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NETE > SEC Filings for NETE > Form 10-K on 12-Apr-2013All Recent SEC Filings

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Form 10-K for NET ELEMENT INTERNATIONAL, INC.


12-Apr-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements contained in this Report and the discussion under "Forward-Looking Statements" on page i at the beginning of this Report and the Risk Factors set forth in Part I, Item 1A of this Report.

Overview; Recent Developments

As of December 31, 2012, we had two reportable business segments, consisting of
(i) mobile commerce and payment processing for electronic commerce, and (ii) entertainment and culture Internet destinations.

On March 8, 2013, we entered into a binding term sheet to acquire all of the business assets of Unified Payments, LLC. Unified Payments provides comprehensive turnkey, payment-processing solutions to small and medium size business owners (merchants) and independent sales organizations across the United States. For additional information, see "Recent Developments" in Part I, Item 1 of this Report.

During the third quarter of 2012, our subsidiary, TOT Money, launched operations as a mobile commerce payment processing business in Russia. Since then, TOT Money has continued seeking to expand its payment processing business primarily in the Commonwealth of Independent States (CIS) countries (comprised of participating states of the former Soviet Union) and other emerging markets. During the second half of 2012, TOT Money entered into contracts with the three largest mobile phone operators in Russia, Mobile TeleSystems OJSC, MegaFon OJSC and OJSC VimpelCom, to facilitate payments using SMS and MMS for their mobile phone subscribers in Russia.

We continue to pursue a strategy to develop and acquire technology and applications for use in the online media industry. In furtherance of this strategy, we acquired Openfilm, LLC on December 14, 2010 and Motorsport, LLC and Music1, LLC on February 1, 2011. On February 8, 2013, in connection with our termination of Music1's employment of Stephen Strother, we transferred and assigned to Mr. Strother our 97% interest in A&R Music Live, LLC, the internet domain name www.arlive.com and related intellectual property rights.

Our subsidiary, LegalGuru LLC, has been developing a video-centric, legal information portal (legalguru.com) intended to allow licensed attorneys (or Gurus) to brand themselves by posting relevant information content related to each attorney's respective practice concentration. We launched a beta test version of legalguru.com in May 2012 and, in the first quarter of 2013, indefinitely discontinued all development and marketing efforts for LegalGuru pending receipt of additional financing, if any.

Our subsidiary, Yapik LLC, was developing, and in the fourth quarter of 2011 launched a beta test version of, Yapik, a peer-to-peer communication and bartering application and service for mobile devices operating within and around colleges and universities in the United States. Upon completion of the beta tests, we decided to discontinue development efforts for Yapik and focus on developing a similar application called Komissionka for use in the Russian market. The Komissionka application was introduced in Russia in the second quarter of 2012 on a pre-loaded smartphone sold by the mobile phone carrier MegaFon.

We believe that our technology platforms and development expertise are able to enhance the digital distribution of content in a variety of industries. Accordingly, we intend to explore additional acquisitions of, as well as developing internally, other Internet based properties, services and companies with similar goals of connecting people in various vertical markets, such as the medical, music, film, sports and legal markets.

Since our inception, we have not generated significant revenues, and we have incurred significant operating losses (for additional information, see "Liquidity and Capital Resources" below). If we fail to maintain our relationships with mobile phone providers in Russia and with content providers, lenders and other business partners, or fail to expand our base of advertisers or generate and maintain high quality content on our websites, it could harm our revenue prospects. We face all of the risks inherent in a new business, including the need for significant additional capital, management's potential underestimation of initial and ongoing costs, and potential delays and other problems in connection with developing our technologies, Internet websites and operations.

Merger with Net Element

On October 2, 2012, the Company completed a merger with Net Element, Inc., which was a company with businesses in the online media and mobile commerce payment processing markets. Immediately prior to the effectiveness of the Merger, the Company changed its jurisdiction of incorporation by discontinuing as an exempted company in the Cayman Islands and continuing and domesticating as a corporation incorporated under the laws of the State of Delaware. Effective upon consummation of the Merger, (i) Net Element was merged with and into the Company, resulting in Net Element ceasing to exist and the Company continuing as the surviving company in the Merger, and (ii) the Company changed its name to Net Element International, Inc. Pursuant to the Merger, the Company issued 24,543,826 shares of its common stock to the former stockholders of Net Element, which shares amount to approximately 86.7% of the 28,303,659 post-Merger issued and outstanding shares of common stock of the Company. Following the Merger, the Company's business consists of the former business of Net Element. For financial reporting purposes, the Merger was accounted for as a recapitalization of Net Element. Since the Merger was consummated during the Company's fourth fiscal quarter, the Company's financial statements reflect the historical financial information of Net Element beginning with the Company's fiscal year ended December 31, 2012.

