31, 2005. Cash used in operations totaled $4.9 million and $4.1 million during the year ended December 31, 2006 and 2005, respectively.
On November 10, 2005, we obtained from Bank of America, N.A. a two-year line of credit of up to $13,000,000 secured by substantially all of our assets. The line of credit along with certain other liabilities were subsequently paid off on October 10, 2006, as the Company issued and sold to certain institutional accredited investors an aggregate of $20.0 million in principal amount of the Company’s Senior Secured Convertible Notes (the “Notes”) and warrants to purchase an aggregate of 312,500 shares of the Company’s common stock (the “Warrants”) in reliance upon the exemption from securities registration afforded by Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”) and Rule 506 of Regulation D as promulgated by the SEC under the Securities Act. The Notes bear interest at the rate of 6.50% per annum, payable quarterly in arrears commencing on January 10, 2007. This interest rate is subject to adjustment up to 12.0% per annum upon the occurrence of certain events of default. As of December 31, 2006, the Company was in compliance with its covenants under the Notes. In addition, the interest rate is subject to adjustment to 7.50% in the event of certain interest test failures which are based on financial thresholds relating to Consolidated Revenue, Consolidated Earnings Before Interest, Tax, Depreciation, and Amortization (“EBITDA”), and Total Debt to EBITDA Ratio. The Company had an interest rate failure as of December 31, 2006 and therefore, the Notes will have an interest rate of 7.50% during 2007 until cured as defined in the Notes agreements. The maturity date of the Notes is October 10, 2011. The Company’s obligations under the Notes are secured by a security interest in substantially all of the Company’s assets.
We had working capital of approximately $11.8 million at December 31, 2006 compared to working capital of $10.8 million at December 31, 2005. We expect our operating working capital requirements to increase in fiscal 2007 as our sales and product development increase. We expect to fund any such increase primarily with cash flow from operations as well as proceeds from the issuance and sale of the Notes for at least the next 12 months. Settlements due from credit card processors were $11.0 million at December 31, 2006 compared to $7.7 million at December 31, 2005. As a result of transitioning to internal ATM transactions processing, the Company also receives settlement funds from its ATM processor. Settlements due from ATM processors were $16.6 and $4.5 million as of December 31, 2006 and 2005, respectively.
For fiscal year 2007, we estimate capital expenditures of approximately $2.3 million related to capital labor, ATMs, and related costs. We expect to fund these capital expenditures primarily with cash flow from operations as well as proceeds from the issuance of and sale of the Notes.
As of December 31, 2006, the Company had cash net of “Checks issued in excess of cash in bank” of $3.6 million.
We anticipate that we will continue to experience growth in our income and expenses for the foreseeable future and that our operating expenses will be a material use of cash resources. We believe that the existing sources of liquidity and the results of our operations will provide cash to fund operations for at least the next 12 months.
Contractual Obligations and Commitments
The following is a table of contractual obligations and commitments as of December 31, 2006:
Payments Due by Period
During the first quarter of 2006, we completed the acquisition of Indian Gaming Services. We paid $12 million for all of the assets of Indian Gaming Services. The purchase price was partially funded through a private placement of 710,000 shares of our common stock with a market value of approximately $4,470,160.
We increased our borrowings under our line of credit to facilitate the cash payment requirements of the acquisition and subsequently paid off our borrowings under our line of credit and other liabilities through the issuance of Notes and Warrants.
The Notes are initially convertible into 2,500,001 shares of our common stock, based on a conversion price of $8.00 per share, and the Warrants are initially exercisable for 312,500 shares of our common stock at an exercise price of $8.00 per share. The conversion price of the Notes, the exercise price of the Warrants and the number of shares of our common
stock that are issuable upon conversion of the Notes and upon exercise of the Warrants are subject to adjustment as a result of certain issuances of our common stock, or securities convertible into or exercisable for shares of our common stock, below $8.00 per share. Pursuant to a registration rights agreement entered into by us in connection with the private placement of the Notes and Warrants, we agreed to register for resale 130% of the shares of our common stock issuable upon conversion of the Notes and upon exercise of the Warrants. As a result, we have registered for resale 3,656,252 shares of our common stock.
Off Balance Sheet Arrangements
The Company does not have any off balance sheet arrangements.
Critical Accounting Policies
Our discussion and analysis is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements, the reported amounts of revenues and expenses during the reporting period, and related disclosures of contingent assets and liabilities for the periods indicated. The notes to the consolidated financial statements contained herein describe our significant accounting policies used in the preparation of the consolidated financial statements. On an on-going basis, we evaluate our estimates, including, but not limited to collectibility of loans receivable, the lives and continued usefulness of property and equipment and software and contingencies. Due to uncertainties, however, it is at least reasonably possible that management’s estimates will change during the next year, which cannot be estimated. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates under different assumptions or conditions.
Our revenue recognition policy is significant because the amount and timing of revenue is a key component of our results of operations. We follow the guidance of Staff Accounting Bulletin No. 104 (“SAB 104”), which requires that a strict series of criteria are met in order to recognize revenue related to services provided. If these criteria are not met, the associated revenue is deferred until the criteria are met. We recognize commission revenue when evidence of a transaction exists, services have been rendered, our price is fixed or determinable and collectibility is reasonably assured. The reasonable assurance is based on the transactions being authorized and preapproved by credit card vendors or third parties. We evaluate our commissions revenue streams for proper timing of revenue recognition.
Credit card cash advance revenue is comprised of upfront patron transaction fees assessed at the time the transaction is initiated and a percentage of the face amount of the cash advance. Credit card cash advance revenue is recognized at the point that a negotiable check instrument is generated by the casino cashier or cash cage operation based upon authorization of the transaction.
ATM fees are comprised of upfront patron transaction fees or surcharges assessed at the time the transactions are initiated. Upfront patron transaction fees are recognized when a transaction is authorized. We provide cash through wire transfers to certain casinos for ATMs and record a receivable from the casinos.
Check cashing services revenue is generally contractual, based upon a percentage of the face amount of total checks warranted. We engage an independent third party to guarantee the collectability of the checks as well as self-guarantee checks. We record a receivable for all guaranteed checks returned for insufficient funds until determined to be uncollectible.
We have determined that the accounting policies for income recognition described above are in accordance with the Financial Accounting Standards Board Emerging Issues Task Force (“EITF”) Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”.
We have recorded an accrual for known and potential chargebacks for possible charges against a gaming patron’s credit card that we are unable to establish the validity of the transaction. The accrual for chargebacks is estimated based on historical information and management’s estimates. The chargeback accrual at December 31, 2006 and 2005 was $102,403 and $226,184, respectively.
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options based on fair values. The Company’s determination of fair value of share-based payment awards is based on the date of grant using an option-pricing model which incorporates a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expect stock price volatility over the eighteen month period prior to the grant date of the awards and estimates regarding projected employee stock option exercise behaviors and forfeitures. The Company recognizes the expense related to the fair value of the award straight-line over the vesting period.
Recently Issued Accounting Pronouncements
The Financial Accounting Standards Board has published FASB Interpretation No. 48 (FIN No. 48), “Accounting for Uncertainty in Income Taxes”, to address the non-comparability in reporting tax assets and liabilities resulting from a lack of specific guidance in FASB Statement of Financial Accounting Standards No. 109 (SFAS 109), “Accounting for Income Taxes”, on the uncertainty in income taxes recognized in an enterprise’s financial statements. Specifically, FIN No. 48 prescribes (a) a consistent recognition threshold and (b) a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and provides related guidance on de-recognition, classification, interest and penalties, accounting interim periods, disclosure and transition. FIN No. 48 applies to fiscal years beginning after December 15, 2006, with earlier adoption permitted. The Company is currently evaluating the effects of FIN No. 48 but does not expect the adoption of FIN No. 48 to have a material impact on the consolidated financial statements.
