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NETE > SEC Filings for NETE > Form 10-Q on 15-May-2013All Recent SEC Filings

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Form 10-Q for NET ELEMENT INTERNATIONAL, INC.


15-May-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion should be read and evaluated in conjunction with the unaudited condensed consolidated financial statements and notes thereto contained in this Report and with the discussion under "Forward-Looking Statements" on page 2 at the beginning of this Report and the Risk Factors set forth in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2012 and in Part II, Item 1A of this Report.

Overview; Recent Developments

We have two reportable business segments, consisting of (i) mobile commerce and payment processing for electronic commerce, and (ii) entertainment and culture Internet destinations. During the quarter ended March 31, 2012, we had only one reportable business segment: entertainment and culture Internet destinations.

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.

On April 16, 2013, we entered into a Contribution Agreement with Unified Payments, LLC, a Delaware limited liability company ("Unified Payments"), TOT Group, Inc., a Delaware corporation (formerly known as TOT, Inc.), which is a direct subsidiary of the Company ("TOT Group"), Oleg Firer, individually, and Georgia Notes 18 LLC, a Florida limited liability company. Pursuant to the Contribution Agreement, on April 16, 2013, certain subsidiaries of TOT Group, which were formed for the purpose of effectuating the transactions contemplated by the Contribution Agreement, acquired substantially all of the business assets of Unified Payments. 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 Note 18 to the accompanying notes to unaudited condensed consolidated financial statements.

In addition to our payment processing operations, 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 merchants, mobile phone providers, 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 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 applications and our operations.

Results of Operations for the Quarters Ended March 31, 2013 and 2012

We reported a net loss of $3,233,831, or $(0.11) per share for the quarter ended March 31, 2013 versus a net loss of $4,523,996 (as restated), or $(0.24) per share, for the quarter ended March 31, 2012. Basic and diluted weighted average shares outstanding were 28,224,893 and 18,819,814 for the quarters ended March 31, 2013 and 2012, respectively.

Net revenues consist of payment processing fees, advertising fees, license fees and membership fees. Net revenues for the quarter ended March 31, 2013 were $874,515, of which $868,401 were payment processing fees from our subsidiary TOT Money in Russia. Additionally, we earned $1,331 from Openfilm and $4,783 from Motorsport web businesses. Net revenues for the quarter ended March 31, 2012 were $74,810, which were primarily comprised of fees generated by our subsidiaries Music1 ($34,031), Motorsport ($31,960) and Openfilm ($8,238). Music1 revenues are primarily services fees while Motorsport revenues are primarily advertising revenue. As of February 8, 2013, A&R Music Live is no longer owned by Music1, so our results of operations in future periods will no longer include service fees generated by A&R Music Live. Openfilm revenues are a mix of license fees, advertising and subscription fees. The increase in net revenues in the quarter ended March 31, 2013 compared to the quarter ended March 31, 2012 is primarily a result of the launch of our mobile commerce payment processing operations in Russia during the third quarter of 2012 through TOT Money. Our results of operations for the quarter ended March 31, 2012 include only the operations of our online media products (websites and mobile applications).

Operating expenses totaled $3,793,451 for the quarter ended March 31, 2013 versus $4,186,995 for the quarter ended March 31, 2012. Most of total operating expenses in each of such periods consisted of general and administrative expenses. For the quarter ended March 31, 2013, general and administrative expenses were $3,068,325, or 80.9% of total operating expenses during that period. For the quarter ended March 31, 2012, general and administrative expenses were $4,017,747 (as restated), or 96.0% of total operating expenses during that period. The components of our general and administrative expenses are discussed below.

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 quarter ended March 31, 2013 was $275,466 as compared to $100,585 for the three months ended March 31, 2012, which represents an increase of $174,881, or 173.9%. The increase in cost of revenues is primarily due to $264,504 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, partially offset by a $89,623 decline in cost of revenues in Motorsport, Openfilm and other web properties due to decreased revenues. The following table details our cost of revenues by entity or web property for the quarters ended March 31, 2013 and 2012.