Critical Accounting Policies and Estimates

Our significant accounting policies are described more fully in Note 1 to the accompanying consolidated financial statements. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates.

In applying estimates, management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical experience, terms of existing contracts, the observance of trends in our industries, information provided by outside sources, trade journals and other sources, as appropriate.

Revenue; Interest Income. We recognize revenue when persuasive evidence of a sales arrangement exists, performance of services has occurred, the sales price is fixed or determinable and collectability is reasonably assured. Our revenues for the years ended December 31, 2012 and 2011 were principally derived from the following sources: service fees generated primarily from TOT Money's payment processing services and also from A&R Music Live (which, as of February 8, 2013, is no longer owned by us); license fees generated from customers who utilize Launchpad to operate and manage on-line contests; advertising revenue generated by certain owned and operated websites; and subscription services revenue generated through the sale of memberships to access content available on certain owned and operated websites and to be eligible to enter our contests. We also generate interest income from lending arrangements made by us.

Reserve for Loan Losses. The Company monitors all accounts receivable, notes receivable and advances to aggregators on a quarterly basis to ensure collectability and the adequacy of loss provisions. Considerations include payment history, business volume history, financial statements of borrower, projections of borrower and other standard credit review documentation. Management uses its best judgment to adequately reserve for future losses after all available information is reviewed.

Due to our limited experience with advances to aggregators, management has determined to maintain a reserve of approximately 10% of the outstanding balance as a general reserve for these unsecured advances. As of December 31, 2012, the Company has reserved $550,000 on an outstanding aggregator advance balance of $5.3 million. Additionally, management has reserved $891,475 for a loan made by the Company to Infratont Equities, Inc. because we were not able to review the financial information or the collateral value of the borrower as of December 31, 2012.

In addition, the Company has fully reserved advances to Stratuscore for $196,557. This amount was advanced in cash and services to develop a new business that provided rendering services to the motion picture industry. The Company decided not to pursue this venture and determined that the advance is uncollectible based on a financial review of the founding shareholder of Stratuscore.

Deferred Taxes. Estimates of deferred income taxes and items giving rise to deferred tax assets and liabilities reflect management's assessment of actual future taxes to be paid on items reflected in the financial statements, giving consideration to both timing and the probability of the realization. Actual income taxes could vary from these estimates for a variety of reasons, including changes in tax law, operating results that vary from budget or the review of our tax returns by the IRS.

Results of Operations for the Year Ended December 31, 2012 Compared to the Year Ended December 31, 2011

We reported a net loss of $16,389,931, or $(0.77) per share, for the year ended December 31, 2012 as compared with a net loss of $24,853,100, or $(1.37) per share, for the year ended December 31, 2011. Our net loss for the years ended December 31, 2012 and 2011 primarily resulted from our general and administrative expenses as discussed further below.

Net revenues primarily consist of service fees, license fees, advertising revenue and membership fees. Net revenues were $1,412,482 for the year ended December 31, 2012 as compared to $183,179 for the year ended December 31, 2011. The increase in net revenues is primarily a result of the launch of our mobile commerce payment processing operations in Russia during the third quarter of 2012 through our subsidiary TOT Money. Our results of operations for the year ended December 31, 2011 include only the operations of our online media products (websites and mobile applications). The following table sets forth our sources of revenues for the years ended December 31, 2012 and 2011.