In September 2006, the FASB has issued SFAS No. 157 (SFAS No. 157), Fair Value Measurements, to eliminate the diversity in practice that exists due to the different definitions of fair value and the limited guidance for applying those definitions in GAAP that are dispersed among the many accounting pronouncements that require fair value measurements. SFAS No. 157 retains the exchange price notion in earlier definitions of fair value, but clarifies that the exchange price is the price in an orderly transaction between market participants to sell an asset or liability in the principal or most advantageous market for the asset or liability. Moreover, the SFAS states that the transaction is hypothetical at the measurement date, considered from the perspective of the market participant who holds the asset or liability. Consequently, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price), as opposed to the price that would be paid to acquire the asset or received to assume the liability at the measurement date (an entry price). SFAS No. 157 also stipulates that, as a market-based measurement, fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability, and establishes a fair value hierarchy that distinguishes between (a) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (b) the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). Finally, SFAS No. 157 expands disclosures about the use of fair value to measure assets and liabilities in interim and annual periods subsequent to initial recognition. Entities are encouraged to
combine the fair value information disclosed under SFAS No. 157 with the fair value information disclosed under other accounting pronouncements, including SFAS No. 107, Disclosures about Fair Value of Financial Instruments, where practicable. The guidance in this Statement applies for derivatives and other financial instruments measured at fair value under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, at initial recognition and in all subsequent periods. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, although earlier application is encouraged. Additionally, prospective application of the provisions of SFAS No. 157 is required as of the beginning of the fiscal year in which it is initially applied, except when certain circumstances require retrospective application. The Company is currently evaluating the effect of adopting SFAS No. 157 on its consolidated financial statements.
Forward-Looking Statements
Certain statements contained in this Annual Report on Form 10-K, as well as some statements by the Company in periodic press releases and some oral statements by Company officials to securities analysts and stockholders during presentations about the Company are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, or the Act. Statements which are predictive in nature, which depend upon or refer to future events or conditions, or which include words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” “hopes,” “assumes,” “may,” and similar expressions constitute forward-looking statements. In addition, any statements concerning future financial performance (including future revenues, earnings or growth rates), ongoing business strategies or prospects, and possible future Company actions, which may be provided by management are also forward-looking statements as defined in the Act. Forward-looking statements are based upon expectations and projections about future events and are subject to assumptions, risks and uncertainties about, among other things, the Company and economic and market factors.
Actual events and results may differ materially from those expressed or forecasted in the forward-looking statements due to a number of factors. The principal factors that could cause the Company’s actual performance and future events and actions to differ materially from such forward-looking statements include, but are not limited to, our failure to develop products or services that achieve market acceptance or regulatory approval; our failure to accurately evaluate the assumptions underlying our estimates of the useful lives for depreciable and amortizable assets, our estimates of cash flows in assessing the recoverability of long-lived assets, and estimated liabilities for chargebacks, litigation, claims and assessments; competitive forces or unexpectedly high increases in interchange and processing costs that preclude us from passing such costs on to our customers through increased surcharges or reduced commissions; unanticipated changes to applicable tax rates or laws or changes in our tax position; regulatory forces, competitive forces or market contraction that affect our cash advance business; our inability to satisfy conditions to borrow additional funds, if required or unanticipated operating capital needs that cause our cash flows from operations and possible borrowing facilities to be insufficient to provide sufficient capital to continue our operations; our failure to accurately estimate our operating cash flows and our failure to accurately predict our working capital and capital expenditure needs; our inability to obtain additional financing through bank borrowings or debt or equity financings at all or on terms that are favorable to us; competitive pressures that prevent us from commanding higher prices for our Cash Access Services than other providers; actions taken by our technology partners or the failure of our technology partners to service our needs; our failure to renew our contracts with our top customers; changes in the rules and regulations of credit card associations that require the discontinuation of or material changes to our products or services; and our inability to identify or form joint ventures with partners that result in products that are commercially successful; and other factors or conditions described or referenced under the caption “Risk Factors” of Item 1A of this Annual Report on Form 10-K. The Company’s past performance or past or present economic conditions are not indicative of future performance or conditions. Undue reliance should not be placed on forward-looking statements. In addition, the Company undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events or changes to projections over time unless required by federal securities law.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
Market Risks
During the normal course of our business, we are routinely subjected to a variety of market risks, examples of which include, but are not limited to, interest and currency rate movements, collectibility of accounts and notes receivable, and recoverability of residual asset values. We constantly assess these risks and have established policies and practices designed to protect against the adverse effects of these and other potential exposures. Although we do not anticipate any material losses in these risk areas, no assurances can be made that material losses will not be incurred in these areas in the future.
Interest Rate Risk
We had $20.0 million in borrowings outstanding under our Senior Secured Convertible Notes (the “Notes”) at December 31, 2006. The Notes bear interest at the rate of 6.50% per annum, payable quarterly in arrears commencing on January 10, 2007. This interest rate is subject to adjustment up to 12.0% per annum upon the occurrence of certain events of default or registration rights failures with the right to cure. Such interest rate adjustments are effective up through and including the date of cure of default or registration rights failure. In addition, the interest rate is subject to adjustment to 7.50% in the event of certain interest test failures which are based on financial thresholds relating to Consolidated Revenue, Consolidated Earnings Before Interest, Tax, Depreciation, and Amortization (“EBITDA”), and Total Debt to EBITDA Ratio. An interest rate default occurred as of December 31, 2006 and therefore, the Notes will have an interest rate of 7.50% during 2007 until cured as defined in the Notes agreements. The Company’s obligations under the Notes are secured by a security interest in substantially all of the Company’s assets. If the interest rates were to increase by 1000 to 5500 basis points for the entire fiscal year, earnings would decrease by approximately $0.2 to $1.1 million on a pre-tax basis.
In addition, our new vault cash arrangement with Fidelity Bank effective December 1, 2006 requires that we pay tiered fees based on the average monthly balance of the funds provided in an amount equal to the prime rate of interest, prime rate minus 1.25%, or prime rate minus 1.50%, depending on the average monthly balance tier. The interest rate can be no less than 6.0% under any tier. At December 31, 2006, the effective interest rate was 6.92%. Under our old vault cash agreement, we were required to pay fees on the balance of the funds provided in an amount equal to the bank’s prime rate of interest plus 2% or 10%, whichever is greater. At December 31, 2005 and 2004, the rate was 10%. If the prime rate were to increase by 100 basis points, with all other factors remaining constant, earnings would decrease by approximately $0.2 million on a pre-tax basis.
We have another vault cash arrangement with Wilmington Savings Fund Society FSB (“WSFS”) effective December 11, 2002 which requires that we pay fees based on the number of ATMs serviced or amount of cash provided in an amount equal to the prime rate of interest plus 1.0%-3.0%. The interest rate can be no less than 7.0%. The interest rate was prime plus 1.0% (or 9.25%, 8.0%, and 7.0%) for the year ended December 31, 2006, 2005, and 2004, respectively. If the prime rate were to increase by 100 basis points, with all other factors remaining constant, earnings would decrease by approximately $0.1 million on a pre-tax basis.
Item 8.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements of Cash Systems and the reports of the independent registered public accounting firm, listed under Item 15, are submitted as a separate section of this Annual Report on Form 10-K beginning on page and are incorporated herein by reference.
Item 9.
Item 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
There have been no changes in or disagreements with our independent certified public accountants on accounting principles or practices or financial statement disclosures.
Item 9A.
Item 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As required by Rule 13a-15(b) promulgated under the Exchange Act, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the design and operating effectiveness as of December 31, 2006 of our disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Exchange Act. Based on this evaluation our Chief Executive Officer and Chief Financial Officer concluded that controls for financial close and reporting were deemed to not be operating effectively as of December 31, 2006.
Notwithstanding management’s assessment that our disclosure controls and procedures were not effective as of December 31, 2006, we believe that the consolidated financial statements included in this Annual Report on Form 10-K fairly present our financial condition, results of operations and cash flows for the fiscal years covered thereby in all material respects.
Internal Control Over Financial Reporting
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) promulgated under the Exchange Act. Internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of an issuer’s financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Internal control over financial reporting includes policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of an issuer’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that an issuer’s receipts and expenditures are being made only in accordance with authorizations of its management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of an issuer’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, the application of any evaluation of effectiveness to future periods is subject to the risk that controls may become inadequate because of changes in conditions, or that compliance with the policies or procedures may deteriorate.
