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 2007, our Cash Access Services were used at 113 gaming locations and 19 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 132 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, 2007, there were approximately 20 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 Agreement and Powercash 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 has developed a product that allows 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. Bally Technologies and the Company have worked together to develop the cashless product as well as 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 cashless product among the Joint Venture partners. The Company has worked with the card associations to ensure that the cashless product and process comply with the card associations’ rules prior to full deployment into the marketplace.
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 ended in April 2007. Revenues from the cashclub™ product in the beta phase were not material to the Company.
On November 26, 2007, the Company announced the implementation of the Joint Venture’s cashless product at Fantasy Springs Resort Casino. Once patrons enroll in the casino player’s club program with the Company’s powercash functionality, they are able to access funds from their desired credit, debit or checking accounts while sitting at the gaming device. Players can request funds from the designated financial account, transfer those funds into their player’s club account and then transfer down to the gaming device the amount of money that they want to use.
The Company incurred research and development costs relating to the development of its Joint Venture product. For the years ended December 31, 2007, 2006, and 2005, the Company expensed $555,255, $91,207, and $0, respectively, which is included in other general and administrative expenses on the consolidated statement of operations. We do not anticipate that future research and development costs related to the Joint Venture will be material to us.
The Casino Gaming Market
Casino gaming in the United States has expanded significantly in recent years. There are now 48 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 over 900 casinos in the United States, comprised of tribal owned 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 predominately located in the United States, as well as to vendors who themselves contract directly with casinos for such services. During 2007, 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 augmented our anti-money laundering program and performed 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 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; serves no business or apparent lawful purpose; or is intended to facilitate criminal activity. In gaming establishments where we staff and operate booths, we are also required to file a Currency Transaction Report (“CTR”) for transactions, which individually or in the aggregate, exceed $10,000 during any rolling 24-hour period.
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 to whether the patents will be granted or if they will provide financial benefit to us in the future.
Dependence on Major Customers
During the years ended December 31, 2007, 2006, and 2005, the following customers accounted for more than 10% of our total revenues:
We contract with The Seminole Tribe of Florida through a third party affiliated with The Seminole Tribe of Florida, and we contract with Ho-Chunk Nation and Chickasaw Nation directly. 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. We have provided Cash Access Services to Ho-Chunk Nation and Chickasaw Nation since May 2003 and March 2005, respectively. There can be no assurance that these contracts will be renewed after their terms expire.
On February 6, 2008, Michael D. Rumbolz, CEO of the Company was appointed to serve on the Board of Directors of Seminole Hard Rock Entertainment, Inc. and as a Manager of Seminole Hard Rock International, LLC, each of which is an affiliate of The Seminole Tribe of Florida.
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 10 people, respectively; we employ approximately 275 people in total including employees at our check cashing booths.
On January 31, 2008, we formally closed our San Diego facility which was primarily used as a technical assistance center and for warehousing. The lease expiration of June 2008 for the San Diego facility remains unchanged.
Available Information
We make available, free of charge, on the Investor Relations section of our Web site (http://www.cashsystemsinc.com), our annual report 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
We have operating losses in consecutive years
We have incurred net losses of $15.4 million, $10.0 million, and $3.8 million for the years ended December 31, 2007, 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 cannot 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 report of our independent registered public accounting firm includes a going concern uncertainty explanatory paragraph and we will need additional funding to support our operations during 2008
We have net losses in consecutive years, have used $1.7 million of cash in operations during the fiscal year ended December 31, 2007, and have an accumulated deficit of $27.3 million and net working capital deficit of $4.5 million at December 31, 2007. Because we have not identified sources of capital and due to recurring losses, negative cash flows, and accumulated deficit, the report of our independent registered public accounting firm dated March 28, 2008 expresses substantial doubt about our ability to continue as a going concern. In addition, the holders of our senior secured convertible notes have the right to require us to redeem a portion of such notes on October 10, 2008 in an amount not to exceed $12.1 million in the aggregate. We anticipate that our existing capital resources will enable us to continue operations through approximately October 2008, or earlier if payments of certain other accrued expenses are accelerated or if unforeseen events or circumstances arise that negatively affect our liquidity. Management will need to take immediate steps to reduce operating expenses, which may include seeking concessions from customers and vendors in the meantime. If we fail to raise additional capital prior to October 2008, we may be forced to cease operations. If we cannot successfully continue as a going concern, our stockholders may lose their entire investment.
Our senior secured convertible notes contain financial and other restrictive covenants that limit our ability to raise financing and 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 raise financing through prohibitions on our incurring senior debt and through the note holders’ rights of first offer on most equity financings. The notes also contain 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. On August 20, 2007, we amended and restated the senior secured convertible notes to, among other things, increase the aggregate principal amount from $20.0 million to $22.0 million. On March 14, 2008, we further amended and restated the senior secured convertible notes to, among other things, increase the aggregate principal amount from $22.0 million to $24.2 million. 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.
Our common stock may be delisted from The NASDAQ Global Market, which could negatively impact the price of our common stock and would constitute an event of default under our senior secured convertible notes.
Our common stock is listed on The NASDAQ Global Market. The listing standards of The NASDAQ Global Market provide, among other things, that a company may be delisted if the bid price of its stock drops below $1.00 for a period of 30 consecutive business days. Recently our stock has traded below $1.00, and if we fail to comply with the listing standards applicable to issuers listed on The NASDAQ Global Market, our common stock may be delisted from The NASDAQ Global Market. The delisting of our common stock would significantly affect the ability of investors to trade our securities and would significantly negatively affect the value and liquidity of our common stock. In addition, the delisting of our common stock would constitute an event of default under our senior secured convertible notes and could also materially adversely affect our ability to raise capital on terms acceptable to us or at all. Delisting from The NASDAQ Global Market could also have other negative results, including the potential loss of confidence by customers and employees, the loss of institutional investor interest and fewer business development opportunities.
Our pursuit of strategic alternatives may lead to uncertainty or may not be successful.
On March 17, 2008, we issued a press release announcing a comprehensive review of strategic alternatives to enhance stockholder value. There can be no assurance that the exploration of strategic alternatives will result in any transaction. During the process, there may be risks that certain customers, employees, and business partners may react negatively to the uncertainty of the process. These same constituencies may react negatively in the event the process does not result in any transaction. The pursuit of strategic alternatives may also involve significant expenses and management time and attention, and otherwise disrupt 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.
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. The Bancorp, Inc. (formerly BankFirst) currently sponsors us into the card associations. In the event we lose our sponsorship by The Bancorp, Inc. 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 the years ended December 31, 2007, 2006, and 2005, the following customers accounted for more than 10% of our total revenues:
We contract with The Seminole Tribe of Florida through a third party affiliated with The Seminole Tribe of Florida, and we contract with Ho-Chunk Nation and Chickasaw Nation directly. 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. We have provided Cash Access Services to Ho-Chunk Nation and Chickasaw Nation since May 2003 and March 2005, respectively. There can be no assurance that these contracts will be renewed after their terms expire. In addition, loss or financial hardship experienced by, or a substantial decrease in revenues from The Seminole Tribe of Florida, Ho-Chunk Nation, Chickasaw Nation, 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. Our customer agreements generally do not contain financial covenants and doubt as to our ability to continue as a going concern is not considered to be “cause” under those agreements. Still, customers who are uncertain about our ability to continue to provide Cash Access Services may seek to terminate agreements or seek concessions, which would further impair our cash flows, revenues and financial condition. 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 unexpected increase in returned checks could adversely affect our check cashing business.
We recorded bad debt expense of $5.4 million and $0.5 million relating to the receivables from collection agency for the years ended December 31, 2007 and 2006, respectively. We currently self-guarantee a significant portion of checks cashed at our various casino locations through the use of our internal check cashing technology and utilize a third party collection agency to collect on dishonored checks. For dishonored checks that are self-guaranteed, we forward the checks to the collections agency which attempts to collect on the checks for certain periods based on terms set forth in the service contract. When the collection agency has exhausted its collection efforts, the checks are forwarded to a third party attorney network for legal action. The aggregate dollar amount to which we are exposed for dishonored checks is a function of the face amount of checks. The substantial increase in bad debt expense in 2007, most of which arose in the fourth quarter, which management believes in large part reflects the weakening U.S. economy, had a material adverse affect on our business, cash flows and results of operations. As a result of the recent increase in bad debt expense, we have adopted more conservative assumptions for establishing bad debt reserves. In any case, if the high level of bad debt expense continues throughout 2008 whether due to an increase in the volume of returned checks, worsening collections efforts, and/or deteriorating market and economic conditions, it would continue to have a material adverse effect upon our business, cash flows, and results of operations.