              Source of Revenues                 2012           2011
              Payment Processing Fees         $ 1,312,152     $       -
              Licensing Fees                        9,826        51,599
              Advertising Revenue                  13,258        41,025
              Subscription and Pay per View        78,114        91,083
              Less: Revenue Sharing                  (868 )        (528 )
                                              $ 1,412,482     $ 183,179

Net revenues for the year ended December 31, 2012 were primarily from TOT Money ($1,312,152), Music1/A&R Music Live ($71,825), Openfilm ($25,551) and Motorsport ($1,833). Net revenues for the year ended December 31, 2011 were primarily from Music1/A&R Music Live ($76,393), Openfilm ($73,426) and Motorsport ($28,152). TOT Money generates most of its revenue from its mobile commerce payment processing operations in Russia, which generate service fees from processing payments initiated through SMS (short message services, which is a text messaging service) and MMS (multimedia message services) by mobile phone users. Music1/A&R Music Live revenues consist primarily of premium service fees earned by providing feedback on music submitted by users for review by music executives; however, as of February 8, 2013, A&R Music Live is no longer owned by us, so our results of operations in future periods will no longer include these service fees. Openfilm's net revenues consist primarily of licensing fees from Launchpad and advertising revenues. Motorsport's net revenues consist primarily of advertising revenues. We believe that inflation has not had a material impact on our net revenues for the years ended December 31, 2012 and 2011.

Cost of revenues represents direct costs of generating revenues, including commissions, purchases of short numbers, content acquired and created and certain payroll expense that is directly related to revenue creation. Cost of revenues for the year ended December 31, 2012 was $1,097,823 (or 77.7% of net revenues during that period) as compared to $596,389 (or 325.6% of net revenues) for the year ended December 31, 2011. The year over year increase in cost of revenues of $501,434 is primarily due to $740,235 in cost of revenues from TOT Money (which first began operations in the third quarter of 2012) for the purchase of short numbers to facilitate creation of payment processing revenues offset by a $238,801 decline in cost of revenues in Openfilm and other web properties. The following table details our cost of revenues by entity or web property for the years ended December 31, 2012 and 2011.

                  Entity or Web Property      2012           2011
                  OOO TOT Money            $   740,235     $       0
                  Yapik*                         1,945        19,863
                  Openfilm                      68,416       154,729
                  LegalGuru*                     1,725        55,589
                  Motorsport                   194,773       209,378
                  Music1/A&R Music Live*        87,193        94,091
                  Other                          3,536        62,739
                                           $ 1,097,823     $ 596,389

* Effective January 1, 2013, we ceased development efforts for the Yapik application in the United States, and are instead focused on developing a similar application called Komissionka for use in the Russian market. In the first quarter of 2013, we indefinitely discontinued all development and marketing efforts for LegalGuru pending receipt of additional financing, if any. On February 8, 2013, in connection with the termination of Music1's employment of Stephen Strother, we transferred and assigned to Mr. Strother our 97% interest in A&R Music Live, LLC, the internet domain name www.arlive.com and related intellectual property rights. As a result of the foregoing, our results of operations in future periods will no longer include the operations of Yapik or A&R Music Live and we expect that our results of operations will not include the operations of LegalGuru for the foreseeable future.

Operating expenses totaled $18,527,006 for the year ended December 31, 2012, as compared to total operating expenses of $25,238,951 for the year ended December 31, 2011. Most of total operating expenses in each of such periods consisted of general and administrative expenses. For the year ended December 31, 2012, general and administrative expenses were $14,578,566, or 78.7% of total operating expenses during the period. For the year ended December 31, 2011, general and administrative expenses were $24,330,623, or 96.4% of total operating expenses during that period. The components of our general and administrative expenses are discussed below.

General and administrative expenses were $14,578,566 for the year ended December 31, 2012 as compared to $24,330,623 for the year ended December 31, 2011. General and administrative expenses for the years ended December 31, 2012 and 2011 consisted of operating expenses not otherwise delineated in our Consolidated Statements of Operations and Comprehensive Loss, including non-cash compensation expense, salaries and benefits, professional fees, rent, filing fees and other expenses required to run our business, as follows:

                                                  Year Ended        Year Ended          Variance
                                                 December 31,      December 31,        Increase /
Category                                             2012              2011            (Decrease)
Non-cash compensation expense from
subscription agreements and share based
compensation                                     $   6,240,196     $  19,350,202     $  (13,110,006 )
Salaries, benefits and contractor payments           3,557,473         3,157,384            400,089
Professional fees                                    2,540,023           671,936          1,868,087
Rent                                                   484,900           247,953            236,947
Product development                                    327,847           113,159            214,688
Business development                                    35,163           385,714           (350,551 )
Travel expense                                         769,098           181,996            587,102
Other expenses                                         623,866           222,279            401,587
Totals                                           $  14,578,566     $  24,330,623     $   (9,752,057 )

Non-cash compensation expense from subscription agreements and share-based compensation was $6,240,196 for the year ended December 31, 2012 compared to $19,350,202 for the year ended December 31, 2011. The non-cash compensation expenses were higher for the year ended December 31, 2011 as compared with the year ended December 31, 2012 primarily due to the intrinsic value charges from the stock issued pursuant to the Enerfund Subscription Agreement (as described below) and the higher use of stock options as compensation for contractors, advisors and employees in 2011.