As required by Rule 13a-15(c) promulgated under the Exchange Act, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our internal control over financial reporting as of December 31, 2006. Management’s assessment was based on criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework (“COSO”). Our assessment identified deficiencies that in the aggregate were determined to be a material weakness.
Under SEC rules, management may assess its internal control over financial reporting as effective if there are no identified material weaknesses at the reporting date. A “material weakness” is a significant deficiency (within the meaning of PCAOB Auditing Standard No. 2), or combination of significant deficiencies, that results in there being more than a remote likelihood that a material misstatement of the annual or interim consolidated financial statements will not be prevented or detected on a timely basis by employees in the normal course of their assigned functions. A material weakness in internal control over financial reporting does not imply that a material misstatement of the financial statements has occurred, but rather, that there is a more than a remote likelihood that a material misstatement could occur. Controls for financial close and reporting were in place as of year end and were found to be operating effectively based on management testing of key controls; however, management re-evaluated the results of testing due to the audit adjustments found during the year end financial audit. Due to the number and dollar value of the adjustments found relating to financial close and reporting, controls in financial close and reporting were deemed to not be operating effectively as of December 31, 2006.
As a result, management has concluded that assessment of the significant deficiencies relating to financial close and reporting constituted, in the aggregate, a material weakness.
The following significant deficiencies identified by management aggregated into a material weakness:
•
Due to the adjustments found during the financial audit, it was noted that controls surrounding monthly review of the balance sheet and use of the monthly close checklist were inadequate.
•
Due to the adjustments found during the financial audit, it was noted that controls surrounding the review of spreadsheets used to record activity with our third party check guarantor and collections agency were insufficient.
•
Due to the adjustments found during the financial audit, it was noted that controls surrounding the review and approval of journal entries was insufficient.
Remediation Plan
Throughout 2006, management and the Board of Directors made a concerted effort to correct the material weakness first disclosed in the fiscal year 2005 report and has been committed to enhancing the overall control environment. While we have made tremendous progress, the number and dollar value of adjustments identified during the financial audit and its relation to certain key controls leaves us with the conclusion that there is still a material weakness in financial close and reporting. We also conclude that our ongoing efforts and commitment are properly focused on achieving continued progress.
Subsequent to December 31, 2006, we have undertaken, and will continue to undertake, work to remediate the material weakness described above, including identifying specific remediation initiatives.
•
We have communicated the significant deficiencies which have aggregated to a material weakness to our Finance department personnel and have implemented procedures to enhance the design and operation of the controls listed above such as performing cut-off procedures and sample auditing of spreadsheets used to record activity with our third party check guarantor and collections agency.
Our independent registered public accounting firm, Virchow Krause & Company, LLP has issued an attestation report on management’s assessment of our internal control over financial reporting which is set forth below.
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders of
Cash Systems, Inc. and Subsidiaries
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting, that Cash Systems, Inc. and Subsidiaries (the “Company”) did not maintain effective internal control over financial reporting as of December 31, 2006, because of the effect of the material weakness identified in management’s assessment based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following significant deficiencies identified by management, which aggregated into a material weakness, are described as follows:
•
Due to adjustments found during the financial audit, it was noted that controls surrounding monthly review of the balance sheet and use of the monthly close checklist were inadequate.
•
Due to the adjustments found during the financial audit, it was noted that controls surrounding the review of spreadsheets used to record activity with our third party check guarantor and collections agency were insufficient.
•
Due to the adjustments found during the financial audit, it was noted that controls surrounding the review an approval of journal entries was insufficient.
This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2006, of the Company and this report does not affect our report on such financial statements and financial statement schedule.
In our opinion, management’s assessment that the Company did not maintain effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We do not express an opinion or any other form of assurance on management’s statements referred to in “Management’s plan to correct material weaknesses.”
We have also audited, in accordance with the Standards of the Public Accounting Oversight Board (United States), the consolidated balance sheets of Cash Systems, Inc. and Subsidiaries as of December 31, 2006 and 2005 and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006, and our report dated March 14, 2007, expressed an unqualified opinion.
/s/ Virchow, Krause & Company, LLP
Minneapolis, Minnesota
March 14, 2007
Changes in Internal Control
There were no changes to our internal control over financial reporting during the fiscal quarter ended December 31, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. OTHER INFORMATION
None.
PART III
Item 10.
Item 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this item is hereby incorporated by reference from the definitive proxy statement for our 2007 annual meeting of stockholders.
Item 11.
Item 11. EXECUTIVE COMPENSATION
The information required by this item is hereby incorporated by reference from the definitive proxy statement for our 2007 annual meeting of stockholders.
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is hereby incorporated by reference from the definitive proxy statement for our 2007 annual meeting of stockholders.
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item is hereby incorporated by reference from the definitive proxy statement for our 2007 annual meeting of stockholders.
Item 14.
Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is hereby incorporated by reference from the definitive proxy statement for our 2007 annual meeting of stockholders.
PART IV
Item 15.
Item 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) (1) Financial Statements. Reference is made to the Index to Consolidated Financial Statements on page for a list of financial statements filed as a part of this Annual Report on Form 10-K.
(2) Financial Statement Schedules. The following financial statement schedules are included herein and should be read in conjunction with the consolidated financial statements referred to above:
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON
SUPPLEMENTARY INFORMATION
To Shareholders, Audit Committee and Board of Directors
Cash Systems, Inc. and Subsidiaries
Las Vegas, Nevada
Our report on our audits of the basic consolidated financial statements of Cash Systems, Inc. and Subsidiaries for the years ended December 31, 2006, 2005 and 2004 appears on page. The audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The supplementary information is presented for purposes of additional analysis and is not a required part of the basic consolidated financial statements. Such information has been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic consolidated financial statements taken as a whole.
/s/ Virchow, Krause & Company, LLP
Minneapolis, Minnesota
March 14, 2007
Financial Statement Schedule:
II - Valuation and Qualifying Accounts
All other schedules are omitted as the required information is inapplicable or the information is presented in the Consolidated Financial Statements or related notes.
SCHEDULE II
CASH SYSTEMS, INC. AND SUBSIDIARIES
Valuation and Qualifying Accounts
Years Ended December 31, 2006, 2005, and 2004
(3) List of Exhibits.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CASH SYSTEMS, INC.
/s/ Michael D. Rumbolz
Michael D. Rumbolz
Chief Executive Officer
DATE: March 16, 2007
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ Michael D. Rumbolz
Michael D. Rumbolz
Chief Executive Officer and Director
(Principal executive officer)
DATE: March 16, 2007
/s/ Andrew Cashin
Andrew Cashin
Chief Financial Officer
(Principal financial and accounting officer)
DATE: March 16, 2007
/s/ Patrick R. Cruzen
Patrick R. Cruzen
Director
DATE: March 16, 2007
/s/ Don R. Kornstein
Don R. Kornstein
Director
DATE: March 16, 2007
/s/ Donald D. Snyder
Donald D. Snyder
Director
DATE: March 16, 2007
/s/ Patricia W. Becker
Patricia W. Becker
Director
DATE: March 16, 2007
CASH SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders, Audit Committee and Board of Directors
Cash Systems, Inc. and Subsidiaries
Las Vegas, Nevada
We have audited the accompanying consolidated balance sheets of Cash Systems, Inc. and Subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006. These consolidated financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, effective January 1, 2006, the Company adopted Financial Accounting Standards Board Statement No. 123(R), “Share-Based Payment.”
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cash Systems, Inc. and Subsidiaries as of December 31, 2006 and 2005 and the results of their operations and their cash flows for each of the three years in the period then ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
/s/ Virchow, Krause & Company, LLP
Minneapolis, Minnesota
March 14, 2007
CASH SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
December 31, 2006 and 2005
See accompanying notes to consolidated financial statements.
CASH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, 2006, 2005 and 2004
See accompanying notes to consolidated financial statements.
CASH SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the Years Ended December 31, 2006, 2005 and 2004
See accompanying notes to consolidated financial statements.
CASH SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
For the Years Ended December 31, 2006, 2005 and 2004
See accompanying notes to consolidated financial statements.