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 nine 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 is 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 were 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, 2007, approximately 60% of the casinos that we serviced were 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.
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 are obligated to evaluate our internal controls over financial reporting in order to allow management to report on, and our independent auditors to attest to, our internal controls over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act of 2002 and the rules and regulations of the SEC. Our management and our independent accounting firm Virchow, Krause & Company, LLP, have each concluded that we had a material weakness in our internal controls as defined under standards adopted by the Public Company Accounting Oversight Board, or PCAOB. Under the PCAOB standards, a “material weakness” is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. A “significant deficiency” is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness yet important enough to merit attention by those responsible for oversight of the company’s financial reporting. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls or procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations or financial condition. Also, we may identify conditions that may result in significant deficiencies or material weaknesses in the future.
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 guarantee 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 Currency Transaction Reports or Suspicious Activity Reports on a timely basis. 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 subject to substantial civil and criminal penalties and fines if we fail to comply with applicable rules and regulations. 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 is 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.
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 2010. 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.
On January 31, 2008, we formally closed our San Diego facility which was primarily used as a technical assistance center and for warehousing. The lease expiration of June 2008 for the San Diego facility remains unchanged.
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 2007.
PART II
Item 5.
Item 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER
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, 2008 was approximately 120. This does not include an indeterminate number of stockholders who may hold their shares in “street name.”
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 note holders 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, 2007, 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)
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, 2007 and 2006. Our senior secured convertible notes prohibit us from repurchasing shares of our common stock without the prior written consent of the note holders representing not less than two-thirds of the aggregate principal amount of the then outstanding notes.
Recent Sales of Unregistered Securities
None.
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 the consolidated 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.
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 113 gaming and 19 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, 2007, there were 20 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 Agreement and Powercash 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 has developed a product that allows 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. Bally Technologies and the Company have worked together to develop the cashless product as well as 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 cashless product among the Joint Venture partners. The Company has worked with the card associations to ensure that the cashless product and process comply with the card associations’ rules prior to full deployment into the marketplace.
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 ended in April 2007. Revenues from the cashclub™ product in the beta phase were not material to the Company.
On November 26, 2007, the Company announced the implementation of the Joint Venture’s cashless product at Fantasy Springs Resort Casino. Once patrons enroll in the casino player’s club program with the Company’s powercash functionality, they are able to access funds from their desired credit, debit or checking accounts while sitting at the gaming device. Players can request funds from the designated financial account, transfer those funds into their player’s club account and then transfer down to the gaming device the amount of money that they want to use.
The Company incurred research and development costs relating to the development of its Joint Venture product. For the years ended December 31, 2007, 2006, and 2005, the Company expensed $555,255, $91,207, and $0, respectively, which is included in other general and administrative expenses on the consolidated statement of operations. We do not anticipate that future research and development costs related to the Joint Venture will be material to us.
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, 2007, 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, virtually all of the Company’s ATM devices are operating on an internal Company-owned switch as of December 31, 2007. The 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 by the network payers. 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.
Recent Developments
Second Amended and Restated Notes and Warrants
On March 14, 2008, the Company entered into a Second Amendment and Exchange Agreement with each of its note holders (each, a “Second Amendment and Exchange Agreement” and collectively, the “Second Amendment and Exchange Agreements”) pursuant to which the Company and each of the note holders agreed to, among other things, amend and restate the Senior Secured Convertible Notes, as previously amended and restated in August 2007 (the “First Amended and Restated Notes”), amend and restate the Warrants to Purchase Common Stock, as previously amended and restated in August 2007 (the “First Amended and Restated Warrants”), and amend certain provisions of the other Transaction Documents.
The Senior Secured Convertible Notes, as amended and restated on March 14, 2008 (the “Second Amended and Restated Notes”) differ from the First Amended and Restated Notes in certain material respects, including, without limitation, (i) the aggregate principal amount was increased from $22.0 million to $24.2 million, (ii) the conversion price was reduced from $8.00 per share to $2.51 per share, (iii) the conversion price may be further reduced by the note holders at any time on or before April 22, 2008 to 120% of the arithmetic average of the weighted average price of the Company’s common stock for each day during the period commencing on March 18, 2008 and ending on April 15, 2008, (iv) the aggregate amount that the note holders may require the Company to redeem, and the aggregate amount that the Company may elect to redeem, on October 10, 2008 was increased from $8 million to $12.1 million, (v) the financial covenants based on Consolidated Total Debt to EBITDA (as defined in the First Amended and Restated Notes) were eliminated and the financial covenants based on Consolidated Revenue and Consolidated EBITDA (as defined in the Second Amended and Restated Notes) were modified to apply starting with the quarter ending March 31, 2009, and (vi) the interest rate will be increased by 1.5% per annum from and after the occurrence of any Dilutive Issuance Event (as defined in the Second Amended and Restated Notes). As a result of the March 14, 2008 amendment and restatement of the notes, the Company has reclassified $12.1 million of the Second Amended and Restated Notes from long term to short term debt on the consolidated balance sheet.
The Warrants to Purchase Common Stock, as amended and restated on March 14, 2008 (the “Second Amended and Restated Warrants”) differ from the First Amended and Restated Warrants in certain material respects, including, without limitation, (i) the exercise price was reduced from $7.38 per share to $2.49 per share, and (ii) the exercise price may be further reduced by the note holders at any time on or before April 22, 2008 to 120% of the arithmetic average of the Weighted Average Price (as defined in the Second Amended and Restated Notes) of the Company’s common stock for each day during the period commencing on March 18, 2008 and ending on April 15, 2008.
The Second Amended and Restated Notes and the Second Amended and Restated Warrants contain various limitations on the number of shares of our common stock that may be issued upon conversion of the Second Amended and Restated Notes and upon exercise of the Second Amended and Restated Warrants. No note holder may convert its Second Amended and Restated Notes or exercise its Second Amended and Restated Warrants to the extent such conversion or exercise would cause such holder, together with such holder’s affiliates, to own more than 9.99% of our common stock following such conversion or exercise. In addition, in order to comply with the rules of The NASDAQ Stock Market, if the note holders make a Holder Conversion Price Adjustment Election (as such term is defined in the Second Amended and Restated Notes), we may not issue more than an aggregate of 3,755,154 shares of our common stock to the note holders without the prior approval of our stockholders. If the note holders do not make a Holder Conversion Price Adjustment Election, the exercise price of the Second Amended and Restated Notes may not be adjusted to less than $2.51 per share and the conversion price of the Second Amended and Restated Warrants may not be adjusted to less than $2.49 per share (subject to adjustment for any stock dividend, stock split, stock combination, reclassification or similar transaction).
The Company will evaluate the financial statement effect of the March 14, 2008 amendment and restatement of the notes and warrants in its quarter ending March 31, 2008. See Note 15 for further information related to the senior convertible secured notes. The Company will finalize the debt extinguishment expense upon the final terms of the stock price and conversion rate and record in the quarter ending March 31, 2008.
Going Concern
We have net losses in consecutive years, have used $1.7 million of cash in operations during the fiscal year ended December 31, 2007, and have an accumulated deficit of $27.3 million and net working capital deficit of $4.5 million at December 31, 2007. Because we have not identified sources of capital and due to recurring losses, negative cash flows, and accumulated deficit, the report of our independent registered public accounting firm dated March 28, 2008 expresses substantial doubt about our ability to continue as a going concern. In addition, the holders of our senior secured convertible notes have the right to require us to redeem a portion of such notes on October 10, 2008 in an amount not to exceed $12.1 million in the aggregate. We anticipate that our existing capital resources will enable us to continue operations through approximately October 2008, or earlier if payments of certain other accrued expenses are accelerated or if unforeseen events or circumstances arise that negatively affect our liquidity. Management will need to take immediate steps to reduce operating expenses, which may include seeking concessions from customers and vendors in the meantime. If we fail to raise additional capital prior to October 2008, we may be forced to cease operations.
Strategic Alternatives
On March 17, 2008, we issued a press release announcing a comprehensive review of strategic alternatives to enhance stockholder value. There can be no assurance that the exploration of strategic alternatives will result in any transaction. During the process, there may be risks that certain customers, employees, and business partners may react negatively to the uncertainty of the process. These same constituencies may react negatively in the event the process does not result in any transaction. The pursuit of strategic alternatives may also involve significant expenses and management time and attention, and otherwise disrupt our business.
Results of Operations
The following table presents, for the fiscal years indicated, selected items from the consolidated statements of operations expressed as a percentage of total sales and service fees and the year-to-year percentage changes in the dollar amounts of those items.