On December 31, 2010, we entered into a Subscription Agreement with Enerfund, LLC (the "Enerfund Subscription Agreement") pursuant to which we received an aggregate of $2,000,000 in exchange for the issuance of 5,000,000 shares of our common stock and warrants to purchase 2,500,000 shares of our common stock at an exercise price of $2.00 per share for a period of five years from the date of issuance. However, we did not have a sufficient number of authorized shares of common stock to fully issue these securities to Enerfund at December 31, 2010. Accordingly, this transaction was accounted for as a purchase by Enerfund as of December 31, 2010 of 2,800,000 shares of common stock and fully vested warrants to purchase 1,400,000 shares of common stock for $2.00 per share in exchange for $1,120,000. A compensation charge of $560,000 was recorded for the nine months ended December 31, 2010 as Mike Zoi, one of our directors and an officer at the time, is also a principal of Enerfund. This amount is calculated as the Black-Scholes valuation of the warrants issued as of December 31, 2010. The balance of the proceeds of $880,000 was accounted for as an advance until March 7, 2011, when we issued the balance of the shares and warrants. Since Enerfund is owned by an officer/director, we recorded a compensation charge of $18,920,000 during the year ended December 31, 2011, which is comprised of the Black-Scholes value of the warrants ($6,600,000) and the intrinsic market value of the common stock issued ($12,320,000).

Salaries, benefits and contractor payments were $3,557,473 for the year ended December 31, 2012 compared to $3,157,384 for the year ended December 31, 2011. Salaries, benefits and contractor payments for the year ended December 31, 2012 were $400,089, or 12.7%, higher than for the year ended December 31, 2011 primarily due to higher engineering expenses ($215,264), the establishment of OOO Net Element Russia ($183,736), higher salaries and benefits due to an increase in LegalGuru headcount ($129,806) and higher salaries and benefits due to an increase in Motorsport headcount ($62,242), partially offset by lower salaries and benefits due to a decrease in corporate headcount ($198,410) and lower salaries and benefits due to a decrease in Openfilm/Launchpad headcount ($155,798). Salaries, benefits and contractor payments attributable to Net Element International (Corporate) and our properties or subsidiaries for the year ended December 31, 2012 versus the year ended December 31, 2011 were as follows:

                                                          Salaries,       Salaries,
                                                          Benefits        Benefits
                                                             and             and
                                                         Contractor      Contractor
                                                          Payments        Payments
                                                           for the         for the
                                                         Year Ended      Year Ended
                                                          December        December
Web Property / Group of Properties                        31, 2012        31, 2011
Net Element International (Corporate)                    $ 1,370,535     $ 1,568,945
LegalGuru                                                    184,282          54,476
Yapik                                                        109,723         115,534
NetLab & Zivos (Engineering)                               1,096,211         880,947
Splinex                                                      199,600          53,123
Music                                                        224,802         202,219
Motorsport                                                    97,701          35,459
Openfilm/Launchpad                                            90,883         246,681
OOO Net Element Russia                                       183,736               -
Total                                                    $ 3,557,473     $ 3,157,384

Professional fees were $2,540,023 for the year ended December 31, 2012 compared to $671,936 for the year ended December 31, 2011, as follows:

                                                   Year Ended           Year Ended          Variance
                                                  December 31,         December 31,        Increase /
                                                      2012                 2011            (Decrease)
General Legal                                    $       366,215     $        161,070     $     205,145
SEC Compliance Legal Fees                                784,684               84,304           700,380
Accounting and Auditing                                  468,750               83,160           385,590
Tax Compliance and Planning                                3,800               73,529           (69,729 )
Consulting                                               916,574              269,873           646,701
Total                                            $     2,540,023     $        671,936     $   1,868,087