CASH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004
1. Nature of Business
Cash Systems, Inc. and subsidiaries (the “Company” or “CSI”) is engaged in three primary products: credit/debit card cash advances, automatic teller machines (ATMs) and check cashing solutions. The credit/debit card cash advances product and ATMs have been installed in casinos and other businesses throughout the United States and Caribbean countries.
2. Summary of Significant Accounting Policies
Accounting Principles
The consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America.
Principles of Consolidation
The consolidated balance sheets as of December 31, 2006 and 2005, the consolidated statements of operations for the years ended December 31, 2006, 2005, and 2004 the consolidated statements of cash flows for the years ended December 31, 2006, 2005, and 2004 have been prepared by the Company and have been audited. All significant intercompany transactions and balances have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates.
Cash Concentrations
Bank balances exceeded federally insured levels during the years ended December 31, 2006 and 2005 and exceeded federally insured levels at December 31, 2006 and 2005. Generally, these balances may be redeemed upon demand and therefore bear minimal risk. There were no short-term investments as of December 31, 2006 and 2005.
Income Taxes
Differences between accounting rules and tax laws cause differences between the basis of certain assets and liabilities for financial reporting purposes and tax purposes. The tax effects of these differences, to the extent they are temporary, are recorded as deferred tax assets and liabilities under Statement of Financial Accounting Standards (SFAS) 109. Temporary differences relate primarily to net operating losses, depreciation and accrued expenses not currently deductible. Deferred tax assets are reduced by a valuation allowance to the extent the realization of the related deferred tax asset is not assured.
Software Development Costs
Statement of Position 98-1 (SOP 98-1), “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” requires the capitalization of direct costs incurred in connection with developing or obtaining software for internal use, including external direct costs of materials and services and payroll and payroll related costs for employees who are directly associated with and devote time to an internal use software development project. During the years ended December 31, 2006 and 2005, the Company capitalized $1,089,124 and $1,134,931 of costs related to the implementation of SOP 98-1, respectively (these costs are included in property and equipment on the consolidated balance sheets). These costs are amortized over the estimated useful lives of three to five years using the straight line method upon being placed in service. Amortization expense related to software costs was $405,508, $250,561, and $142,098 for the years ended December 31, 2006, 2005 and 2004, respectively.
Goodwill and Intangible Assets
Goodwill represents the excess of the purchase price over the fair value of assets acquired. The Company adopted the provisions of FASB Statement No. 142 (SFAS 142), “Goodwill and Other Intangible Assets,” as of February 28, 2006 in conjunction with the purchase of Indian Gaming Services (IGS). Pursuant to SFAS 142, goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with FASB Statement No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.” Intangible assets consist of patents, customer relationships and employment/non-compete agreements. Intangible assets are amortized using the straight-line method over their estimated useful lives ranging from 1 1/2 to 7 1/2 years. The Company reviews intangible assets for impairment as changes in circumstances or the occurrence of events suggest the remaining value is not recoverable.
Debt Issuance Costs
Debt issuance costs are amortized over the life of the related loan of two to five years using the straight-line method, which approximates the interest method. Debt issuance costs were $1,709,006 and $55,338 for the years ended December 31, 2006 and 2005, respectively, and are included in other assets on the consolidated balance sheets. Estimated future amortization for each of the years ending December 31, 2007 through 2010 is $357,907 and for the year ending December 31, 2011 is $277,378. Amortization expense for the years ended December 31, 2006, 2005 and 2004 was $171,264, $5,031, and $0, respectively.
Loans Receivable
The Company has advanced funds relating to strategic investments or advances of funds relating to service contracts. Some of the advances were reviewed with and approved by the Company’s board of directors, while other transactions were initiated and authorized by management. The loans bear interest at negotiated rates with negotiated terms. The collectibility of individual loans is reviewed throughout the life of the loan and a reserve, if required, would be recorded for the loan. Management believes that the loans receivable recorded on the consolidated financial statements as presented are properly stated.
Prepaid Commissions
The Company has advanced commissions relating to service contracts. The advances were initiated and authorized by management. The prepaid commissions are tied to the service contracts and are amortized or deducted against commissions earned by those contracts over the term of the contracts. In the event that the contracts are terminated early, which is not anticipated, the prepaid commission would be returned to the Company. The collectibility of individual prepaid commissions is reviewed throughout the life of the contract and a reserve, if required, would be recorded for the commission. Management believes that the prepaid commissions recorded on the consolidated financial statements as presented are properly stated.
Patents
Patents are stated at cost and are amortized upon issuance of a patent on a straight-line basis over 60 months. Amortization expense relating to the patents for the year ended December 31, 2006 was $4,112. There was no amortization expense for the years ended December 2005 and 2004. Future amortization for each of the years ending December 31, 2007 through 2010 is estimated to be $4,112.
Revenue Recognition
The Company’s revenue recognition policy is significant because the amount and timing of revenue is a key component of the Company’s results of operations. The Company follows the guidance of Staff Accounting Bulletin No. 104 (“SAB 104”), which requires that a strict series of criteria are met in order to recognize revenue related to services provided. If these criteria are not met, the associated revenue is deferred until the criteria are met. We recognize commission revenue when evidence of a transaction exists, services have been rendered, our price is fixed or determinable and collectibility is reasonably assured. The reasonable assurance is based on the transactions being authorized and pre-approved by credit card vendors or third parties. We evaluate our commissions revenue streams for proper timing of revenue recognition.
Credit card cash advance revenue is comprised of upfront patron transaction fees assessed at the time the transaction is initiated and a percentage of the face amount of the cash advance. Credit card cash advance revenue is recognized at the point that a negotiable check instrument is generated by the casino cashier or cash cage operation based upon authorization of the transaction.
ATM fees are comprised of upfront patron transaction fees or surcharges assessed at the time the transactions are initiated. Upfront patron transaction fees are recognized when a transaction is authorized.
The Company provides cash to certain casinos for ATMs and records a receivable from the casinos. Check cashing services revenue is generally contractual, based upon a percentage of the face amount of total checks warranted. The Company engages an independent third party to guarantee the collectibility of the checks for certain properties, while for others, the Company uses a major credit bureau and a third party check collections agency to collect on checks with insufficient funds. The Company records a receivable for all checks returned for insufficient funds.
The Company has determined that the accounting policies for income recognition described above are in accordance with the Financial Accounting Standards Board Emerging Issues Task Force (“EITF”) Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”.
The Company has recorded an accrual for known and potential chargebacks for possible charges against a gaming patron’s credit card for which the Company is unable to establish the validity of the transaction. The accrual for chargebacks is estimated based on historical information and management’s estimates. The chargeback accrual at December 31, 2006 and December 31, 2005 was $102,403 and $226,184, respectively.
Segment Reporting
A business segment is a distinguishable component of an enterprise that is engaged in providing an individual product or service or a group of related products or services and that is subject to risks and returns that are different from those of other business segments. Revenues from customers are from a similar customer base, mainly at casinos. Management believes that the Company meets the criteria for aggregating its operating segments into a single reporting segment.
Research and Development
The Company expenses research and development as costs are incurred. For the years ended December 31, 2006, 2005, and 2004, the Company expensed $91,207, $0, and $0, which is included in other general and administrative expenses on the consolidated statements of operations.
Reclassifications
Certain reclassifications have been made in the prior period consolidated financial statements to conform to the presentation used at and for the year ended December 31, 2006. These reclassifications had no effect on the Company’s consolidated net income (loss) for the year ended December 31, 2006.
Property and Equipment
Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, ranging from three to seven years. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and the resulting gain or loss is recognized in income for the period. The
cost of maintenance and repairs is expensed as incurred; significant renewals and betterments are capitalized. Deduction is made for retirements resulting from renewals or betterments. Leasehold improvements are amortized using the straight-line method over the shorter of the lease term or the estimated useful life of the assets.
Fair Value of Financial Instruments
SFAS No. 107, “Disclosures About Fair Value of Financial Instruments” requires disclosure of the estimated fair value of financial instruments as follows:
Short-term Assets and Liabilities:
The fair values of cash, settlements due from processors, other assets, accounts payable, accrued liabilities, and line of credit-bank approximate their carrying values due to the short-term nature of these financial instruments.