2007 Compared With 2006
Revenues for the year ended December 31, 2007 were $104.9 million compared to $95.7 million for the same period in 2006. The $9.2 million increase or a 9.5% increase in 2007 revenues over 2006 revenues is primarily due to an increase in overall transaction volume. The volume of transaction dollars processed through our Cash Access Services during the year ended December 31, 2007 was $3.5 billion compared to $2.9 billion during the same period in 2006. The volume increase was primarily driven by our ATM and check cashing transactions.
Commissions increased by $7.1 million during the year ended December 31, 2007 to $60.0 million compared to $52.9 million during the same period in 2006 which was directly related to the Company’s increased transaction volume at existing locations as services were expanded. Total processing costs increased by only $0.1 million compared to the same period last year, despite the 9.5% increase in revenues, reflecting the results of our switch to internal processing. Total check cashing costs showed an overall increase of $2.6 million compared to the same period last year primarily due to an increase in bad debt reserve on our receivables from collection agency, slightly offset by lower costs associated with our third party check guarantor as we shifted from using a third party check guarantor to using our own internal check cashing technologies to guarantee checks and utilizing a third party for collections. We continue to monitor collection rates and adjust bad debt reserve levels as appropriate based on historical data and current market conditions. Armored carrier services increased by $0.3 million primarily due to increases in our cash volume and expansion of armored carrier services to certain Florida based properties.
Payroll and related costs increased by $0.8 million for the year primarily due to more restricted stock awards granted during the year. Professional fees decreased by $0.9 million from the same period last year due to lower general legal fees and less reliance on outside professional services, including expenditures for SOX 404 compliance work. Other General and Administrative expenses increased by $0.2 million over prior year primarily due to an impairment charge on our intangible assets related to non-renewal of an IGS contract. Depreciation and amortization increased by approximately $0.6 million primarily due to depreciation on our internal processing switch and more terminals added to new and existing locations.
Total operating expenses for the year ended December 31, 2007 were $110.7 million compared to $100.0 million for 2006 (or a $10.7 million increase representing an 11% increase in total operating expenses).
Interest expense increased by approximately $1.7 million due to the increased amount of vault cash required to fund our ATMs and interest related to the Senior Secured Convertible Notes. The Company also recorded a loss on extinguishment of debt during the year ended December 31, 2007 in the amount of $4.3 million representing the difference between the carrying value of the Senior Secured Convertible Notes prior to the August 2007 amendment and restatement and the fair market value of the Senior Secured Convertible Notes as amended and restated in August 2007 (the “First Amended and Restated Notes”).
On a fully diluted basis, after-tax net loss of ($15,383,035) for the year ended December 31, 2007 was 15% of sales or ($0.84) per diluted common share, as compared to a net loss of ($10,018,412) which was 11% of sales or ($0.57) per diluted common share for the same prior year period.
2006 Compared With 2005
Revenues for the year ended December 31, 2006 were $95.7 million compared to $63.2 million for the same period in 2005. The $32.6 million increase or a 51.6% 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 $2.9 billion compared to $2.0 billion 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 $24.7 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 $100.0 million compared to $68.9 million for 2005. The $31.1 million, or 45% 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 the operating effectiveness throughout the year. Management plans to continue its efforts in this area going forward.
Other General and Administrative expenses increased by $2.6 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. In addition, the Company recovered previously written-off or reserved accounts receivable relating to resubmitted transactions during the fourth quarter of 2006.
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.
Management recorded a full valuation allowance for deferred tax assets of $5.4 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 $3.1 million resulting in expense of $2.3 million for the year ended December 31, 2006 (see Note 14).
On a fully diluted basis, after-tax net loss of ($10,018,412) for the year ended December 31, 2006 was 11% of sales or ($0.57) 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.
Liquidity and Capital Resources
At December 31, 2007, we had cash of $16.6 million compared to $24.8 million at December 31, 2006 and cash net of “Checks issued in excess of cash in bank” of $1.4 million as of December 31, 2007. Cash used in operations totaled $1.7 million and $4.9 million during the year ended December 31, 2007 and 2006, respectively. We had a working capital deficit of approximately $4.5 million at December 31, 2007, compared to working capital of $13.5 million at December 31, 2006. Operating working capital includes “Settlements due from credit card processors” totaling $14.8 million and $13.2 million, and “Settlements due from ATM processor” totaling $12.1 million and $12.1 million as of December 31, 2007 and 2006, respectively. We estimate capital expenditures for fiscal year 2008 of approximately $2.0 million related to software development, ATM purchases for new customers or existing customer expansion, and related costs. In addition to meeting operating capital needs, our note holders relating to our Second Amended and Restated Notes currently have the right of optional redemption pursuant to which, on October 10, 2008, such note holders can require the Company to redeem a portion of the Second Amended and Restated Notes in an amount not to exceed $12.1 million in the aggregate.
We anticipate that our existing capital resources will enable us to continue operations through approximately October 2008, or earlier if payments of certain other accrued expenses are accelerated or if unforeseen events or circumstances arise that negatively affect our liquidity. If we fail to raise additional capital prior to October 2008, we may be forced to cease operations. Management is taking steps to reduce operating expenses and may consider reducing the scope of our operations, planned product development, and expansion efforts, which could harm our business, financial condition, and operating results. Management may also request that the note holders further amend the Second Amended and Restated Notes to, among other things, modify their right to require the Company to redeem up to $12.1 million in aggregate on October 10, 2008. We are aggressively looking for financing in a manner that takes into account the limitation contained in the Seconded Amended and Restated Notes, including prohibitions on our incurring senior debt and the note holders’ rights of first offer on most equity financings, which would delay the closing on those equity financings. Although the Company is aggressively pursuing additional financing and may seek a further amendment to the Second Amended and Restated Notes, there can be no assurance that the Company will be able to achieve profitable operations, generate sufficient cash from operations, obtain additional funding, modify the Second Amended and Restated Notes in a beneficial manner or repay the redemption option of our note holders of up to $12.1 million should they exercise their redemption right.
The Company and its Board of Directors have also decided to explore strategic alternatives to maximize shareholder value. Deutsche Bank, which the Company engaged earlier this year to assist with strategic matters, will serve as the Company’s financial advisor in this process. There can be no assurances that this process will result in any specific transaction.
Going Concern
We have net losses in consecutive years, have used $1.7 million of cash in operations during the fiscal year ended December 31, 2007, and have an accumulated deficit of $27.3 million and net working capital deficit of $4.5 million at December 31, 2007. Because we have not identified sources of capital and due to recurring losses, negative cash flows, and accumulated deficit, the report of our independent registered public accounting firm dated March 28, 2008 expresses substantial doubt about our ability to continue as a going concern. In addition, the holders of our senior secured convertible notes have the right to require us to redeem a portion of such notes on October 10, 2008 in an amount not to exceed $12.1 million in the aggregate. We anticipate that our existing capital resources will enable us to continue operations through approximately October 2008, or earlier if payments of certain other accrued expenses are accelerated or if unforeseen events or circumstances arise that negatively affect our liquidity. Management will need to take immediate steps to reduce operating expenses, which may include seeking concessions from customers and vendors in the meantime. If we fail to raise additional capital prior to October 2008, we may be forced to cease operations.
Contractual Obligations and Commitments
The following is a table of contractual obligations and commitments as of December 31, 2007:
Payments Due by Period
The above table reflects the increased principal and interest payments due resulting from the amendment and restatement of the senior secured convertible notes on March 14, 2008.
Letter of Credit
The Company maintains a $250,000 letter of credit with a lending institution to secure performance under a regulatory application. To secure this letter of credit, the Company is required to maintain a cash position with the issuing lending institution in an amount equal to the letter of credit. The letter of credit expires December 31, 2008.
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.
In accordance with Statement of Accounting Standards No. 154 “Accounting Changes and Error Corrections,” changes in accounting estimates that result in a material effect on income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or other performance indicator), and any related per-share amounts of the current period shall be disclosed. In the current period, we changed our method for estimating our reserve for uncollectible accounts relating to our check cashing receivables. As a result of the recent increase in bad debt expense, we have adopted a more conservative policy whereby we have increased our reserve for uncollectible accounts to 74% for current receivables and 95% for receivables greater than 180 days old. This change in reserve reflects changes in assumptions based on additional historical data and current market 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. We self guarantee a majority of our checks and engage an independent third party for collections as well as engage an independent third party to guarantee the collectability of a smaller portion of our checks. We record a receivable from collection agency for all self-guaranteed checks returned for insufficient funds until determined to be uncollectible. We record a reserve of 74% for current receivables and 95% for receivables greater than 180 days old based on historical data and current market conditions.
