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NETE > SEC Filings for NETE > Form 10-K on 15-Apr-2014All Recent SEC Filings

Show all filings for NET ELEMENT, INC.

Form 10-K for NET ELEMENT, INC.


15-Apr-2014

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, 2013, we operate in a single operating segment, that being a provider of transactional services and mobile payment solutions in the United States and emerging countries, including the CIS. During the year ended December 31, 2012, we had two operating segments, consisting of (i) mobile commerce and payment processing, and (ii) entertainment and culture Internet destinations, in the United States and emerging countries, including the Commonwealth of Independent States (CIS). However, during the quarter ended September 30, 2013, we divested all of our interests in online media businesses and operations (which comprised our entertainment and culture Internet destinations business segment), which are presented as discontinued operations for the years ended December 31, 2013 and December 31, 2012 (restated).

The Company previously owned several popular content monetization verticals (i.e., interests in online media businesses and operations) that were divested during the quarter ended September 30, 2013 (see Note 5 for additional information regarding this divestiture). As a result of this divestiture, the Company operates in a single operating segment, that being a provider of mobile commerce and payment processing services in two geographical locations, the United States and International. Operations of the divested businesses are presented as discontinued 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.

Payment and Transaction Processing Business

The Company's subsidiary TOT Group, Inc. ("TOT Group") is a multinational, mobile payments and transaction processing holding company, which provides a range of flexible online and offline payment solutions. Clients include wireless carriers, content providers and merchants. TOT Group delivers comprehensive, end-to-end payment solutions to enable merchants to reliably accept cashless transactions at the point of sale ("POS"). From processing electronic payments at the POS to processing mobile commerce transactions to managing merchant terminals and providing information management services, TOT Group through its proprietary technology offers innovative solutions which allow its merchants to streamline their payments resources. Through TOT Group, the Company generates revenues from transaction fees, service fees, percentage of the dollar amount of each transaction and other fees associated with processing of cashless transactions at the points of sale. The Company serves merchants primarily in the retail, restaurant, supermarket, petroleum and hospitality sectors. In addition, TOT Group (through its subsidiary OOO TOT Money ("TOT Money")) operates the Company's provider of carrier-integrated mobile payments solutions. TOT Money's relationships with mobile operators give the Company substantial geographic coverage, a strong capacity for innovation in mobile payments and messaging, and the ability to offer customers In-App, P-SMS and Online and Carrier Billing solutions in over 49 countries.

During the third quarter of 2012, our subsidiary, TOT Money, launched operations as a provider of carrier-integrated mobile payments solutions in Russia. Since then, TOT Money has continued seeking to expand its carrier-integrated mobile payments 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, certain subsidiaries of TOT Group acquired substantially all of the business assets of Unified Payments, LLC, a Delaware limited liability company. 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 4 to the accompanying Notes to Consolidated Financial Statements.

On June 24, 2013, TOT Group, through its newly formed subsidiary Aptito, LLC ("Aptito") acquired substantially all of the business assets of Aptito.com, Inc., a New York corporation, a new generation of smart, customer engaged, patent-pending payments platform, mobile Point of Sale ("mPOS"), mobile commerce application and self-ordering AppleŽ iPadŽ-based kiosk. See Note 4 for additional information regarding this acquisition.

Discontinuance of Entertainment Business

On September 25, 2013, we entered into a Contribution Agreement (the Divestiture Contribution Agreement) with T1T Lab, LLC, a Florida limited liability company (T1T Lab), and T1T Group, LLC, a Delaware limited liability company (T1T Group), pursuant to which, on September 25, 2013, we contributed to T1T Lab all of our membership and participation interests in our subsidiaries Openfilm, LLC, Motorsport, LLC, Splinex, LLC, LegalGuru, LLC and MUSIC 1 LLC (a/k/a OOO Music1) (collectively, the Disposed Subsidiaries). The Disposed Subsidiaries constitute all of the Company's interests in online media businesses and operations (referred to herein collectively as the Company's "entertainment assets"). Immediately following the transactions effectuated pursuant to the Divestiture Contribution Agreement, the Company indirectly owned a minority interest in the Disposed Subsidiaries through its 10% membership interest in T1T Lab and the other 90% membership interest in T1T Lab is owned by T1T Group (which is indirectly wholly-owned by Mike Zoi, a director and majority stockholder of the Company). The Company disposed its entertainment assets in order to focus its business operations on mobile payments, transactional services and related technologies and to reduce the significant expenses associated with developing and maintaining the entertainment assets. During the first quarter of 2014, Company further reduced its liabilities by divesting its remaining 10% ownership interest in T1T Lab, LLC in exchange for termination of its obligation to commit funding of T1T Lab, LLC associated with its equity ownership. For additional information regarding the divestiture of the Company's entertainment assets, see Note 5 of the accompanying Notes to Consolidated Financial Statements.