General legal expenses increased $205,145 in 2012 primarily due to business development work in Russia, which totaled approximately $146,348 partially offset by a reduction in corporate general legal expenses of $46,361. Securities and Exchange Commission compliance costs increased by $700,380 due to the Company's merger with Net Element and related actions. Accounting and auditing fees increased by $385,590 due to the Company's merger with Net Element. Tax compliance and planning expenses decreased $69,729 as the Company had less compliance specialists employed during 2012 versus 2011. Consulting fees increased by $646,701 in 2012 compared to 2011 primarily due to $275,000 in consulting fees related to the Company's merger with Net Element, $160,728 for post-merger management fees and an increase in corporate consulting fees of $69,379 primarily for development of an advertising network.

Rent expenses were $484,900 for the year ended December 31, 2012 compared to $247,953 for the year ended December 31, 2011, representing an increase of $236,947. The increase in rent expenses was primarily due to setting up office for Net Element Russia of which the cost was $181,778.

Product development costs increased by $214,688 (from $113,159 for the year ended December 31, 2011 to $327,847 for the year ended December 31, 2012) primarily resulting from an increase in spending to develop and commercialize certain "3D" web video technologies. We spent money to demonstrate our product at the 2012 London Olympics at the Russian pavilion and additional travel expenses to develop grant opportunities in other countries.

Business development expenses decreased by $350,551, from $385,714 for the year ended December 31, 2011 to $35,163 for the year ended December 31, 2012. The primary reason for this decrease was a reduction in promotion expense relating to the Ferrari Challenge. On April 4, 2011, we entered into a two-year cross advertising transaction with Ferrari North America, Inc., whereby we contracted to pay $50,000 in cash and provide $200,000 per year in advertising value (non-cash) on our websites in exchange for a Platinum Sponsorship for the Ferrari Challenge over two race seasons). We expect business development expenses to increase in 2013 due in part to the Company entering into its second sponsorship agreement with Ferrari North America, Inc. on February 1, 2013 (the Company agreed to pay $50,000 in cash and provide $200,000 in advertising services).

Travel expenses increased by $587,102, from $181,996 for the year ended December 31, 2011 to $769,098 for the year ended December 31, 2012. Travel expenses were higher in 2012 due to the build-out of our Russian operations and the increased amount of travel required, as well as more executives traveling in 2012 than in 2011, for road shows in connection with our merger with Net Element.

Other general and administrative expenses totaled $623,866 for the year ended December 31, 2012 compared to other general and administrative expenses of $222,279 for the year ended December 31, 2011, representing an increase of $401,587. Other general and administrative expenses for the year ended December 31, 2012 were higher than 2011 primarily due to other Russian general and administrative expenses related to the start-up of our mobile commerce payment processing operations that did not exist in 2011.

We recorded a provision for loan losses of $1,638,032 for the year ended December 31, 2012, which was comprised of a bad debt reserve for the unpaid balance as of April 12, 2013 of a loan made by the Company to Infratont Equities, Inc. ($891,475), a 10% general loan loss provision for advances to aggregators ($550,000) and a full reserve for advances to Stratuscore ($196,557). For additional information, see "Critical Accounting Policies and Estimates-Reserve for Loan Losses" in this Item 7 and Notes 7, 8 and 14 of the accompanying Notes to Consolidated Financial Statements. We had no provision for loan losses for the year ended December 31, 2011.

We recorded a goodwill and intangible asset impairment charge of $680,499 for the year ended December 31, 2012, which was primarily related to a $422,223 write-off of goodwill of motorsport.com and a $258,275 write-off of the web development expenses capitalized for motorsport.com and LegalGuru. Our projections for motorsport.com show continued losses and we are unable to support the goodwill balance based on these projections. LegalGuru development efforts have ceased pending further investment and, therefore, we cannot support the capitalized web development for LegalGuru. We had no goodwill or intangible asset impairment charges for the year ended December 31, 2011.

Depreciation and amortization expenses were $532,086 for the year ended December 31, 2012 as compared to $311,939 for the year ended December 31, 2011, representing an increase of $220,147. This increase is attributable to increases in web development amortization for LegalGuru ($127,611), Yapik ($92,912), Motorsport.com ($36,315) and AR Live ($27,021). This was partially offset by a decrease in web development amortization for Music1 of $85,793 as we had fully . . .

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