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, 2007 and 2006 was $326,563 and $102,403, 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
During September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements” (“SFAS 157”). This statement defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, however, during February 2008, the FASB issued FASB Staff Position SFAS 157-2 which deferred the effective date of certain provisions of SFAS 157 until fiscal years beginning after November 15, 2008. The Company does not believe that the adoption of SFAS 157 will have a material effect on its results of operations or financial position.
During February 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). This statement permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company believes the adoption of SFAS 159 will not have a material effect on its results of operations or financial position.
During December 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 160, “Noncontrolling Interests in Consolidated Financial Statements an amendment of ARB No. 51” (“SFAS 160”). This statement establishes accounting and reporting standards for noncontrolling interests in subsidiaries and for the deconsolidation of subsidiaries and clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. This Statement also requires expanded disclosures that clearly identify and distinguish between the interests of the parent owners and the interests of the noncontrolling owners of a subsidiary. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. The Company does not believe that the adoption of SFAS 160 will have a material effect on its results of operations or financial position.
During December 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 141 (Revised 2007), “Business Combinations” (“SFAS 141 (Revised 2007)”). While this statement retains the fundamental requirement of SFAS 141 that the acquisition method of accounting (which SFAS 141 called the purchase method) be used for all business combinations, SFAS 141 (Revised 2007) now establishes the principles and requirements for how an acquirer in a business combination: recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interests in the acquiree; recognizes and measures the goodwill acquired in the business combination or the gain from a bargain purchase; and determines what information should be disclosed in the financial statements to enable the users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS 141 (Revised 2007) is effective for fiscal years beginning on or after December 15, 2008. The Company does not believe that the adoption of SFAS 141 (Revised 2007) will have a material effect on its results of operations or financial position.
During March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (SFAS No. 161). SFAS No. 161 is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. SFAS No. 161 also improves transparency about the location and amounts of derivative instruments in an entity’s financial statements; how derivative instruments and related hedged items are accounted for under Statement 133; and how derivative instruments and related hedged items affect its financial position, financial performance, and cash flows.
SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company does not believe the adoption of SFAS No. 161 will have a material effect on its results of operations or financial position.
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 continue as a going concern; our failure to explore strategic alternatives that result in a definitive transaction; 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 $24.2 million in borrowings outstanding under our Second Amended and Restated Notes entered into on March 14, 2008. The Second Amended and Restated Notes bear interest at the rate of 7.50% per annum, payable quarterly in arrears. This interest rate is subject to adjustment up to 12.0% per annum upon the occurrence of certain events of default. In the event of default under the Second Amended and Restated Notes, the interest rate would increase to 12.0% beginning on the date of default. In addition, the interest rate will be increased by 1.5% per annum from and after the occurrence of any Dilutive Issuance Event (as defined in the Second Amended and Restated Notes). The 600 basis points increase, if effective for an entire year and with all other factors remaining constant, would decrease earnings by approximately $1.5 million on a pre-tax basis.
In addition, our 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 fees can be no less than 6.0% under any tier and requires fees in an amount equal to the prime rate plus 1.25% on balances over a certain maximum threshold. At December 31, 2007, the prime rate was 7.25%. 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 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 fees can be no less than 7.0%. At December 31, 2007, the prime rate was 7.25%. 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.
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 registered public accountants on accounting principles or practices or financial statement disclosures.
Item 9A.
Item 9A.
CONTROLS AND PROCEDURES
Evaluation of 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, 2007 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 not operating effectively as of December 31, 2007.
Notwithstanding management’s assessment that our internal controls over financial reporting were not effective as of December 31, 2007, we believe that the consolidated financial statements included in this Annual Report on Form 10-K correctly present our financial condition, results of operations and cash flows for the fiscal years covered thereby in all material respects.
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 consolidated 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, 2007. 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 deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. 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 reasonable possibility 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 certain findings discovered during the year end audit by our independent registered public accounting firm. Due to these audit findings relating to financial close and reporting, controls in financial close and reporting were not operating effectively as of December 31, 2007.
Our independent registered public accounting firm identified the following significant deficiencies, which aggregated into a material weakness, related to lack of controls over outside and third party contracts:
•
Inadequate reserve on receivable from collection agency as a result of improper treatment, oversight and adherence to the contract resulting in an overstatement of other current assets and understatement of check cashing costs of $1.6 million.
•
Improper recording of commissions revenue and commissions expense at gross rather than net as a result of review and adherence to accounting treatment of the contract resulting in an overstatement of revenues and an overstatement of commissions expense of $1.7 million.
•
Failure of controls related to review and proper accounting treatment of other contracts and debt agreements of $8 million resulting in an understatement of current liabilities and overstatement of long-term debt.
Remediation Plan
Throughout 2007, management and the Board of Directors continued their efforts to correct the material weaknesses disclosed in the fiscal year 2006 report as well as committed to enhancing the overall control environment. While management has made tremendous progress, the findings identified by our independent registered public accounting firm 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.
We have taken the following actions to remediate the material weakness described above:
•
The Company changed its method for estimating reserves for uncollectible accounts relating to the receivable from collection agency. We adopted a more conservative policy whereby the Company increased its reserve for uncollectible accounts to 74% for current receivables and 95% for receivables greater than 180 days old. The Company will continue to monitor and adjust its reserve for uncollectible accounts based on historical data and current market conditions as well as work with its collection agency to continue to refine data and enhance contract related procedures.
•
Although the Company’s internal controls detected the improper recording of commissions revenue and commissions expense and the quarterly effect of the adjustment was deemed immaterial through internal investigation and analysis, the Company’s internal controls did not detect the error on a timely basis. Accordingly, the Company has taken measures to re-train its accounting personnel, restrict revenue recording responsibilities, and augment existing quarterly analytic controls.
•
Although failure of controls related to commission contracts were found to be immaterial and the Company believes that the debt reclassification finding would have been detected by normal year end review procedures, the Company’s internal controls require remediation in this area. Accordingly, the Company has held meetings and trained personnel as appropriate to establish procedures for and heighten overall awareness on contract and debt agreement related matters.
Our independent registered public accounting firm, Virchow, Krause & Company, LLP has issued an attestation report on the Company’s internal control over financial reporting which is set forth on page.
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 2008 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 2008 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 2008 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 2008 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 2008 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, 2007, 2006 and 2005 appears on page which report contains an unqualified opinion on the financial statements and an adverse opinion on the internal control over financial reporting, (which includes an explanatory paragraph which express substantial doubt about the ability of Cash Systems, Inc. and Subsidiaries to continue as a going concern). 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 28, 2008
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, 2007, 2006, and 2005
(3) List of Exhibits.
(b)
Exhibits. Reference is made to the Exhibit Index and exhibits filed as a part of this Annual Report on Form 10-K.
(c)
Additional Financial Statements. Not applicable.
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.
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.
CASH SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders, 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, 2007 and December 31, 2006, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2007. We have also audited Cash Systems, Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2007, based on criteria established in “Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).” Cash Systems, Inc. and Subsidiaries’ management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting included in Item 9A. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the company’s internal control over financial reporting 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 and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated 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 transaction are recorded as necessary to permit preparation of consolidated 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 consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that 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 deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. We identified significant deficiencies which aggregated into a material weakness and is included in management’s assessment. The aggregated significant deficiencies were all related to lack of controls over outside and third party contracts and are described as follows:
•
Inadequate reserve on receivable from collection agency as a result of improper treatment, oversight and adherence to the contract resulting in an overstatement of other current assets and understatement of check cashing costs of $1.6 million.
•
Improper recording of commissions revenue and commissions expense at gross rather than net as a result of review and adherence to accounting treatment of the contract resulting in an overstatement of revenues and an overstatement of commissions expense of $1.7 million.
•
Failure of controls related to review and proper accounting treatment of other contracts and debt agreements of $8 million resulting in an understatement of current liabilities and overstatement of long-term debt.
This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated balance sheet as of December 31, 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year ended December 31, 2007, of the Company and this report does not affect our report on such consolidated financial statements.
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, 2007 and December 31, 2006 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Cash Systems, Inc. and Subsidiaries did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in “Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).”
The accompanying consolidated financial statements have been prepared assuming that Cash Systems, Inc. and Subsidiaries will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, Cash Systems, Inc. and Subsidiaries have incurred recurring operating losses, negative cash flows from operations, a working capital and accumulated deficit, and additionally, holders of notes have an option to put $12.1 million in outstanding notes to the Company in October 2008. These conditions raise substantial doubt about the ability of Cash Systems, Inc. and Subsidiaries to continue as a going concern. Management’s plans in regards to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Minneapolis, Minnesota
March 28, 2008
CASH SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
December 31, 2007 and 2006
See accompanying notes to consolidated financial statements.