Since our inception, 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, it could harm our revenues and materially adversely affect our financial condition and results of operations. 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 and operations.

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. The Company recognizes revenue when the following four basic criteria have been met: (1) persuasive evidence of a sales arrangement exists; (2) performance of services has occurred, (3) the sales price is fixed or determinable, and (4) collectability is reasonably assured. The Company considers persuasive evidence of a sales arrangement to be the receipt of a billable transaction from aggregators, signed contract or website advertising insertion order. Collectability is assessed based on a number of factors, including transaction history with the customer and the credit worthiness of the customer. If it is determined that the collection is not reasonably assured, revenue is not recognized until collection becomes reasonably assured, which is generally upon receipt of cash. The Company records cash received in advance of revenue recognition as deferred revenue.

Reserve for Loan Losses. The Company monitors all accounts receivable, notes receivable and transactions with mobile operators and 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 the lawsuit filed by First Data (see Note 14 of the accompanying Notes to Consolidated Financial Statements), the Company has reserved the $2.1million that it is due from First Data. The effect, net of interchange and Visa/Master card costs, was a charge to bad debt in the amount of $703,768 in December 2013. In addition, there were additional charges to bad debts for $423,179 for net ACH rejects that occurred in the normal course of operations.

In addition, the Company fully reserved the $1.8 million due to the Company by the former general director of TOT Money in connection with a June 2013 settlement agreement that is recorded as a note receivable.

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 their 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, 2013 Compared to the Year Ended December 31, 2012

We reported a net loss of $48,309,347, or $(1.70) per share, for the year ended December 31, 2013 as compared with a net loss of $16,389,931, or $(0.77) per share, for the year ended December 31, 2012. Loss from continuing operations (including loss attributable to the noncontrolling interest) for the year ended December 31, 2013 was $48,099,020 or ($1.65) per share as compared to a loss from continuing operations of $13,223,466 or ($0.62) per share for the year ended December 31, 2012. Our net loss for the years ended December 31, 2013 and 2012 primarily resulted from our impairment of goodwill, increase in provision for loan losses and general and administrative expenses, as discussed further below.

Net revenues consist primarily of payment processing fees. Net revenues were $18,749,470 for the year ended December 31, 2013 as compared to $1,384,852 for the year ended December 31, 2012. The increase in net revenues is primarily a result of the purchase of Unified Payments, LLC and a full year of operations of TOT Money in 2013. The following table sets forth our sources of revenues for the years ended December 31, 2013 and 2012.

                                                              For the year ended December 31,
Source of Revenues                                            2013               2012 (as restated)       Increase / (Decrease)
Credit Card Processing Fees                             $      14,798,488       $                  -     $            14,798,488
Mobile Payment Processing                                       3,948,087                  1,312,152                   2,635,935
Other Revenues                                                      2,895                     72,700                     (69,805 )
Total                                                   $      18,749,470       $          1,384,852     $            17,364,618

Net revenues for the year ended December 31, 2012 were primarily service fees from TOT Money ($1,312,152).

Cost of revenues represents direct costs of generating revenues, including commissions, purchases of short numbers, interchange expense and processing fees. Cost of revenues for the year ended December 31, 2013 was $13,374,669 as compared to $832,909 for the year ended December 31, 2012. The year over year increase in cost of revenues of $12,541,760 is primarily a result of the purchase of Unified Payments, LLC ($12,055,118) and a full year of operations of TOT Money in 2013 ($539,436).

Operating expenses totaled $50,121,253 for the year ended December 31, 2013, as compared to total operating expenses of $13,992,640 for the year ended December 31, 2012. Total operating expenses for the year ended December 31, 2013 consisted of general and administrative expenses ($28,166,387) or (56% of the operating expenses), provision of loan losses ($7,640,008), goodwill impairment ($11,200,000), intangible assets impairment ($872,354) and depreciation and amortization ($2,242,504). For the year ended December 31, 2012, general and administrative expenses were $12,088,602, or 86% of total operating expenses, during the period. Loan losses for the year ended December 31, 2012 were $1,638,032 and depreciation and amortization was $266,006. The components of our general and administrative expenses are discussed below.