                                                           Variance
                            Qtr End      Qtr Ended       Increase /
Entity or Web Property    3/31/2013      3/31/2012       (Decrease)
OOO TOT Money            $  264,504     $        -     $    264,504
Yapik                           250            736             (486 )
LegalGuru                       130              -              130
Openfilm                    (16,000 )       23,172          (39,172 )
Motorsport                   15,789         60,106          (44,317 )
Music1                       10,793         16,571           (5,778 )
                         $  275,466     $  100,585     $    174,881

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 (which previously was owned by Music1), 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.

General and administrative expenses were $3,068,325 for the quarter ended March 31, 2013 as compared to $4,017,747 (as restated) for the quarter ended March 31, 2012, representing a decrease of $949,421, or 23.6%. General and administrative expenses for the quarter ended March 31, 2013 and 2012 consisted of operating expenses not otherwise delineated in our Unaudited Condensed Consolidated Statements of Operations, including certain salaries, benefits, taxes, professional fees, travel, rent, Internet expenses and other expenses required to run our business. General and administrative expenses for the quarter ended March 31, 2013 and 2012 were attributable to:

                                                     Three Months       Three Months
                                                        Ended              Ended
                                                      March 31,          March 31,         Increase /
Category                                                 2013               2012           (Decrease)
Non-cash compensation expense                       $            -     $    2,661,772     $  (2,661,772 )
Salaries, benefits, taxes and contractor payments        1,054,225            637,718           416,507
Professional fees                                        1,145,992            335,120           810,872
Rent                                                        95,114             69,206            25,908
Product development                                         69,082             50,711            18,371
Business development                                        63,044            142,841           (79,797 )
Travel expense                                             192,942             69,373           123,569
Filing fees                                                 12,322              8,495             3,827
Other expenses                                             435,604             42,511           393,093
  Totals                                            $    3,068,325     $    4,017,747     $    (949,422 )

Non-cash compensation expense was $0 and $2,661,772 for the quarters ended March 31, 2013 and 2012, respectively. No stock based compensation was issued during the first quarter of 2013. For the quarter ended March 31, 2012, we incurred $2,661,772 in non cash compensation expense comprised of $1,333,334 in compensation expense related to a subscription agreement entered into with one of our current directors, Kenges Rakishev, pursuant to which shares of common stock were sold to Mr. Rakishev below the market price at the time of sale, $806,667 in compensation expense related to a subscription agreement entered into with one of our current directors, Felix Vulis, pursuant to which shares of common stock and warrants were sold to Mr. Vulis below the market price at the time of sale, and $521,771 in compensation expense primarily for employee stock option and share grants.

Salaries, benefits, taxes and contractor payments were $1,054,225 for the quarter ended March 31, 2013 as compared to $637,718 for the quarter ended March 31, 2012, representing an increase of $416,507, or 65.3%. The increase was attributable to Net Element Russia ($238,673), Music1 ($124,910) and Splinex ($51,787), partially offset by decreases in salaries, benefits and taxes at Yapik ($17,910), Openfilm ($11,205), LegalGuru ($9,288) and Corporate ($5,188). Net Element Russia began operations in the second quarter of 2012 so it had no expenses in the quarter ended March 31, 2012. Music1 expenses were higher due to higher headcount during the quarter ended March 31, 2013 than for the same period during 2012. Splinex salaries and benefits were higher due to a shift from consulting to salaries during 2013. These increases were partially offset by decreased salaries, benefits and taxes in Yapik, Openfilm, LegalGuru and Corporate for the quarter ended March 31, 2013, all due to reduced headcount.

Professional fees were $1,145,992 for the quarter ended March 31, 2013 as compared to $335,120 for the quarter ended March 31, 2012. The most significant increases were attributable to general legal fees ($294,132), Securities and Exchange Commission compliance ($140,564) and accounting / auditing fees ($388,225). General legal expenses increased $294,132 during the quarter ended March 31, 2013 versus the quarter ended March 31, 2012 due to the use of additional outside legal counsel by Bond Street Management. Pursuant to the Company's Management and Consulting Agreement with Bond Street Management, the Company was required to reimburse Bond Street Management for all of its documented business expenses incurred directly on behalf of the Company. On April 15, 2013, the Company entered into an agreement to terminate its Management and Consulting Agreement with Bond Street Management because the Company no longer needed the services of Bond Street Management. Legal fees for Securities and Exchange Commission compliance were $140,564 higher due to an increase in the complexity of the Company's filings during the quarter ended March 31, 2013 versus the quarter ended March 31, 2012. Accounting and auditing fees were $388,225 higher as the Company changed auditors from a local firm to a national firm.

Rent expense increased by $25,908, or 37.4%, from $69,206 for the quarter ended March 31, 2012 to $95,114 for the quarter ended March 31, 2013, primarily due to our newest office in Russia that did not exist during the quarter ended March 31, 2012.

Business development expenses were $63,044 for the quarter ended March 31, 2013 as compared to $142,841 for the quarter ended March 31, 2012. For the quarter ended March 31, 2012, the Company incurred $132,953 of expenses relating to the Ferrari Challenge. For the quarter ended March 31, 2013, $52,600 was incurred for the Ferrari Challenge. For the quarter ended March 31, 2012, the Company incurred business development expenses of $8,979 for LegalGuru development efforts. For the quarter ended March 31, 2013, there were no business development expenses for LegalGuru.

Travel expenses were $192,942 for the quarter ended March 31, 2013 and $69,373 for the quarter ended March 31, 2012. Travel costs were higher for the quarter ended March 31, 2013 due to increased travel to Russia in connection with the Russian operations of TOT Money. Our Russian operations were not started until the second quarter of 2012 so there was not extensive Russian travel during the first quarter of 2012. During the quarter ended March 31, 2013, we also had more persons traveling due to the Management and Consulting Agreement with Bond Street Management.

Other expenses were $435,603 for the quarter ended March 31, 2013 as compared to $42,511 in other expenses for the quarter ended March 31, 2012. Included in the $435,603 of other expenses for the quarter ended March 31, 2013 were incremental other expenses from our Russian operations of $328,942 and corporate expenses including $32,000 in NASDAQ fees, $13,760 in taxes & licenses and $10,870 in office supplies. Of the $328,942 in other expenses from Russia, $268,689 was due to foreign currency losses in operating activities and $60,253 in other office expenses (telephone, training, bank fees, office supplies).

We recorded a provision for loan losses of $406,585 for the quarter ended March 31, 2013, which is comprised primarily of a 10% general loan loss provision for advances to aggregators. Due to limited experience with advances to aggregators, a loan loss provision of approximately 10% of the outstanding balance is maintained against advances to aggregators, since we generally are unable to obtain financial information from the aggregators to perform a full credit review. A loan loss provision charge of $406,585 was recorded at March 31, 2013 to maintain the 10% loss reserve. The total loss provision for advances to aggregators at March 31, 2013 was $956,585. Net advances to aggregators as of March 31, 2013 was $8,128,762. We had no provision for loan losses for the quarter ended March 31, 2012.

Depreciation and amortization expense consists of depreciation expense on fixed assets used by the Company and the amortization of capitalized website development, intellectual property and deferred compensation expenses. Depreciation and amortization expense was $43,075 for the quarter ended March 31, 2013 as compared with $68,663 for the quarter ended March 31, 2012. The $25,588 variance is primarily related to a $29,971 reduction in amortization of intangibles for Motorsport as all the intangibles were written off at December 31, 2012 for this business. There also was a reduction of amortization in Yapik of $10,839 as no further web development occurred for the quarter ended March 31, 2013. This was partially offset by a $10,568 increase in depreciation expense for Net Element Russia (did not exist in 2012) and a $3,435 increase in depreciation expense for Splinex which acquired additional assets subsequent to March 31, 2012.