CASH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, 2007, 2006 and 2005
See accompanying notes to consolidated financial statements.
CASH SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the Years Ended December 31, 2007, 2006 and 2005
See accompanying notes to consolidated financial statements.
CASH SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
For the Years Ended December 31, 2007, 2006 and 2005
See accompanying notes to consolidated financial statements.
CASH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2007, 2006 and 2005
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, 2007 and 2006, the consolidated statements of operations for the years ended December 31, 2007, 2006, and 2005, the consolidated statements of cash flows for the years ended December 31, 2007, 2006, and 2005 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.
Change in Accounting Estimate
In accordance with Statement of Accounting Standards No. 154 “Accounting Changes and Error Corrections,” changes in accounting estimates that result in a material effect on income (loss) from continuing operations, net income (loss) (or other appropriate captions of changes in the applicable net assets or other performance indicator), and any related per-share amounts of the current period shall be disclosed. In the current period, the Company changed its method for estimating reserves for uncollectible accounts relating to the receivable from collection agency. The Company has adopted a more conservative policy whereby the Company has increased its reserve for uncollectible accounts to 74% for current receivables and 95% for receivables greater than 180 days old. This change in reserve reflects changes in assumptions based on additional historical data and current market conditions.
The following table shows the effect of the change in estimate on loss from operations, net loss, and net loss per share:
Cash Concentrations
Bank balances exceeded federally insured levels during the years ended December 31, 2007, 2006, and 2005 and exceeded federally insured levels at December 31, 2007 and 2006. Generally, these balances may be redeemed upon demand and therefore bear minimal risk. There were no short-term investments as of December 31, 2007 and 2006.
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, 2007 and 2006, the Company capitalized $1,271,672 and $1,089,124 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 $793,441, $405,508, and $250,561 for the years ended December 31, 2007, 2006, and 2005, 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 (SFAS 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. As more fully described in Note 7, the Company reviews long-lived and 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 $113,347, $1,709,006 and $55,338 at December 31, 2007, 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, 2008 through 2010 is $29,982 and for the year ending December 31, 2011 is $23,402. Amortization expense for the years ended December 31, 2007, 2006, and 2005 was $239,573, $171,264, and $5,031, respectively. See Note 15 related to the write-off of debt issuance costs of $1,480,343 during the year ended December 31, 2007 in connection with the loss on extinguishment of debt.
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, is 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, 2007, 2006, and 2005 was $4,112, $4,112, and $0. Future amortization for each of the years ending December 31, 2008 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. The Company recognizes 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. The Company evaluates its 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, 2007 and December 31, 2006 was $326,563 and $102,403, 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, 2007, 2006, and 2005, the Company expensed $555,255, $91,207, 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, 2007. These reclassifications relate to certain other general and administrative costs that were reclassed to check cashing costs of $618,867 and $42,645 for the years ended December 31, 2006 and 2005, respectively, to better reflect the nature of the expenses; commissions revenues and commissions expenses of $302,017 for the year ended December 31, 2006; and cash that was reclassed to restricted cash of $88,135 for the year ended December 31, 2006. In addition, $820,212 of other current assets was reclassed to a change in reserve related to receivable from collection agency in the consolidated statement of cash flow for the year ended December 31, 2006. These reclassifications had no effect on the Company’s consolidated net loss for the year ended December 31, 2007 or stockholders’ equity at December 31, 2007.
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, and accrued liabilities 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
During September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements” (“SFAS 157”). This statement defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, however, during February 2008, the FASB issued FASB Staff Position SFAS 157-2 which defered the effective date of certain provisions of SFAS 157 until fiscal years beginning after November 15, 2008. The Company does not believe that the adoption of SFAS 157 will have a material effect on its results of operations or financial position.
During February 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). This statement permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company believes the adoption of SFAS 159 will not have a material effect on its results of operations or financial position.
During December 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 160, “Noncontrolling Interests in Consolidated Financial Statements an amendment of ARB No. 51” (“SFAS 160”). This statement establishes accounting and reporting standards for noncontrolling interests in subsidiaries and for the deconsolidation of subsidiaries and clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. This Statement also requires expanded disclosures that clearly identify and distinguish between the interests of the parent owners and the interests of the noncontrolling owners of a subsidiary. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. The Company does not believe that the adoption of SFAS 160 will have a material effect on its results of operations or financial position.
During December 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 141 (Revised 2007), “Business Combinations” (“SFAS 141 (Revised 2007)”). While this statement retains the fundamental requirement of SFAS 141 that the acquisition method of accounting (which SFAS 141 called the purchase method) be used for all business combinations, SFAS 141 (Revised 2007) now establishes the principles and requirements for how an acquirer in a business combination: recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interests in the acquiree; recognizes and measures the goodwill acquired in the business combination or the gain from a bargain purchase; and determines what information should be disclosed in the financial statements to enable the users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS 141 (Revised 2007) is effective for fiscal years beginning on or after December 15, 2008. The Company does not believe that the adoption of SFAS 141 (Revised 2007) will have a material effect on its results of operations or financial position.
During March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (SFAS No. 161). SFAS No. 161 is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. SFAS No. 161 also improves transparency about the location and amounts of derivative instruments in an entity’s financial statements; how derivative instruments and related hedged items are accounted for under Statement 133; and how derivative instruments and related hedged items affect its financial position, financial performance, and cash flows.
SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company does not believe the adoption of SFAS No. 161 will have a material effect on its results of operations or financial position.
Net Loss per Common Share
Basic net loss per common share is computed by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per common share is computed by dividing net 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, 2007, 2006 and 2005 were not dilutive.
The following table presents a reconciliation of the denominators used in the computation of net loss per common share - basic, and net loss per common share - diluted, for the years ended December 31, 2007, 2006 and 2005, 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
Share-based compensation expense recorded under SFAS 123(R) “Share-Based Payment” for the years ended December 31, 2007 and 2006 was $854,372 (or $0.05 per share) and $703,678 (or $0.04 per share), respectively.
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.
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, 2007 related to awards granted prior to January 1, 2006.
During the year ended December 31, 2007, 25,000 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 $363,800. During the same period, eighteen restricted stock awards were granted totaling 289,500 shares of common stock at a fair value on the date of grant with vesting terms of 2 to 4 years. The effect of this action was a non-cash expense of $490,572 during the current year.
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 2007 option grants as they immediately vested.
The Company uses the Black-Scholes option-pricing model (Black-Scholes model) for the Company’s stock based compensation expense recognized under SFAS 123(R). The Company determines the fair value of share-based payment awards on the date of grant using an option-pricing model which 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 award, and actual and projected employee stock option exercise behaviors and forfeitures. During the year ended December 31, 2007, the Company recorded $490,572 in stock compensation expense relating to restricted stock awards.
For stock options granted during the year ended December 31, 2007, 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 of 53.13%, 3) a risk-free interest rate of 4.625% and 4) an expected life of 6.5 years.
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 loss and 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 year ended December 31, 2005, 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% risk free interest rate, 6.5 for expected life of options granted, 54.1% to 65.4% expected volatility and 0% dividend yield, respectively.
Advertising Expenses
Advertising costs are charged to expense as incurred. Advertising costs were $10,330, $27,481 and $44,955 for the years ended December 31, 2007, 2006, and 2005, respectively.
Liquidity and Capital Resources
At December 31, 2007, we had cash of $16.6 million compared to $24.8 million at December 31, 2006 and cash net of “Checks issued in excess of cash in bank” of $1.4 million as of December 31, 2007. Cash used in operations totaled $1.7 million and $4.9 million during the year ended December 31, 2007 and 2006, respectively. We had a working capital deficit of approximately $4.5 million at December 31, 2007, compared to working capital of $13.5 million at December 31, 2006. Operating working capital includes “Settlements due from credit card processors” totaling $14.8 million and $13.2 million, and “Settlements due from ATM processor” totaling $12.1 million and $12.1 million as of December 31, 2007 and 2006, respectively. We estimate capital expenditures for fiscal year 2008 of approximately $2.0 million related to software development, ATM purchases for new customers or existing customer expansion, and related costs. In addition to meeting operating capital needs, our note holders relating to our Second Amended and Restated Notes currently have the right of optional redemption pursuant to which, on October 10, 2008, such note holders can require the Company to redeem a portion of the Second Amended and Restated Notes in an amount not to exceed $12.1 million in the aggregate.