Long-term debt:
The fair value of long-term debt approximates the carrying amounts based upon the Company’s expected borrowing rate for debt with similar remaining maturities and comparable risk.
Recently Issued Accounting Pronouncements
FIN No. 48
The Financial Accounting Standards Board has published FASB Interpretation No. 48 (FIN No. 48), “Accounting for Uncertainty in Income Taxes”, to address the non-comparability in reporting tax assets and liabilities resulting from a lack of specific guidance in FASB Statement of Financial Accounting Standards No. 109 (SFAS 109), “Accounting for Income Taxes”, on the uncertainty in income taxes recognized in an enterprise’s financial statements. Specifically, FIN No. 48 prescribes (a) a consistent recognition threshold and (b) a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and provides related guidance on derecognition, classification, interest and penalties, accounting interim periods, disclosure and transition. FIN No. 48 will apply to fiscal years beginning after December 15, 2006, with earlier adoption permitted. The Company is currently evaluating the effects of FIN No. 48 but does not expect the adoption of FIN No. 48 to have a material impact on the consolidated financial statements.
SFAS No. 157
In September 2006, the FASB has issued SFAS No. 157 (SFAS No. 157), Fair Value Measurements, to eliminate the diversity in practice that exists due to the different definitions of fair value and the limited guidance for applying those definitions in GAAP that are dispersed among the many accounting pronouncements that require fair value measurements. SFAS No. 157 retains the exchange price notion in earlier definitions of fair value, but clarifies that the exchange price is the price in an orderly transaction between market participants to sell an asset or liability in the principal or most advantageous market for the asset or liability. Moreover, the SFAS states that the transaction is hypothetical at the measurement date, considered from the perspective of the market participant who holds the asset or liability. Consequently, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price), as opposed to the price that would be paid to acquire the asset or received to assume the liability at the measurement date (an entry price). SFAS No. 157 also stipulates that, as a market-based measurement, fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability, and establishes a fair value hierarchy that distinguishes between (a) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (b) the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). Finally, SFAS No. 157 expands disclosures about the use of fair value to measure assets and liabilities in interim and annual periods subsequent to initial recognition. Entities are encouraged to combine the fair value information disclosed under SFAS No. 157 with the fair value information disclosed under other accounting pronouncements, including SFAS No. 107, Disclosures about Fair Value of Financial Instruments, where practicable. The guidance in this Statement applies for derivatives and other financial instruments measured at fair value under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, at initial recognition and in all subsequent periods. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, although earlier application is encouraged. Additionally, prospective application of the provisions of SFAS No. 157 is required as of the beginning of the fiscal year in which it is initially applied, except when certain circumstances require retrospective application.
Net Income (Loss) per Common Share
Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares outstanding plus all additional common stock that would have been outstanding if potentially dilutive common stock related to stock options and warrants had been issued. Due to the net loss, options or warrants for December 31, 2006 and 2005 were not dilutive. All options and warrants outstanding at December 31, 2004 were dilutive.
The following table presents a reconciliation of the denominators used in the computation of net income (loss) per common share - basic, and net loss per common share - diluted, for the years ended December 31, 2006, 2005, and 2004, respectively:
The Company uses the treasury method for calculating the dilutive effect of the stock options and warrants (using the average market price).
Stock-Based Compensation
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R)) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options based on estimated fair values. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).
The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. Under the modified prospective approach, SFAS 123(R) applies to new awards and to awards that were outstanding on January 1, 2006, that are subsequently modified, repurchased or cancelled. In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Share-based compensation expense recorded under SFAS 123(R) for the year ended December 31, 2006 was $703,678 ($0.04 per share).
SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Consolidated Statement of Operations. Prior to the adoption of SFAS 123(R), the Company accounted for share-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123). Under the intrinsic value method, no share-based compensation expense had been recognized in the Company’s consolidated statement of operations because the exercise price of the Company’s stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant.
Share-based compensation expense recognized for periods after the adoption of SFAS 123(R) is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. As of December 31, 2005, all share-based awards were fully vested and therefore; no share-based compensation expense was recognized in the Company’s consolidated statement of operations for the year ended December 31, 2006 related to awards granted prior to January 1, 2006.
During the year ended December 31, 2006, 30,000 stock options were granted to each of four independent members of the Board of Directors at a fair value on the date of grant with immediate vesting which resulted in a non-cash expense of $472,950.
During the same period, three restricted stock awards were granted totaling 67,500 shares of common stock at a fair value on the date of grant with vesting terms of 1/3 annually. The effect of this action was a non-cash expense of $106,728 during the current year.
During the year ended December 31, 2006, the Company modified the terms of 150,000 options to extend the exercise period from 90 days from the date of termination to twelve months from the date of termination. The effect of these actions was an additional non-cash expense of $124,000.
SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company did not estimate a forfeiture rate for 2006 option grants as they immediately vested.
The Company uses the Black-Scholes option-pricing model (Black-Scholes model) for the Company’s pro forma information required under SFAS 123 and stock based compensation expense recognized under SFAS 123(R). The Company’s determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the Company’s expected stock price volatility over the eighteen month period prior to the grant date of the awards, and actual and projected employee stock option exercise behaviors and forfeitures.
For stock options granted during the year ended December 31, 2006, the Company determined compensation expense under the provisions of SFAS No. 123(R) using the Black-Scholes pricing model and the following assumptions: 1) an expected dividend yield of 0%, 2) an expected stock price volatility ranging from 55.3% - 56.5%, 3) a risk-free interest rate ranging from 4.88% - 5.12% and 4) an expected life of 6.5 years.
Pro Forma Information under SFAS 123 for Periods Prior to Fiscal 2006
The following table illustrates the effect on net income (loss) and income (loss) per common share if the Company had applied the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, to share-based employee compensation.
In determining the compensation cost of the options granted during the years ended December 31, 2005 and 2004, as specified by SFAS No. 123, the fair value of each option grant has been estimated on the date of grant using the Black Scholes pricing model and the weighted average assumptions of 4.0 to 4.5% and 4.3 to 4.75% risk free interest rate, 6.5 and 6.5 for expected life of options granted, 54.1 to 65.4% and 70.3% to 207.3% expected volatility and 0% dividend yield, respectively.
Advertising Expenses
Advertising costs are charged to expense as incurred. Advertising costs were $27,481, $44,955, and $76,024 for the years ended December 31, 2006, 2005 and 2004, respectively.
3. Funding Arrangement
Vault Cash Agreements
In February 2000, the Company entered into an agreement with Fidelity Bank to provide the funding for cash inside its ATMs. The agreement required the Company to pay fees, on the balance of the funds provided, equal to the bank’s prime rate of interest plus 2% or 10%, whichever is greater. At December 31, 2005 and 2004, the rate was 10%.
Effective December 1, 2006, the Company entered into a new vault cash agreement with Fidelity Bank. The new vault cash arrangement with Fidelity Bank requires that we pay tiered fees based on the average monthly balance of the funds provided in an amount equal to the prime rate of interest, prime rate minus 1.25%, or prime rate minus 1.50%, depending on the average monthly balance of total cash utilized under the agreement. The interest rate can be no less than 6.0% under any tier. At December 31, 2006, the prime rate was 8.25% and the effective rate under the agreement was 6.92%.
The Company assumes the risk of loss and agrees to reimburse the financial institution for any loss occurring from the point in time at which the funds leave the bank. The Company must provide armored carrier services and bear the cost of such services. The Company obtains insurance coverage for the funds provided. The armored carrier company carries the usual bond insurance coverage on its employees. Employees of the Company do not have access to the funds in the cash machines. Under this agreement, the Company receives settled funds for ATM transactions from the network processor and distributes the funds to various accounts such as the casinos and the bank the same or next day. The Company records a payable during the period the funds are held. As of December 31, 2006, this payable had a balance of $12,899,940 (included in other accrued expenses on the consolidated balance sheets - see Note 11). In 2005, all cash provided by Fidelity Bank remained the sole property of Fidelity Bank at all times until dispensed, at which time Fidelity Bank obtained an interest in the corresponding settlement receivable. Because it was never an asset of the Company, supplied cash was not reflected on the Company’s balance sheet. Because Fidelity Bank obtained an interest in our settlement receivables, there was no liability corresponding to the supplied cash reflected on the Company’s balance sheet.
We have an additional vault cash arrangement with Wilmington Savings Fund Society FSB (“WSFS”) effective December 11, 2002 which requires that we pay fees based on the number of ATMs serviced or amount of cash provided in an amount equal to the prime rate of interest plus 1.0%-3.0%. The interest rate can be no less than 7.0%. The interest rate was prime plus 1.0% (or 9.25%, 8.25%, and 7.0%) for the years ended December 31, 2006, 2005, and 2004 respectively.
Site Funded ATMs
The Company operates ATMs at certain customer locations where the Company provides the cash required for ATM operational needs. As of December 31, 2006 and 2005, the Company operated 59 and 71 ATMs, respectively, that were site funded.
4. Other Current Assets
Other current assets consisted of the following at December 31:
Receivable from casinos
The Company has receivables from certain customers as a result of chargeback disputes which are refunded to the Company and related to check cashing fees. We also have receivables from certain casinos for which we fund ATMs. The Company has not recorded an allowance related to these receivables since the Company considers the balances 100% collectible.
Receivable from bank
The Company records a receivable of $2,172,952 from its vault cash provider for standard ATM settlements and related surcharges owed. In addition, the Company records a receivable for Debit POS fees that are owed by the vault cash provider relating to the newly acquired Indian Gaming Service locations amounting to $184,411 at December 31, 2006. All fees relating to this receivable are sent to the Company on a weekly basis and are considered 100% collectible.
Receivable for check guarantees
The Company has an agreement with a vendor for the guarantee of 69% of the funds to be paid on personal checks cashed at the various casino locations. The Company records a receivable for all guaranteed checks returned for insufficient funds and recognizes the revenue associated with these checks as there is no further obligation from the Company. In addition to the third party guaranteed transactions, the Company has self-guaranteed the remaining 31% of funds paid on personal checks cashed at various casino locations. The increase in the percentage of self-guaranteed checks during the current year is primarily due to the acquisition of Indian Gaming Services where all check-cashing is self-guaranteed and one customer’s discontinuation of check guarantee services during the third quarter of 2006. The Company has an agreement with a third party agency for collections on self-guaranteed checks. The Company has reserved for amounts that are not collectible.
Holdback reserve from credit card processor
During 2005, the Company’s current credit card processor improperly withheld transaction fees of $780,825. The Company believes the processor had no basis for assessing these fees. A demand was made of the processor’s new parent company for repayment of the withheld fees on November 14, 2006. A response was received as of December 8, 2006, which stated the new owners were investigating the claim. There was no resolution of the matter as of December 31, 2006. Due to the legal status of this matter and the potential accounting treatment, the Company increased its reserve by $585,825 during the third quarter of 2006 to fully reserve for the entire balance of $780,825.
5. Settlements due from processors
Settlements due from credit card processors
The Company processes transactions with its credit card processor which are usually reimbursed to the Company within three to five days of the date of the advance occurring and is recorded as a receivable. At times, the Company may be required to provide additional support to the credit card processor to collect money related to the authorized transactions. As of December 31, 2006 and December 31, 2005, the balance of settlements due from credit card processors was $11,027,242 and $7,683,417, respectively.
Settlements due from ATM processors
The Company processes transactions with its ATM processor which are usually reimbursed to the Company within one to three days of the date of the advance occurring. Since the Company performs its own internal processing, the ATM processor sends settlement funds including fees to the Company’s bank account for all ATM transactions including those ATMs which are not funded by the Company. The entire reimbursed amount is recorded as a receivable from the ATM processor, while amounts for non-Company funded ATMs are recorded as a payable as more fully described in Note 11. At times, the Company may be required to provide additional support to the ATM processor to collect money related to the authorized transactions. As of December 31, 2006 and 2005, the balance of settlements due from ATM processors was $16,636,000 and $4,492,620, respectively.
6. Property and Equipment
Property and equipment consisted of the following at December 31:
Depreciation expense and amortization of computer software for the years ended December 31, 2006, 2005, and 2004 was $1,858,955, $1,259,337, and $762,987, respectively.
Long-Lived Assets
In accordance with SFAS No. 144, “Accounting For The Impairment Of Long-Lived Assets And For Long-Lived Assets To Be Disposed Of”, the Company reviews its long-lived assets and intangibles related to those assets periodically to determine potential impairment by comparing the carrying value of the long-lived assets outstanding with estimated future cash flows expected to result from the use of the assets, including cash flows from disposition. Should the sum of the expected future cash flows be less than the carrying value, the Company would recognize an impairment loss. An impairment loss would be measured by comparing the amount by which the carrying value exceeds the fair value of the long-lived assets and intangibles. To date, management has determined that no impairment of long-lived assets exists.
7. Goodwill and Intangible Assets
As of December 31, 2006, goodwill was $4,077,700 which related to the acquisition of Indian Gaming Services. Other identifiable intangible assets are as follows:
Total amortization expense for the years ended December 31, 2006, 2005, and 2004 were $1,130,112, $0 and $0, respectively. As of December 31, 2006, we expect amortization expense in future periods to be as shown below:
8. Loans Receivable
During September 2004, the Company advanced $375,000 and an additional $200,000 in March 2005 to a possible acquisition candidate. In addition, the parent of the acquisition candidate is a co-maker of the loan receivable. The loan receivable had an original maturity date of February 15, 2005, which was extended by the Company under written agreement to September 30, 2005. Effective March 24, 2006, based on a Loan Modification and Assumption Agreement and Consent to Sale of Assets (this “Agreement”), executed on July 13, 2006, the acquisition candidate sold all of its assets, including the collateral, to a new borrower. Acquisition candidate and the new borrower requested that the Company allow the sale of the assets and extend the maturity date of the note to September 2007. The Company, although under no obligation to do so, consented to the sale of the assets and extended the maturity date of the note, subject to the terms and conditions as set forth in the Agreement. Upon execution of the Agreement, the new borrower made an initial payment on the note in the amount of $184,103 in July 2006, including accrued interest of 6% since March 24, 2006. During 2006, subsequent payments were received for the payments due quarterly beginning September 30, 2006 totaling $180,864. The remaining payments are due quarterly continuing in 2007, until paid in full. New UCC filings were filed in Texas to perfect the Company’s secured position in the assets of new borrower.
The Company has not recorded a reserve for uncollectibility of this note receivable as the secured collateral, particularly equipment owned by the debtor, has a fair market value that exceeds the note balance. The balances outstanding including interest as of December 31, 2006 and 2005 were $263,317 and $606,217, respectively.
During 2005, the Company entered into an unsecured, non-interest bearing loan for approximately $403,000 with a customer for the purchase and installation of ATMs. Fifty percent (50%) of the loan is to be repaid to the Company upon installation of the ATMs at the ATM sites. During the third quarter of 2006, additional purchase and installation of ATMs resulted in an additional $109,482 to the note balance. The combined balance outstanding as of December 31, 2006 and 2005 was $218,524 and $213,941, respectively. The remaining balance is to be repaid over 36 months.
During 2004, the Company advanced approximately $390,000 to sales agents in the form of unsecured loans receivable bearing interest ranging from 5% to 10% due through December 2006. At December 31, 2006 and 2005, the remaining balance was $0 and $101,916, respectively, including interest.
Total outstanding loans receivable at December 31, 2006 and 2005 was $481,841 and $922,074, respectively, which includes interest receivable of $9,986 and $34,431, respectively.
The future payments due to the Company relating to these loans receivable are as follows for the years ending December 31:
9. Restricted Cash
Under our new vault cash agreement with Fidelity Bank effective December 1, 2006, the Company maintains restricted cash in the amount of $350,000 with Fidelity to cover potential cash losses for which the Company is responsible under the terms of the agreement. The restricted cash earns interest at the lowest interest rate as defined in the agreement and the interest is credited to a bank account designated by the Company.
10. Checks Issued in Excess of Cash in Bank
The Company’s credit card cash advance and check cashing business results in timing differences between funds availability and funding commitments. These timing differences result in operating deficits in select bank accounts, which do not have a right of offset, which have been classified as a liability at the end of the reporting period.
11. Other Accrued Expenses
Other accrued expenses consisted of the following at December 31, 2006 and 2005:
Amounts due casinos represent funds owed to various casinos for reimbursement on credit card cash advance transactions once the Company receives settlement funds.
Due to a transition to internal processing, the Company now receives settled funds for ATM transactions from the network processor for all ATM transactions processed by the Company including settled funds for non-Company funded ATMs. The Company distributes the funds to various customer accounts (i.e. Fidelity bank and various casinos) the same or next day. The Company records a payable during the period the funds are held (Amounts due for ATM processing) and a receivable from the ATM processor as more fully described in Note 5.
12. Commitments and Contingencies
Legal Proceedings
The Company is involved in various legal actions in the ordinary course of its business. Although the outcome of any such legal action cannot be predicted, management believes that there are no pending legal proceedings against or involving the Company for which the outcome is likely to have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.
Regulatory Bond
The Company maintains a $250,000 bond with Fidelity and Deposit Company of Maryland to secure performance under a regulatory application for licensing in the state of Florida. The license is to conduct business as a money transmitter/check casher.
Major Customer
During the years ended December 31, 2005 and 2004, two of our customers each accounted for more than 10% of our total revenues. The two customers together accounted for 39.3% and 44.5% of our total revenues in 2005 and 2004, respectively. During the year ended December 31, 2006, only one customer accounted for more than 10% of our total revenues. This customer accounted for 27% of total revenues for the year ended December 31, 2006.
Employment Agreement
The Company entered into an employment agreement with its Chief Financial Officer (CFO) during 2006 with a term of three years. The agreement requires annual compensation of $250,000, plus an annual bonus as defined in the agreement and payment of any unpaid salary through the end of the agreement if the CFO is terminated without cause.
Operating Leases
The Company’s principal office is located in Las Vegas, Nevada. In addition, the Company has offices in Burnsville, Minnesota and San Diego, California which are used for the Company’s Technical Assistance Center, technical support staff, and warehousing. The leases in Las Vegas, Burnsville, and San Diego expire in July 2010, June 2007, and June 2008, respectively. The Company is required to pay base monthly rent plus real estate taxes and operating expenses on all locations. Rent expense was $290,826, $246,973, and $171,859 for the years ended December 31, 2006, 2005, and 2004, respectively. From December 2003 through October 2005, the Company leased space from a former officer of the Company on a month-to-month basis. Total rent expense to the former officer was $53,166 and $63,663 for the years ended December 31, 2005 and 2004, respectively. The Company also maintains an equipment lease requiring monthly payments through March 2007.
Future minimum lease payments for the years ending December 31:
13. Line of Credit - Bank
On November 10, 2005, the Company entered into a Credit Agreement and a Security Agreement with Bank of America, N.A. The loan documents provided for a two-year line of credit of up to $13,000,000 collateralized by substantially all of the Company’s assets with the outstanding balance due on the expiration of the line of credit on November 9, 2007. The Company had outstanding borrowings of $5,200,000 at an interest rate of 7.25% at December 31, 2005. The line of credit was repaid in full in 2006 using proceeds from the issuance and sale of Senior Secured Convertible Notes and warrants in a private placement to certain institutional accredited investors as more fully described in Note 17.
14. Equity Transactions
On October 10, 2006, the Company issued 312,500 warrants to certain institutional accredited investors in connection with the issuance and sale of $20.0 million in principal amount of the Company’s Senior Secured Convertible Notes (See Note 17).
On February 28, 2006, the Company received cash proceeds of $4,470,160 upon the issuance and sale in a private offering of 710,000 shares of the Company’s common stock at a price of $6.296 per share to The Viejas Band of Kumeyaay Indians, a federally recognized Indian tribe which owns 100% of Borrego Springs Bank, N.A.
During 2006, a total of 30,000 warrants having an exercise price of $1.50 were exercised on a “cashless” or “net exercise” basis (based on the average market price of the Company’s common stock prior to exercise) resulting in the issuance of 24,050 shares of common stock.
During 2006, a total of 15,625 warrants were exercised for cash of $23,438 at a weighted average exercise price of $1.50 per share.
During 2006, 294,500 options were exercised for cash of $1,701,250 at a weighted average exercise price of $5.78 per share.
During 2006, 50,000 options having a weighted average price of $6.82 per share were either cancelled or had expired.
During 2005, a total of 113,000 five-year warrants having an exercise price of $1.50 were exercised on a “cashless” or “net exercise” basis (based on the average market price of the Company’s common stock prior to exercise) resulting in the issuance of 93,593 shares.
During 2005, 90,450 five-year warrants were exercised for cash of $190,900 at a weighted average exercise price of $2.11 per share.
During 2005, 522,250 options were exercised for cash of $1,363,529 a weighted average exercise price of $2.61.
On January 2, 2004, we sold 476,190 shares of common stock at $5.25 per share for gross proceeds of $2,500,000 in a private placement to an accredited investor. On July 30, 2004, we issued the same accredited investor 23,810 additional shares of common stock for no additional consideration, effectively reducing the initial per share purchase price from $5.25 per share to $5.00 per share. The additional shares were issued based on the Company’s commitment to the investor that the price per share would be equal to the private placement in March 2004.
In March 2004, we offered for sale 2,000,000 shares at $5.00 per share for up to $10,000,000 of our common stock in a private placement to “accredited investors” only. We sold 1,810,000 shares of our common stock for gross proceeds of $9,049,000 on March 25, 2004, and the remaining $950,000 on April 14, 2004. We were required to register the resale of these shares pursuant to Form S-3 of the Securities and Exchange Commission within 30 days of the closing of the offering. Such registration was effective on May 6, 2004. Total stock issuance costs incurred related to the equity financing during 2004 was $1,270,634.
During 2004, a total of 66,920 five-year warrants having an exercise price of $1.50 were exercised on a “cashless” or “net exercise” basis (based on the average market price of the Company’s common stock prior to exercise) resulting in the issuance of 51,460 shares. The Company relied upon Section 4(2) of the Securities Act for an exemption for transactions not involving a public offering.
During 2004, 144,750 five-year warrants were exercised for cash of $222,250 at a weighted average exercise price of $1.54 per share.
During 2004, 584,500 options were exercised for cash of $1,387,200 at a weighted average exercise price of $2.37.
In January 2005, the Company’s Board of Directors authorized the repurchase of up to 1,000,000 shares of our common stock. During 2005 and 2006, the Company did not repurchase any equity securities.
Stock Options
During 2001, the Company adopted the 2001 Stock Option Plan (the “2001 Plan”); pursuant to which share-based awards to acquire an aggregate of 1,000,000 shares of the Company’s common stock may be granted. The 2001 Plan was amended on March 4, 2004 to increase the number of authorized shares to 2,500,000. In general, options granted to employees vest over a period of up to three years and expire ten years from the date of grant.
On April 20, 2005, the Board of Directors adopted the Cash Systems, Inc. 2005 Equity Incentive Plan (the “2005 Plan”), which was approved by our stockholders. Upon stockholder approval of the 2005 Plan, no further options were granted under the Company’s 2001 Plan. The 2005 Plan provides for the issuance of up to 1,000,000 shares of Common Stock of the Company for equity incentive instruments. In general, options granted to employees vest over a period of up to three years and expire no more than ten years from the date of grant. In general, restricted stock vests over a period of three years.
Information regarding the Company’s stock options is summarized below:
The aggregate intrinsic value in the preceding table represent the total pretax intrinsic value, based on the Company’s closing stock price of $7.29 as of December 29, 2006, which theoretically could have been received by the option holders had all option holders exercised their options as of that date. The total number of in-the-money options exercisable as of December 31, 2006 was 1,176,000. The intrinsic value of stock options exercised during the years ended December 31, 2006, 2005, and 2004 was $305,690, $2,435,770, and $2,688,830, respectively.
Options outstanding at December 31, 2006 have a weighted average remaining contractual life of 6.98 years.
CASH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables summarize information about stock options outstanding as of December 31, 2006:
Stock Warrants
Information regarding the Company’s stock warrants is summarized below:
Warrants outstanding at December 31, 2006 are as follows:
All warrants were recorded at fair value using the Black Scholes pricing model using the following assumptions for the year ended December 31, 2006: 5.0% risk free interest rate, 5 years expected life for each warrant, 55.90% expected volatility and 0% dividend yield.
Restricted Stock Awards
Restricted stock awards are awards of common stock that are subject to restrictions on transfer and to a risk of forfeiture if the awardee leaves the Company before the restrictions lapse. The holder of a restricted stock award is generally entitled at all times on and after the date of issuance of the restricted shares to exercise the rights of a shareholder of the Company, including the right to vote the shares and the right to receive dividends on the shares. The value of such stock was established by the market price on the date of the grant. Compensation expense is being recorded over the applicable restricted stock vesting periods, generally three years, using straight line vesting. There were no restricted stock awards granted prior to 2006. A summary of the Company’s restricted stock activity for the year ended December 31, 2006 is presented in the following table:
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As of December 31, 2006, there was $343,522 of total unrecognized compensation costs related to the outstanding restricted stock awards which is expected to be recognized over a weighted average vesting period of 2.29 years. Recognized compensation expense related to restricted stock awards was $106,728 for the year ended December 31, 2006.
15. Income Taxes
At December 31, 2006, 2005 and 2004, the Company had a federal operating loss carryforward of $15,456,000, $8,102,000 and $318,000, respectively, and multiple state net operating loss carryforwards of $10,252,000, $5,491,000 and $50,000, respectively, which begin to expire in 2025. The provision for (benefit from) income taxes consisted of the following components for the years ended December 31:
The tax benefit for 2006, 2005, and 2004 of $85,259, $394,000 and $906,000, respectively, noted above, relates to compensation expense for tax purposes in excess of amounts recognized for financial reporting purposes.
Components of net deferred income taxes, including a valuation allowance, are as follows at December 31:
The valuation allowance for deferred tax assets as of December 31, 2006 and 2005 was $6,141,000 and $0, respectively. In assessing the recovery of the deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income in the periods in which those temporary differences become deductible. Management considers the scheduled reversals of future deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. As a result, management determined it was more likely than not the deferred tax assets would not be realized as of December 31, 2006 and recorded a full valuation allowance.
Reconciliation between the statutory rate and the effective tax rate for the years ended December 31, is as follows:
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16. Acquisition
Effective February 28, 2006, the Company acquired certain assets and assumed certain liabilities of Indian Gaming Services, a San Diego-based cash-access provider to the gaming industry and a division of Borrego Springs Bank, N.A. The acquisition provides the Company with additional ATM, check cashing and credit and debit services to 11 casino facilities. In addition, the acquisition provides the Company with access to other credit and debit processing opportunities. The $12 million purchase price was funded at closing with a combination of (i) funds borrowed under the Company’s $13 million credit facility with Bank of America, N.A., a national banking association, (ii) cash proceeds received upon the issuance and sale in a private offering of 710,000 shares of the Company’s common stock at a price of $6.296 per share to The Viejas Band of Kumeyaay Indians, a federally recognized Indian tribe which owns 100% of Borrego Springs Bank, N.A., and (iii) cash on hand. The transaction was accounted for using the purchase method of accounting in accordance with Statement of Financial Accounting Standards No. 141 (“SFAS 141”), “Business Combinations.”
The purchase price of the acquisition was:
Purchase Price Allocation
The purchase price was allocated to the tangible and identifiable intangible assets acquired based on their estimated fair values at the acquisition date. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed as of the acquisition date:
The allocation of the purchase price was based, in part, on a third-party valuation of the fair value of identifiable intangible assets, and certain property, plant and equipment. The cost of the identifiable intangible assets will be amortized on a straight-line basis over periods ranging from 1 1/2 to 7 1/2 years. We expect that substantially all of the amount allocated to goodwill will be deductible for tax purposes.
The results of Indian Gaming Services have been included in the consolidated financial statements since the date of acquisition of February 28, 2006. Unaudited pro forma results of operations for the years ended December 31, 2006, 2005, and 2004 are included below. Such pro forma information assumes that the above acquisition had occurred as of January 1, 2004. This summary is not necessarily indicative of what our results of operations would have been had we been a combined entity during the period ended December 31, 2006, 2005, and 2004 nor does it purport to represent results of operations for any future periods. Pro forma adjustments consist primarily of amortization of intangible assets.
17. Senior Convertible Secured Notes
On October 10, 2006, the Company has issued and sold to certain institutional accredited investors an aggregate of $20.0 million in principal amount of senior secured convertible notes and five-year warrants (immediately exercisable) to purchase an aggregate of 312,500 shares of the Company’s common stock at $8 per share. The notes bear interest at the rate of 6.50% per annum, payable quarterly in arrears commencing on January 10, 2007. This interest rate is subject to adjustment up to 12.0% per annum upon the occurrence of certain events of default. The Company was in default related to the interest rate covenants of the notes at December 31, 2006 and the interest rate in 2007 will be 7.5% per annum. The maturity date of the notes is October 10, 2011. The Company’s obligations under the Notes are collateralized by a security interest in substantially all of the Company’s assets. The Company used proceeds from the issuance and sale of the Notes for repayment of its two-year line of credit with Bank of America, N.A. At December 31, 2006, the Company was in compliance with all financial covenants as defined in the agreements.
Pursuant to EITF 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments,” the gross proceeds of $20.0 million were allocated between the convertible notes and the common stock warrants based on the relative fair values of the securities at the time of issuance. The common stock warrants were valued using the Black-Scholes pricing model with the resulting original issue discount being amortized over the term of the notes, which approximates the interest method. The notes are convertible into common shares at a conversion price of $8 per share. Based on the fair market value of the stock on the date of the agreement for the notes of $6.30 per share, there was not a beneficial conversion noted.
In connection with the financing, the Company agreed to file with the SEC a registration statement by February 7, 2007, covering the issuance or resale of the shares of common stock underlying the warrants issued to the note holders. The Company filed the registration statement on December 7, 2006 and the registration statement was declared effective on January 11, 2007.
With the registration statement requirement of the agreement, the Company evaluated the terms of the agreement in accordance with EITF 00-19, “Accounting for Derivative Financial Instruments, Indexed to, and Potentially Settled in a Company’s Own Stock.” As a result, the Company recorded a derivative liability related to the warrants. The Company adjusted the value of the warrants related to changes in the Company’s stock price. For the year ended December 31, 2006, the Company recorded $35,397 in interest expense related to the derivative reevaluation related to warrants and had a derivative liability for warrants of $777,011 at December 31, 2006.
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18. Subsequent Events
New Banking Relationship
During January 2007, we commenced and fully transitioned all of our major commercial banking needs to a new nationwide commercial banking services provider. Provision of continued services by the new commercial bank is subject to satisfactory compliance with banking regulations relating to conducting business with a Money Services Business (“MSB”) including compliance with the Bank Secrecy and USA PATRIOT Acts. Planning has commenced and internal milestones have been established between both parties to ensure compliance.
CEO Contract Renewal
On March 6, 2007, the Company entered into an Executive Employment Agreement with Michael Rumbolz effective March 6, 2007, pursuant to which Chief Executive Officer Michael Rumbolz would also serve as the Company’s Chairman of the Board and President. Under the terms of the employment agreement, Mr. Rumbolz receives an annual base salary of $350,000 and is entitled to an annual bonus and other usual benefits. Mr. Rumbolz was granted 65,000 shares of restricted stock vesting in four equal annual installments, such bonus compensation as determined by the Company’s Board of Directors, no less than two weeks paid annual vacation, and reimbursement for any and all ordinary and necessary business expenses that he reasonably incurs in connection with the business of the Company. The agreement is for a two year term. Upon the expiration of the initial two year term and each anniversary thereafter, Mr. Rumbolz and the Company may agree in writing to renew the agreement for an additional year. In the event that the Company terminates Mr. Rumbolz’s employment without cause prior to the expiration of the agreement, Mr. Rumbolz will be entitled to base compensation, bonus compensation and benefits through the end of the term of the agreement.
19. Selected Quarterly Data (unaudited)
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