Interest expense was $250,570 for the quarter ended March 31, 2013 as compared with $72,674 for the quarter ended March 31, 2012. Interest expense for the quarter ended March 31, 2013 is attributable to the credit line and factoring line that OOO TOT Money has with Alfa Bank (did not exist in 2012). Interest expense for the three months ended March 31, 2012 includes interest on convertible loans from Enerfund to Net Element ($49,025 in interest expense at 5% per annum) with principal balances totaling $3,600,000 and a loan from Enerfund to Openfilm with a principal balance of $1,667,762 ($20,790 in interest expense at 5% per annum).

Other expenses totaled $80,541 for the three months ended March 31, 2013 compared to other expenses of $411,225 for the three months ended March 31, 2012. Other expenses for the quarter ended March 31, 2013 were comprised of $83,823 from the disposition of A&R Music Live partially offset by other income of $3,282 from Net Element Corporate. Other expenses for three months ended March 31, 2012 were primarily attributable to the amendment of amounts payable to prior owners of Motorsport.com.

The net loss attributable to non-controlling interests relating to Yapik, LLC, LegalGuru, LLC, and Splinex, LLC was $16,216 for the three months ended March 31, 2013 as compared with net attributable to non-controlling interests of $72,088 for the three months ended March 31, 2012. The non-controlling interest reflects the results of operations of subsidiaries that are allocable to equity owners other than the Company.

Liquidity and Capital Resources

The Company's total assets at March 31, 2013 were $23,802,809 compared to $28,378,634 at December 31, 2012. The change in total assets is primarily attributable to the significant decrease in net notes receivable (which decreased $5,531,562) and cash (which decreased $3,606,971, including a $2,056,821 decrease in restricted cash), partially offset by increases in the Company's accounts receivable (which increased $1,041,985) and net advances to aggregators (which increased $3,351,729) as of March 31, 2013 compared to December 31, 2012 resulting from the reinvestment of proceeds from notes receivable from payment processing operations into advances to aggregators.

At March 31, 2013, we had total current assets of $22,841,516 including $2,029,588 of cash, $557,372 in net notes receivable, $11,905,562 of accounts receivable, $8,128,762 in net advances to aggregators and $220,232 of prepaid expenses and other assets. At December 31, 2012, we had total current assets of $27,874,752 including $3,579,737 of cash, $2,056,821 of restricted cash (consisting of approximately $1.8 million deposited in a segregated bank account pursuant to our credit facility with Alfa-Bank, and $250,000 in a certificate of deposit that was liquidated in February 2013), $6,088,934 in net notes receivable, $10,863,577 of accounts receivable, $4,777,033 in net advances to aggregators and $508,650 of prepaid expenses and other assets.

As of the date this Report was filed with the Commission, management expects that our cash flows from operations and existing available cash will not be sufficient to fund our current operations through 2013. We expect to have a significant increase in our capital requirements during the 2013 fiscal year due to our expanding payment processing operations, including as a result of our acquisition of the business assets of Unified Payments, LLC. In connection with the closing of our acquisition of Unified Payments' business assets on April 16, 2013, we assumed, among other obligations and liabilities, approximately $23.4 million of Unified Payments' long-term debt (which includes approximately $12.5 million currently owed in respect of an outstanding preferred equity interest in Unified Payments, LLC that is to be converted on January 1, 2014 into a 8% interest only loan and assumed on such date by a subsidiary of TOT Group) and approximately $1.2 million of other liabilities reflected on or reserved against on Unified Payments' balance sheet as of the closing date. Such long-term debt
(including the outstanding preferred equity interest in Unified Payments, LLC)
currently bears interest at rates ranging from 8% to 15.63% and has maturity dates ranging from October 2014 until January 2016. We also are seeking a way to buy, license or build our own mobile payment processing system since we are currently using on a trial basis for no consideration the payment processing systems of RM Invest, which is another payment processing business operating in Russia.