We anticipate that our existing capital resources will enable us to continue operations through approximately October 2008, or earlier if payments of certain other accrued expenses are accelerated or if unforeseen events or circumstances arise that negatively affect our liquidity. If we fail to raise additional capital prior to October 2008, we may be forced to cease operations. Management is taking steps to reduce operating expenses and may consider reducing the scope of our operations, planned product development, and expansion efforts, which could harm our business, financial condition, and operating results. Management may also request that the note holders further amend the Second Amended and Restated Notes to, among other things, modify their right to require the Company to redeem up to $12.1 million in aggregate on October 10, 2008. We are aggressively looking for financing in a manner that takes into account the limitation contained in the Seconded Amended and Restated Notes, including prohibitions on our incurring senior debt and the note holders’ rights of first offer on most equity financings, which would delay the closing on those equity financings. Although the Company is aggressively pursuing additional financing and may seek a further amendment to the Second Amended and Restated Notes, there can be no assurance that the Company will be able to achieve profitable operations, generate sufficient cash from operations, obtain additional funding, modify the Second Amended and Restated Notes in a beneficial manner or repay the redemption option of our note holders of up to $12.1 million should they exercise their redemption right.
The Company and its Board of Directors have also decided to explore strategic alternatives to maximize shareholder value. Deutsche Bank, which the Company engaged earlier this year to assist with strategic matters, will serve as the Company’s financial advisor in this process. There can be no assurances that this process will result in any specific transaction.
Going Concern
We have net losses in consecutive years, have used $1.7 million of cash in operations during the fiscal year ended December 31, 2007, and have an accumulated deficit of $27.3 million and net working capital deficit of $4.5 million at December 31, 2007. Because we have not identified sources of capital and due to recurring losses, negative cash flows, and accumulated deficit, the report of our independent registered public accounting firm dated March 28, 2008 expresses substantial doubt about our ability to continue as a going concern. In addition, the holders of our senior secured convertible notes have the right to require us to redeem a portion of such notes on October 10, 2008 in an amount not to exceed $12.1 million in the aggregate. We anticipate that our existing capital resources will enable us to continue operations through approximately October 2008, or earlier if payments of certain other accrued expenses are accelerated or if unforeseen events or circumstances arise that negatively affect our liquidity. Management will need to take immediate steps to reduce operating expenses, which may include seeking concessions from customers and vendors in the meantime. If we fail to raise additional capital prior to October 2008, we may be forced to cease operations.
3. Funding Arrangement
Vault Cash Agreements
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 the Company 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 fees can be no less than 6.0% under any tier and the new vault cash agreement requires fees in an amount equal to the prime rate plus 1.25% on balances over a certain maximum threshold. At December 31, 2007 and 2006, the prime rate was 7.25% and 8.25%, respectively. The Company paid Fidelity vault cash fees totaling $2,872,301 and $2,006,670 for the years ended December 31, 2007 and 2006, respectively.
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, Fidelity Bank receives settled funds for ATM transactions related to Fidelity funded ATMs as well as certain casino funded ATMs from the network processor. Fidelity Bank then transfers the Company’s and the customers’ portion of funds, to a Company bank account. The Company then distributes the funds to various casino customer accounts the same or next day. In 2007, all cash provided by Fidelity Bank remained the sole property of Fidelity Bank at all times until dispensed. Because it was never an asset of the Company, supplied cash was not reflected on the Company’s balance sheet. Because Fidelity Bank’s portion of the settlement funds was never held by the Company, there was no liability corresponding to the supplied cash reflected on the Company’s balance sheet.
For two customer locations, the Company has a secondary vault cash arrangement with Wilmington Savings Fund Society FSB (“WSFS”) effective December 11, 2002 which requires that the Company 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% to 3.0%. The fees can be no less than 7.0%. At December 31, 2007 and 2006, the prime rate was 7.25% and 8.25%, respectively. The Company paid fees totaling $610,210, $299,420, and $264,943 for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company and its primary vault cash provider, Fidelity Bank, have agreed to reduce and eventually eliminate the ATM cash levels described in the Fidelity vault cash agreement dated December 1, 2006. The ATM cash reduction schedule will terminate by July 2008 by which time the Company expects to have its primary vault cash needs fully transitioned to a new third party financial services provider based on an agreement entered into during March 2008. The Company does not anticipate the change in providers to have a substantial impact on the Company.
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, 2007 and 2006, the Company operated 32 and 59 ATMs, respectively, that were site funded. The Company had $1,952,670 and $6,019,355 in ATM cash as of December 31, 2007 and 2006, respectively. During the current year, the Company reduced its number of customer locations having site funded ATMs to two locations.
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 periodically orders cash directly from casinos in order to fund its various booth locations. As there is a lag between the time cash is ordered and the cash is received by the booths, the Company records a receivable for cash that is in transit and includes these amounts in receivables from casinos. The balance as of December 31, 2007 increased compared to the prior year due to more such receivables at the Company’s Oklahoma booth locations. The Company has recorded a reserve related to the receivables for amounts that are not deemed collectible.
Receivable from bank
The Company recorded a receivable of $449,692 and $2,172,952 from its vault cash provider for standard ATM settlements and related surcharges owed at December 31, 2007 and December 31, 2006, respectively. In addition, the Company recorded a receivable for Debit POS fees that are owed by the vault cash provider relating to the Indian Gaming Service locations amounting to $93,757 and $184,411 at December 31, 2007 and December 31, 2006, respectively. All fees relating to this receivable are sent to the Company on a weekly basis and are considered 100% collectible.
Receivable from collection agency
During 2007, the Company significantly expanded its self-guarantee of funds on cashed checks to various casino locations, while decreasing its reliance on a third party vendor to guarantee such funds. For returned self-guaranteed checks, the Company forwards the checks to the collections agency which attempts to collect on the checks for certain periods based on terms set forth in the service contract. When the collection agency has exhausted its collection efforts (which generally applies to all checks that have been outstanding for more than 120 days), the checks are forwarded to a third party attorney network for legal action. The total gross amount of checks sent to the collection agency during 2007 was $14,161,626 of which $7,998,186 remained in the gross receivable at December 31, 2007. As of December 31, 2007 and 2006, the gross receivables balance for checks sent to the collection agency was $9,158,860 and $1,287,141 with reserves for uncollectible amounts of $6,134,405 and $422,382, respectively. For guaranteed checks and checks with insufficient funds from the Company’s booth locations, the gross receivables balance as of December 31, 2007 and 2006 was $88,747 and $929,902, respectively, with reserves for uncollectible amounts of $0 and $397,830, respectively.
In the current period, the Company changed its method for estimating the reserve for uncollectible accounts relating to the receivable from collection agency. The Company has adopted a more conservative policy whereby it has increased the reserve for uncollectible accounts to 74% for current receivables and 95% for receivables greater than 180 days old. This change in reserve reflects changes in assumptions based on additional historical data and current market conditions.
Other receivables
Other receivables consist of miscellaneous processor and bank receivables, ATM interchange income, employee advances, and security deposits. The Company has recorded a reserve for amounts that are not deemed collectible.
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, 2007 and December 31, 2006, the balance of settlements due from credit card processors was $14,779,241 and $13,212,907, 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 for Company funded ATMs as well as certain casino funded ATMs. The entire amount reimbursed from the processor directly to the Company is recorded as a receivable from the ATM processor, while amounts for casino funded ATMs received from the processor 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, 2007 and 2006, the balance of settlements due from ATM processors was $12,094,482 and $12,144,380, 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, 2007, 2006, and 2005 was $2,248,157, $1,858,955 and $1,259,337, respectively.
Long-Lived Assets
As more fully described in Note 7, 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, in accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.”
7. 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 (SFAS 144), “Accounting for Impairment or Disposal of Long-Lived Assets.” In accordance with SFAS 144, 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.
Management performed a formal valuation of its existing long-lived assets, intangibles, and goodwill using expected future cash flows, among other valuation methodologies, to determine fair values as of the year ended December 31, 2007. One customer contract (related to IGS) was found to be impaired due to non-renewal and an expiration of March 2008. The contract was not renewed as initially anticipated. The amount of the impairment loss totaled $449,444 which is included in other general and administrative expenses on the consolidated statement of operations.
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.
As of both December 31, 2007 and 2006, goodwill was $4,077,700 which related to the acquisition of Indian Gaming Services. Other identifiable intangible assets are as follows:
Accumulated amortization as of December 31, 2007 includes an impairment charge of $449,444.