General and administrative expenses were $28,166,387 for the year ended December 31, 2013 as compared to $12,088,602 for the year ended December 31, 2012. General and administrative expenses for the years ended December 31, 2013 and 2012 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                  Year
                                                         Ended                Ended
                                                     December 31,          December 31,
Category                                                 2013           2012 (as restated)       Increase / (Decrease)
Non-cash compensation expense                        $  16,549,820     $          6,240,196     $            10,309,624
Salaries, benefits, taxes and contractor payments        4,331,580                2,985,007                   1,346,573
Professional fees                                        4,003,850                2,170,379                   1,833,471
Other expenses                                           3,281,137                  693,020                   2,588,117
Totals                                               $  28,166,387     $         12,088,602     $            16,077,785

Non-cash compensation expense from subscription agreements and share-based compensation was $16,549,820 for the year ended December 31, 2013 compared to $6,240,196 for the year ended December 31, 2012. The non-cash compensation expenses were higher for the year ended December 31, 2013 primarily due to the value of stock issued to employees pursuant to the acquisition of the 10% minority interest in TOT Group, Inc. (see Note 4 to the accompanying notes consolidated financial statements).

Salaries, benefits, taxes and contractor payments were $4,331,580 for the year ended December 31, 2013 as compared to $2,985,007 for year ended December 31, 2012, representing an increase of $1,346,573 as follows:

                                                        Salaries and           Salaries and
                                                      Benefits for the       Benefits for the
                                                         Year Ended             Year Ended
                                                        December 31,         December 31, 2012       Variance Increase /
                      Group                                 2013               (As restated)             (Decrease)
Net Element, Inc (Corporate)                         $          921,138     $         1,370,535     $            (449,397 )
Yapik                                                                 -                 109,723                  (109,723 )
NetLabs (Engineering)                                           926,301               1,096,211                  (169,910 )
Aptito                                                           44,524                       -                    44,524
Music                                                           203,644                 224,802                   (21,158 )
TOT Payments                                                  1,128,078                       -                 1,128,078
TOT Money                                                       543,907                  91,534                   452,373
Net Element Russia                                              563,988                  92,202                   471,786
Total                                                $        4,331,580     $         2,985,007     $           1,346,573

The primary reason for the increase are the salaries of TOT Payments, in the amount of $1,128,078 which was not part of the consolidated group in 2012 and Net Element Russia and TOT Money attributable to a full twelve months of operations in 2013. These were offset by decreases in Net Element (Corp) ($449,397), Yapik ($109,723) and Net Labs ($169,910) due to scaling back of operations and cost cutting.

Professional fees were $4,003,850 for the year ended December 31, 2013 as compared to $2,170,379 the year ended December 31, 2012, representing an increase of $1,833,471 as follows:

                                                             Year                     Year
                                                      Ended December 31,       Ended December 31,       Variance Increase /
                                                             2013              2012 (as restated)           (Decrease)
                                                                                      2012
                                                             2013                (as restated)
General Legal                                        $            746,490     $            265,189     $             481,301
SEC Compliance Legal Fees                                         401,143                  784,684                  (383,541 )
Accounting and Auditing                                         1,125,486                  462,836                   662,650
Tax Compliance and Planning                                        71,400                    3,800                    67,600
IT & Call Center Services                                         797,262                        -                   797,262
Consulting                                                        862,069                  653,870                   208,199
Total                                                $          4,003,850     $          2,170,379     $           1,833,471

The most significant increases in professional fees were attributable to general legal fees ($481,301), accounting / auditing fees ($662,650) and IT & Call Center Services ($797,262). General legal expenses increased $481,301 during the year ended December 31, 2013 versus the year ended December 31, 2012 due to the use of additional outside legal counsel to assist in the reorganization of the Company after its merger transaction with Net Element. Accounting and auditing fees were $662,650 higher as the Company changed auditors from a local firm to a national firm and there was additional work related to the merger and acquisitions and deconsolidation. IT & Call Center Services were used by TOT Money to assist in their mobile payment processing operations.

Other expenses were $3,281,137 for the year ended December 31, 2013 as compared to $693,020 in other expenses for the year ended December 31, 2012, representing an increase of $2,588,117. Other expenses for the year ended December 31, 2013 was primarily attributed to acquisition of TOT Payments in 2013.

We recorded a provision for bad debts and unrecoverable advances of $7,640,008 for the year ended December 31, 2013, which is primarily comprised of $4,528,759 in loss provision for advances to aggregators, $1,834,302 in loss provision for notes receivable and $703,768 from reserving revenue and costs related to the First Data lawsuit (See Note 14 of the accompanying notes to Consolidated Financial Statements and Liquidity and Capital Resources below) and $423,179 from net ACH rejects in the normal course of operations. We had $1,638,032 for bad debts and unrecoverable advances for the year ended December 31, 2012.

During the year ended December 31, 2013 the Company recognized $11,200,000 of non-cash, goodwill impairment losses relating to the goodwill from the Unified Payments acquisition. In connection with that acquisition, the Company recorded goodwill of approximately $17 million. As part of its financial statement closing processes, as well as the Company's review of its valuation of the Unified Payments business combination, the Company determined that the reported goodwill of its TOT Payments reporting unit was impaired at December 31, 2013.

Depreciation and amortization expense consists of depreciation expense on fixed assets used by the Company and the amortization of merchant portfolios, client acquisition costs, IP software, intellectual property and employee non-compete agreements. Depreciation and amortization expense was $2,242,504 for the year ended December 31, 2013 as compared with $266,006 for the year ended December 31, 2012. The $1,976,498 increase in depreciation and amortization expense was primarily due to $1,799,225 of merchant portfolio amortization and $85,769 of amortization of client acquisition costs.

Total interest expense, net for the year ended December 31, 2013 amounted to $2,979,102 versus $370,568 of interest income, net for the year ended December 31, 2012. The increase in interest expense, net was primarily due to TOT Group's assumption of $20.6 million of indebtedness in connection with its acquisition of the business operations of Unified Payments, which resulted in interest expense of $2,137,852 the year ended December 31, 2013. This includes $942,961 of interest expense on notes payables that had a total balance of $9,865,889 at December 31, 2013 and $1,194,891 of interest for the loan payable to Georgia Notes, LLC of $11,098,066 at December 31, 2013 (see Note 12 of the accompanying Notes to Consolidated Financial Statements). Interest expense for the year ended December 31, 2013 also includes $819,214 of interest on a factoring line that TOT Money has with Alfa Bank.

Interest income, net for the year ended December 31, 2012 was $370,568, which primarily was composed of interest income from TOT Money loan to RM Invest.

The company recognized the Intangible assets impairment in the amount of $872,354. This is due to the write off of the First Data Portfolio. The First Data portfolio was written off entirely at December 31, 2013 since the lawsuit to regain the portfolio was dismissed in early 2014

The net loss attributable to noncontrolling interests amounted to $1,129,319 for the year ending December 31, 2013 as compared to $133,360 year ending December 31, 2012. The $1,204,059 was primarily attributed to TOT Group. The noncontrolling interest reflects the results of operations of subsidiaries that are allocable to equity owners other than the Company.

Since our inception, we have incurred significant operating losses. We incurred net losses totaling $48.3 million and $16.4 million for the years ended December 31, 2013 and 2012, respectively. We had negative cash flows from operating activities of $10.8 million for the year ended December 31, 2013 and an accumulated deficit of $119 million at December 31, 2013. We had negative working capital of $8.0 million at December 31, 2013, and our current assets at December 31, 2013 included $10.6 million of accounts receivable, and $1.1 million of advances to aggregators. These conditions raise substantial doubt about our ability to continue as a going concern. The independent auditors' report on our consolidated financial statements for the year ended December 31, 2013 contains an explanatory paragraph expressing substantial doubt as to our ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern. See also "Liquidity and Capital Resources" below.

Liquidity and Capital Resources

The Company's total assets at December 31, 2013 were $22,508,725 compared to $28,378,634 at December 31, 2012. The year over year change in total assets is primarily attributable to the significant decreases in the Company's cash used to support operations and reductions in notes receivable and advances to aggregators as of December 31, 2013 compared to December 31, 2012.

At December 31, 2013, we had total current assets of $12,689,171 including $126,319 of cash, $10,619,289 of accounts receivable, $1,109,538 of advances to aggregators and $834,025 of prepaid expenses and other assets. At December 31, 2012, we had total current assets of $28,005,205 including $3,546,787 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, $10,855,175 of accounts receivable, $4,777,033 in advances to aggregators and $487,995 of prepaid expenses and other assets.

The Company is currently negotiating an $11.2 million convertible note with Cayman Invest, SA. The draft terms of the agreement call for a zero interest . . .

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