We currently believe that we will require an additional $11.5 million (including $5.5 million to purchase certain credit card portfolios) in financing to continue operations as currently conducted, to integrate and continue the operations of Unified Payments' and our combined payment processing businesses and to pay for other currently anticipated capital expenditures over the next 12 months. We have historically been dependent upon our director and majority stockholder, Mike Zoi (including entities directly or indirectly controlled by Mr. Zoi), and/or other affiliates of the Company, to fund our operations and we are exploring additional sources of financing in order to meet our financial requirements. Additional funds may be raised through debt financing and/or the issuance of equity securities, there being no assurance that any type of financing on terms satisfactory to us will be available or otherwise occur. Debt financing must be repaid regardless of whether we generate revenues or cash flows from operations and may be secured by substantially all of our assets. Any equity financing or debt financing that requires the issuance of equity securities or warrants to the lender would cause the percentage ownership by our current stockholders to be diluted, which dilution may be substantial. Also, any additional equity securities issued may have rights, preferences or privileges senior to those of existing stockholders. If such financings are not available when required or are not available on acceptable terms, we may be unable to implement our business plans or take advantage of business opportunities, any of which could have a material adverse effect on our business, financial condition, results of operations and/or prospects and may ultimately require us to suspend or cease operations, which could cause investors to lose the entire amount of their investment.

Operating activities used $7,212,072 of cash for the quarter ended March 31, 2013, compared to $1,276,012 (as restated) of cash for the quarter ended March 31, 2012. The net loss for the quarter ended March 31, 2013 was $3.2 million, which included $406,585 of provision for bad debts as our advances to aggregators increased significantly. The majority of the cash used in operating activities went to increase our working capital in TOT Money (Russia) as we continue to expand our payment processing business. Specifically, our accounts receivable (due from mobile operators) increased $1.0 million while our advances to aggregators increased $3.5 million as we continue to seek additional business transactions from content providers.

Investing activities provided $5,080,105 of cash for the quarter ended March 31, 2013, compared to using $190,624 of cash for the quarter ended March 31, 2012. The increase in cash provided in investing activities for the quarter ended March 31, 2013 was primarily attributable to $5,231,562 of net repayments on two loans originally made during 2012 (which are described below) partially offset by $454,814 in cash advanced to Unified Payments as a loan made prior to the closing of our acquisition of Unified Payments' business.

We did not have any outstanding loans receivable during the quarter ended March 31, 2012.

On July 12, 2012, our Russian subsidiary, TOT Money, entered into a loan agreement pursuant to which it agreed to loan RM Invest up to a maximum of 200 million Russian rubles (approximately $6.6 million in U.S. dollars), which, on August 16, 2012, was increased to 300 million Russian rubles (approximately $9.8 million in U.S. dollars). RM Invest is a payment processing business operating in Russia whose payment processing systems are currently being used by TOT Money. RM Invest is 20% owned by TOT Money's general director, Tcahai Hairullaevich Katcaev. As of March 31, 2013, the outstanding principal loan balance and accrued interest was 8 million rubles (approximately $257,372 in U.S. dollars). The original interest rate on the loan was 10% from the date of advance to the date of scheduled repayment and the original stated maturity date of the loan was October 31, 2012. On February 25, 2013, TOT Money refinanced the loan with RM Invest and extended the maturity date until October 1, 2013. As of February 25, 2013, the remaining balance of this loan does not accrue interest. The loan was fully satisfied in April 2013. For additional information, see Note 5 of the accompanying notes to unaudited condensed consolidated financial statements.

In addition, on November 26, 2012, the Company entered into a loan agreement with Infratont Equities, Inc., pursuant to which the Company loaned $1,791,475 to Infratont Equities for the purpose of providing the borrower with working capital and funding of business development in general. As of March 31, 2013, the outstanding principal loan balance and accrued interest was $1.2 million. The loan matures on November 15, 2013 and accrues interest at a rate of 1.75% . . .

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