Total amortization expense for the years ended December 31, 2007, 2006 and 2005 were $1,321,980, $1,130,112 and $0, respectively. As of December 31, 2007, we expect amortization expense in future periods to be as shown below:
8. Loans Receivable
During 2007, the Company accounted for four additional loan agreements in connection with three of its service contracts having an initial principal balance totaling $248,940 at an annual interest rate of 10%. Principal and interest are to be paid in equal monthly installments of $8,124 with payments ending in January 2009 and September 2010. These loans are secured by the ATM machines underlying the loan agreements.
During 2007, the Company entered into an unsecured loan with a third party affiliated with our Florida based properties having an initial principal balance totaling $450,000 at an annual interest rate of 10%. Principal and interest are paid in equal monthly installments of $17,025 with payments ending in September 2009.
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 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, 2007 and 2006 was $86,563 and $218,524, respectively. The remaining balance is to be repaid over 36 months.
Total outstanding loans receivable at December 31, 2007 and 2006 was $596,509 and $481,841, respectively, which includes interest receivable of $0 and $9,986, 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 vault cash agreement with Fidelity Bank effective December 1, 2006, the Company maintains restricted cash in the amount of $375,059 and $350,000 as of December 31, 2007 and 2006, respectively, 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. The Company also maintains cash reserves totaling $206,317 and $88,135 at December 31, 2007 and 2006, respectively, with its card association sponsor bank as required for card association compliance as well as to cover potential losses due to chargebacks.
The Company maintains a $250,000 and $5,000 letter of credit with a lending institution to secure performance under a regulatory application. To secure these letters of credit, the Company is required to maintain a cash position with the issuing lending institution in an amount equal to the letter of credit. The $250,000 and $5,000 letters of credit expire December 31, 2008 and 2010, respectively.
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:
Amounts due casinos represent funds owed to various casinos for reimbursement on credit card cash advance and ATM transactions once the Company receives settlement funds.
Due to a transition to internal processing in 2006, the Company receives settled funds for ATM transactions from the network processor for ATM transactions processed by the Company for Company funded ATMs and certain casino funded ATMs. The Company distributes the funds to various casino accounts 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.
Major Customers
During the years ended December 31, 2007, 2006, and 2005, the following customers accounted for more than 10% of our total revenues:
We contract with The Seminole Tribe of Florida through a third party affiliated with The Seminole Tribe of Florida, and we contract with Ho-Chunk Nation and Chickasaw Nation directly. 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. We have provided Cash Access Services to Ho-Chunk Nation and Chickasaw Nation since May 2003 and March 2005, respectively. There can be no assurance that these contracts will be renewed after their terms expire.
On February 6, 2008, Michael D. Rumbolz, CEO of the Company was appointed to serve on the Board of Directors of Seminole Hard Rock Entertainment, Inc. and as a Manager of Seminole Hard Rock International, LLC.
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 2010, 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 $315,230, $290,826 and $246,973 for the years ended December 31, 2007, 2006 and 2005, respectively. From December 2003 through October 2005, the Company leased space from a former officer of the Company on a month-to-month basis.
Future minimum lease payments for the years ending December 31:
13. Equity Transactions
On August 20, 2007, in connection with the amendment of the Senior Secured Convertible Notes and Warrants as more fully described in Note 15, the Company increased the aggregate number of shares of common stock underlying warrants to certain institutional accredited investors from 312,500 shares to 487,500 shares. The exercise price was reduced from $8.00 per share to $7.38 per share. The Company recorded expense of $314,724 during the year ended December 31, 2007.
During 2007, 496,000 options were exercised for cash of $1,765,980 at a weighted average exercise price of $3.56 per share.
During 2007, 315,000 options having a weighted average price of $6.61 per share were either cancelled or had expired.
During 2007, 26,250 shares of restricted stock vested at a weighted average price of $6.47 per share.
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.
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 to 2007, 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.
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 $4.42 as of December 31, 2007, which theoretically could have been received by the option holders had all option holders exercised their options as of that date. As of December 31, 2007 and 2006, the total number of exercisable in-the-money options was 5,000 and 1,176,000 with weighted average remaining contractual lives of 5.26 and 6.21 years, respectively. The intrinsic value of stock options exercised during the years ended December 31, 2007, 2006 and 2005 was $884,680, $305,690 and $2,435,770, respectively.
Options outstanding at December 31, 2007 have a weighted average remaining contractual life of 7.46 years.
CASH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables summarize information about stock options outstanding as of December 31, 2007:
Stock Warrants
Information regarding the Company’s stock warrants is summarized below:
All warrants outstanding at December 31, 2007 have an exercise price of $7.38 with a remaining contractual life of 3.78 years. All warrants were recorded at fair value using the Black Scholes pricing model using the following assumptions for the year ended December 31, 2007: 5.0% risk-free interest rate, 2.5 years expected life for each warrant, 52.61% expected volatility and 0% dividend yield. See Note 15 related to the re-pricing and accounting for additional warrants issued in connection with the amendment of the Senior Secured Convertible Notes.
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, 2007 and 2006 is presented in the following tables:
There were $1,604,647 and $343,522 of total unrecognized compensation costs related to the outstanding restricted stock awards which are expected to be recognized over a weighted average vesting period of 2.42 and 2.29 years as of December 31, 2007 and 2006, respectively. Recognized compensation expense related to restricted stock awards was $490,572 and $106,728 for the years ended December 31, 2007 and 2006, respectively. No restricted stock was awarded during the year ended December 31, 2005.
14. Income Taxes
At December 31, 2007, 2006 and 2005, the Company had a federal operating loss carryforward of $19,631,000, $13,271,000 and $8,102,000, respectively, and multiple state net operating loss carryforwards of $12,814,000, $8,780,000 and $5,491,000, 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 2007, 2006 and 2005 of $0, $0 and $394,000, 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, 2007 and 2006 was $11,480,000 and $5,438,000, 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, 2007 and maintained a full valuation allowance.
Reconciliation between the statutory rate and the effective tax rate for the years ended December 31, is as follows:
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. To the extent interest and penalties would be assessed by taxing authorities on any underpayment of income taxes, such amounts would be accrued and classified as a component of income tax expenses on the consolidated statement of operations. FIN No. 48 applies to fiscal years beginning after December 15, 2006, with earlier adoption permitted. The Company has evaluated the effects of FIN No. 48 and found its adoption to not have a material impact on the consolidated financial statements. The Company’s federal and state tax returns are potentially open to examinations for fiscal years 2004 through 2006.
15. Senior Secured Convertible Notes
On October 10, 2006, the Company issued and sold to certain institutional accredited investors an aggregate of $20.0 million in principal amount of senior secured convertible notes (the “Original 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 “Original Warrants”). The Original Notes bore interest at the rate of 6.50% per annum, payable quarterly in arrears commencing on January 10, 2007. This interest rate was subject to adjustment up to 12.0% per annum upon the occurrence of certain events of default and 7.50% in the event of certain interest test failures which were based on financial thresholds relating to Consolidated Revenue, Consolidated Earnings Before Interest, Tax, Depreciation, and Amortization (“EBITDA”), and Total Debt to EBITDA Ratio (when applicable). The maturity date of the Original Notes was October 10, 2011. The Company’s obligations under the Original Notes were collateralized by a security interest in substantially all of the Company’s assets. The Company used proceeds from the issuance and sale of the Original Notes for repayment of its two-year line of credit with Bank of America, N.A.
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 Original Notes and the Original Warrants based on the relative fair values of the securities at the time of issuance. The Original Warrants were valued using the Black-Scholes pricing model with the resulting original issue discount being amortized over the term of the Original Notes, which approximates the interest method. The Original 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 Original 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 Original 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 Original Warrants during 2006 as a payment penalty of 2% was required if the registration statement was ever deemed ineffective.
In accordance with guidance from FASB Staff Position No. EITF 00-19-2 (FSP), the Company noted upon the adoption of this FSP, a payment under the registration agreement is not probable. If the registration agreement had not been part of the terms of the original agreement, the Original Warrants would have been classified as an equity instrument under other applicable GAAP rules for all periods. The Company reclassified $656,879 to additional paid-in capital and $120,132 to the note discount at January 1, 2007. The Company determined that the income statement effect on 2006 was not material. Amortization expense on the original issue discount was $124,822 for the year ended December 31, 2007.
On August 8, 2007, the note holders waived until August 20, 2007 any event of default arising under the Original Notes or any other note related documents as a result of the Company’s failure as of June 30, 2007 to meet the quarterly financial threshold in the note agreements relating to Consolidated EBITDA. The waiver was designed to provide a reasonable period of time for the Company and the note holders to reach an agreement on amending the Original Notes and the other related documents.
On August 20, 2007, the Company entered into an amendment with each of its note holders as contemplated by the waiver. Pursuant to the amendment, the Company and each of the note holders agreed to, among other things, amend and restate the Original Notes (as amended, the “Amended Notes”), amend and restate the Original Warrants (as amended, the “Amended Warrants”), and amend certain provisions of other related documents.
The Amended Notes differ from the Original Notes in certain material respects, including, without limitation, (i) the aggregate principal amount was increased from $20.0 million to $22.0 million, (ii) the interest rate was increased from 6.5% per annum to 7.5% per annum, (iii) each note holder was given an additional right of optional redemption pursuant to which, on October 10, 2008, each note holder may require the Company to redeem a portion of the Conversion Amount (as defined in the Amended Notes) in an amount not to exceed the Maximum Redemption Amount, which is the portion of an Amended Note equal to the product of (x) $8 million and (y) the quotient of (a) the principal amount outstanding under such note holder’s Amended Note and (b) the aggregate principal amount outstanding under all of the amended notes, at a price equal to the Conversion Amount being redeemed, (iv) the Company was given the right of mandatory redemption, pursuant to which, on October, 10, 2008, the Company may, if certain conditions set forth in the amended notes are satisfied or waived, redeem a portion of the Conversion Amount then remaining under the Amended Notes in an amount not to exceed the Maximum Redemption Amount, as described above, at a price equal to the product of (x) 130% and (y) the Conversion Amount being redeemed.
The Amended Warrants differ from the Original Warrants in certain material respects, including, without limitation, (i) the aggregate number of shares of common stock underlying such warrants was increased from 312,500 shares to 487,500 shares, and (ii) the exercise price was reduced from $8.00 per share to $7.38 per share.
The Company applied EITF 96-19, Debtor’s Accounting for a Modification or Exchange of Debt Instruments, and determined that since the modified debt had substantially different terms, it should be treated as an extinguishment of debt. As a result, the Company recorded a debt extinguishment loss of $4.3 million representing the difference between the carrying value of the Original Notes and Original Warrants and the fair market value of the Amended Notes and Amended Warrants during 2007. The $4.3 million debt extinguishment loss resulted from a $2.0 million increase in the aggregate principal amount of the Original Notes, $1.5 million and $0.5 million in write-offs of debt issuance costs and original issue discount relating to the Original Notes, respectively, and a $0.3 million increase in the value of the Amended Warrants and fair value of the additional warrants granted.
The Company used the Black-Scholes pricing model (Black-Scholes) as of the grant date of the Amended Warrants to determine the fair market value of the Amended Warrants. The Company’s determination of fair value using Black Scholes 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 Amended Warrants.
The original issue discount relating to the Original Notes has been expensed and there is no discount or beneficial conversion relating to the Amended Notes as of December 31, 2007.
On March 14, 2008 and as more fully described in Note 16 - Subsequent Events, the Company entered into a Second Amendment and Exchange Agreement with each of its note holders (each, a “Second Amendment and Exchange Agreement” and collectively, the “Second Amendment and Exchange Agreements”) pursuant to which the Company and each of the note holders agreed to, among other things, amend and restate the First Amended and Restated Notes, amend and restate the First Amended and Restated Warrants, and amend certain provisions of the other Transaction Documents.
16. Subsequent Events
Consulting Agreement with Alpine Advisors LLC
As of January 30, 2008, the Company entered into an agreement with Alpine Advisors LLC, a strategic, management and financial consulting firm, to provide financial advisory services. Don R. Kornstein, who is a former director of the Company, is the managing member of Alpine Advisors LLC.
Amended Agreement with Native American Cash Systems Florida, Inc. (“NACSF”)
During January 2008, the Company amended its financial services agreement dated December 7, 2006 with NACSF to specify the amount of ATM surcharge to be paid to the Seminole Tribe of Florida and the amount of commissions to be paid to NACSF, and to loan NACSF $1.5 million at an annual interest rate of 6% pursuant to the terms and conditions of a secured promissory note and security agreement. Principal and interest are to be paid in equal monthly installments of $129,100 with payments ending in December 2008. The loan is secured by any and all assets of NACSF, including but not limited to, all commissions, fees, or other revenues due NACSF.
Second Amended and Restated Notes and Warrants
On March 14, 2008, the Company entered into a Second Amendment and Exchange Agreement with each of its note holders (each, a “Second Amendment and Exchange Agreement” and collectively, the “Second Amendment and Exchange Agreements”) pursuant to which the Company and each of the note holders agreed to, among other things, amend and restate the Senior Secured Convertible Notes, as previously amended and restated in August 2007 (the “First Amended and Restated Notes”), amend and restate the Warrants to Purchase Common Stock, as previously amended and restated in August 2007 (the “First Amended and Restated Warrants”), and amend certain provisions of the other Transaction Documents.
The Senior Secured Convertible Notes, as amended and restated on March 14, 2008 (the “Second Amended and Restated Notes”) differ from the First Amended and Restated Notes in certain material respects, including, without limitation, (i) the aggregate principal amount was increased from $22.0 million to $24.2 million, (ii) the conversion price was reduced from $8.00 per share to $2.51 per share, (iii) the conversion price may be further reduced by the note holders at any time on or before April 22, 2008 to 120% of the arithmetic average of the weighted average price of the Company’s common stock for each day during the period commencing on March 18, 2008 and ending on April 15, 2008, (iv) the aggregate amount that the note holders may require the Company to redeem, and the aggregate amount that the Company may elect to redeem, on October 10, 2008 was increased from $8 million to $12.1 million, (v) the financial covenants based on Consolidated Total Debt to EBITDA (as defined in the First Amended and Restated Notes) were eliminated and the financial covenants based on Consolidated Revenue and Consolidated EBITDA (as defined in the Second Amended and Restated Notes) were modified to apply starting with the quarter ending March 31, 2009, and (vi) the interest rate will be increased by 1.5% per annum from and after the occurrence of any Dilutive Issuance Event (as defined in the Second Amended and Restated Notes). As a result of the March 14, 2008 amendment and restatement of the notes, the Company has reclassified $12.1 million of the Second Amended and Restated Notes from long term to short term debt on the consolidated balance sheet.
The Warrants to Purchase Common Stock, as amended and restated on March 14, 2008 (the “Second Amended and Restated Warrants”) differ from the First Amended and Restated Warrants in certain material respects, including, without limitation, (i) the exercise price was reduced from $7.38 per share to $2.49 per share, and (ii) the exercise price may be further reduced by the note holders at any time on or before April 22, 2008 to 120% of the arithmetic average of the Weighted Average Price (as defined in the Second Amended and Restated Notes) of the Company’s common stock for each day during the period commencing on March 18, 2008 and ending on April 15, 2008.
The Second Amended and Restated Notes and the Second Amended and Restated Warrants contain various limitations on the number of shares of our common stock that may be issued upon conversion of the Second Amended and Restated Notes and upon exercise of the Second Amended and Restated Warrants. No note holder may convert its Second Amended and Restated Notes or exercise its Second Amended and Restated Warrants to the extent such conversion or exercise would cause such holder, together with such holder’s affiliates, to own more than 9.99% of our common stock following such conversion or exercise. In addition, in order to comply with the rules of The NASDAQ Stock Market, if the note holders make a Holder Conversion Price Adjustment Election (as such term is defined in the Second Amended and Restated Notes), we may not issue more than an aggregate of 3,755,154 shares of our common stock to the note holders without the prior approval of our stockholders. If the note holders do not make a Holder Conversion Price Adjustment Election, the exercise price of the Second Amended and Restated Notes may not be adjusted to less than $2.51 per share and the conversion price of the Second Amended and Restated Warrants may not be adjusted to less than $2.49 per share (subject to adjustment for any stock dividend, stock split, stock combination, reclassification or similar transaction).
The Company will evaluate the financial statement effect of the March 14, 2008 amendment and restatement of the notes and warrants in its quarter ending March 31, 2008. See Note 15 for further information related to the senior convertible secured notes. The Company will finalize the debt extinguishment expense upon the final terms of the stock price and conversion rate and record in the quarter ending March 31, 2008.
17. Selected Quarterly Data (unaudited)
During the fourth quarter of 2007, the Company made adjustments totaling $1,709,571 to reduce revenue and commissions expense during the first three quarters of 2007 and $302,017 during the fourth quarter of 2006 relating to two of its properties. These adjustments had no impact on the consolidated statement of operations. The adjustments are presented below in order to reconcile to quarterly amounts previously reported in Forms 10-Q and 10-K/A: