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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 FOR THE PERIOD ENDED JUNE 30, 2005
OR
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
COMMISSION FILE NUMBER: 0-15245
-------------------------------
[GRAPHIC OMITTED]
ECHO
Electronic Clearing House
ELECTRONIC CLEARING HOUSE, INC.
(Exact name of registrant as specified in its charter)
NEVADA 93-0946274
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
730 PASEO CAMARILLO,
CAMARILLO, CALIFORNIA 93010
(Address of principal executive offices)
TELEPHONE NUMBER (805) 419-8700, FAX NUMBER (805) 419-8682
WWW.ECHO-INC.COM
(Registrant's telephone number, fax number, including area code; web site
address)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days:
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
As of July 26, 2005, there were 6,555,981 shares of the Registrant's Common
Stock outstanding.
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ELECTRONIC CLEARING HOUSE, INC.
INDEX
-----
PART I. FINANCIAL INFORMATION
Page No.
--------
Item 1. CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED):
Consolidated Balance Sheets 3
June 30, 2005 and September 30, 2004
Consolidated Statements of Operations 4
Three months and nine months ended
June 30, 2005 and 2004
Consolidated Statements of Cash Flows 5
Nine months ended June 30, 2005 and 2004
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of 11
Financial Condition and Results of
Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk 23
Item 4. Controls and Procedures 23
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 24
Item 6. Exhibits and Reports on Form 8-K 24
Signatures 25
2
PART I. FINANCIAL INFORMATION
--------------------------------
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
ELECTRONIC CLEARING HOUSE, INC.
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
ASSETS
JUNE 30, SEPTEMBER 30,
2005 2004
------------ ---------------
Current assets:
Cash and cash equivalents $ 6,800,000 $ 7,576,000
Restricted cash 1,225,000 1,024,000
Settlement deposits 18,472,000 18,282,000
Settlement receivable less allowance of $25,000 and $22,000 835,000 451,000
Accounts receivable less allowance of $126,000 and $111,000 2,092,000 1,943,000
Prepaid expenses and other assets 393,000 368,000
Deferred tax asset 148,000 279,000
------------ ---------------
Total current assets 29,965,000 29,923,000
Noncurrent assets:
Property and equipment, net 2,397,000 2,293,000
Software, net 8,510,000 6,844,000
Other assets, net 304,000 368,000
------------ ---------------
Total assets $41,176,000 $ 39,428,000
============ ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Short-term borrowings and current portion of long-term debt
and capital leases $ 552,000 $ 878,000
Accounts payable 358,000 305,000
Settlement payable 19,519,000 18,733,000
Accrued expenses 1,979,000 2,003,000
------------ ---------------
Total current liabilities 22,408,000 21,919,000
Noncurrent liabilities:
Long-term debt and capital leases 766,000 704,000
Deferred tax liability 714,000 565,000
------------ ---------------
Total liabilities 23,888,000 23,188,000
------------ ---------------
Commitments and contingencies - see Note 7
Stockholders' equity:
Common stock, $0.01 par value, 36,000,000 authorized:
6,554,481 and 6,451,331 shares issued; 6,516,212 and
6,413,062 shares outstanding 65,000 64,000
Additional paid-in capital 25,076,000 24,658,000
Accumulated deficit (7,387,000) (8,016,000)
Less treasury stock at cost, 38,269 common shares (466,000) (466,000)
------------ ---------------
Total stockholders' equity 17,288,000 16,240,000
------------ ---------------
Total liabilities and stockholders' equity $41,176,000 $ 39,428,000
============ ===============
See accompanying notes to consolidated financial statements.
3
ELECTRONIC CLEARING HOUSE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS, NINE MONTHS
ENDED JUNE 30 ENDED JUNE 30,
-------------------------- --------------------------
2005 2004 2005 2004
------------ ------------ ------------ ------------
REVENUE: $14,281,000 $12,356,000 $40,362,000 $35,822,000
COSTS AND EXPENSES:
Processing and transaction expense 9,051,000 7,791,000 25,783,000 22,494,000
Other operating costs 1,493,000 1,240,000 4,236,000 3,903,000
Research and development expense 354,000 363,000 1,271,000 1,090,000
Selling, general and administrative expenses 2,680,000 1,880,000 8,044,000 5,534,000
------------ ------------ ------------ ------------
13,578,000 11,274,000 39,334,000 33,021,000
------------ ------------ ------------ ------------
Income from operations 703,000 1,082,000 1,028,000 2,801,000
Interest income 37,000 19,000 95,000 49,000
Interest expense (29,000) (31,000) (87,000) (146,000)
Gain on sale of building -0- -0- -0- 1,319,000
------------ ------------ ------------ ------------
Income before provision for income taxes 711,000 1,070,000 1,036,000 4,023,000
Provision for income taxes (278,000) (419,000) (407,000) (1,577,000)
------------ ------------ ------------ ------------
Net income $ 433,000 $ 651,000 $ 629,000 $ 2,446,000
============ ============ ============ ============
Basic net earnings per share $ 0.07 $ 0.10 $ 0.10 $ 0.39
============ ============ ============ ============
Diluted net earnings per share $ 0.06 $ 0.09 $ 0.09 $ 0.35
============ ============ ============ ============
Weighted average shares outstanding
Basic 6,512,411 6,347,919 6,469,632 6,289,843
============ ============ ============ ============
Diluted 6,942,122 6,977,897 6,956,111 6,890,389
============ ============ ============ ============
See accompanying notes to consolidated financial statements.
4
ELECTRONIC CLEARING HOUSE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
NINE MONTHS
ENDED JUNE 30,
--------------------------
2005 2004
------------ ------------
Cash flows from operating activities:
Net income $ 629,000 $ 2,446,000
Adjustments to reconcile net income to net
cash provided by operating activities:
Gain on sale of building -0- (1,319,000)
Depreciation 558,000 446,000
Amortization of software 1,258,000 1,061,000
Provision for losses on accounts receivable 31,000 84,000
Deferred income taxes 280,000 1,561,000
Stock option compensation 8,000 25,000
Tax benefit from exercise of stock option 82,000 -0-
Changes in assets and liabilities:
Restricted cash (201,000) (65,000)
Settlement deposits (190,000) (5,120,000)
Accounts receivable (177,000) (82,000)
Settlement receivable (387,000) 219,000
Accounts payable 53,000 (455,000)
Settlement payable 786,000 4,891,000
Accrued expenses (24,000) 165,000
Prepaid expenses and other assets (25,000) 68,000
------------ ------------
Net cash provided by operating activities 2,681,000 3,925,000
------------ ------------
Cash flows from investing activities:
Other assets 36,000 17,000
Purchase of equipment (623,000) (398,000)
Proceed from sale of building -0- 2,233,000
Purchased and capitalized software (2,896,000) (2,554,000)
------------ ------------
Net cash used in investing activities (3,483,000) (702,000)
------------ ------------
Cash flows from financing activities:
Proceeds from issuance of notes payable 400,000 811,000
Repayment of notes payable (330,000) (1,827,000)
Repayment of capitalized leases (373,000) (476,000)
Proceeds from private placement of common stock -0- 2,693,000
Proceeds from exercise of stock options 329,000 131,000
------------ ------------
Net cash provided by financing activities 26,000 1,332,000
------------ ------------
Net (decrease) increase in cash (776,000) 4,555,000
Cash and cash equivalents at beginning of period 7,576,000 2,908,000
------------ ------------
Cash and cash equivalents at end of period $ 6,800,000 $ 7,463,000
============ ============
See accompanying notes to consolidated financial statements.
5
ELECTRONIC CLEARING HOUSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 - BASIS OF PRESENTATION:
------------------------------------
The accompanying consolidated financial statements as of June 30, 2005, and for
the three and nine month periods then ended are unaudited and reflect all
adjustments (consisting only of normal recurring adjustments) which are, in the
opinion of management, necessary for a fair statement of the financial position
and the results of operations for the interim periods. The consolidated
financial statements herein should be read in conjunction with the consolidated
financial statements and notes thereto, together with management's discussion
and analysis of financial condition and results of operations, contained in the
Company's Annual Report to Stockholders incorporated by reference in the
Company's Annual Report on Form 10-K for the fiscal year ended September 30,
2004. The results of operations for the three and nine months ended June 30,
2005 are not necessarily indicative of the likely results for the entire fiscal
year ending September 30, 2005.
Certain reclassifications have been made to the prior year financial statements
to conform with the current year presentations. Beginning with the first fiscal
quarter of 2005, the Company revised the way it classifies certain commission
expenses paid to its independent sales agents who sell the Company's bankcard
processing services to merchants. The gross commissions paid are now recorded
as processing and transaction expense in the consolidated statements of
operations. Previously, the commissions paid to the independent sales agents
were recorded as a reduction to the revenue earned on the transaction.
For the presentation of the three and nine months ended June 30, 2004, the
Company has revised amounts previously reported to conform to the revised
classification. None of the classification changes has an impact on the gross
margin, operating income, net income, net cash flow or any element of the
Company's consolidated balance sheets for all periods presented. The Company
does not consider the effect of these revisions in classification in 2004 or in
prior periods, individually or in the aggregate, to be material.
NOTE 2 - NEW ACCOUNTING PRONOUNCEMENT:
------------------------------------------
In December 2004, the FASB issued SFAS 123R (revised 2004), Share-Based Payment.
This statement will eliminate the ability to account for share-based
compensation transactions using APB 25, Accounting for Stock Issued to
Employees, and will require instead that compensation expense be recognized
based on the fair value on the date of the grant. Additional footnote
disclosures will be required. The Company is in the process of evaluating the
impact on the Company's consolidated financial statements. In April 2005, the
SEC amended the adoption date of SFAS 123R making it effective with the
Company's first fiscal quarter of 2006.
NOTE 3 - STOCK-BASED COMPENSATION:
-------------------------------------
The Company has elected to account for its stock-based compensation plans in
accordance with APB Opinion No. 25 and to adopt only the disclosure requirements
of FAS 123, as amended by SFAS No. 148.
The Company measures compensation expense for its employee stock-based
compensation under APB 25. The Company provides pro-forma disclosures of net
income and earnings per share as if a fair value method had been applied using
the Black Scholes option pricing model. Compensation expense is recognized in
association with the issuance of stock options for the difference, if any,
between the trading price of the stock at the time of issuance and the price to
be paid by the optionee. Compensation expense is recorded over the vesting
period. Pro forma compensation costs for employee stock and stock option awards
is amortized over the related service periods using the straight-line method.
The following table compares net income and earnings per share as reported to
the pro forma amounts that would be reported had compensation expense been
recognized for the stock-compensation plans in accordance with the fair value
recognition provisions of SFAS No. 123, as amended by SFAS No. 148, "Accounting
for Stock-Based Compensation":
6
NOTE 3: CONTINUED
-------------------
THREE MONTHS NINE MONTHS
ENDED JUNE 30, ENDED JUNE 30,
---------------------- -----------------------
2005 2004 2005 2004
---------- ---------- ---------- -----------
Net income, as reported $ 433,000 $ 651,000 $ 629,000 $2,446,000
Add: Stock-based employee
compensation expense included
in reported net income net of
related tax effect -0- 5,000 5,000 15,000
Deduct: Total stock-based employee
compensation expense determined
under fair value-based method for
all awards, net of related tax effect (133,000) (104,000) (399,000) (292,000)
---------- ---------- ---------- -----------
Pro forma net income $ 300,000 $ 552,000 $ 235,000 $2,169,000
========== ========== ========== ===========
Net earnings per share:
Basic - as reported $ 0.07 $ 0.10 $ 0.10 $ 0.39
Basic - pro forma $ 0.05 $ 0.09 $ 0.04 $ 0.34
Diluted - as reported $ 0.06 $ 0.09 $ 0.09 $ 0.35
Diluted - pro forma $ 0.04 $ 0.08 $ 0.03 $ 0.31
NOTE 4 - EARNINGS PER SHARE:
---------------------------------
The Company calculates earnings per share as required by Statement of Financial
Accounting Standard No. 128, "Earnings per Share".
THREE MONTHS NINE MONTHS
ENDED JUNE 30, ENDED JUNE 30,
---------------------- ----------------------
2005 2004 2005 2004
---------- ---------- ---------- ----------
Numerator:
Net income $ 433,000 $ 651,000 $ 629,000 $2,446,000
========== ========== ========== ==========
Denominator:
Weighted average shares outstanding
for basic earnings per share 6,512,411 6,347,919 6,469,632 6,289,843
Effect of dilutive stock options 429,711 629,978 486,479 600,546
---------- ---------- ---------- ----------
Adjusted weighted average shares
outstanding for diluted earnings
per share 6,942,122 6,977,897 6,956,111 6,890,389
========== ========== ========== ==========
Basic net earnings per share: $ 0.07 $ 0.10 $ 0.10 $ 0.39
========== ========== ========== ==========
Diluted net earnings per share: $ 0.06 $ 0.09 $ 0.09 $ 0.35
========== ========== ========== ==========
7
NOTE 4: CONTINUED
-------------------
For the three months ended June 30, 2005 and 2004, approximately 79,500 option
shares and 42,500 option shares, and for the nine months ended June 30, 2005 and
2004, approximately 79,500 option shares and 42,500 option shares, respectively,
attributable to the exercise of outstanding options were excluded from the
calculation of diluted EPS because the effect was antidilutive.
NOTE 5 - SUPPLEMENTAL CASH FLOW INFORMATION:
--------------------------------------------------
THREE MONTHS NINE MONTHS
ENDED JUNE 30, ENDED JUNE 30,
---------------- ------------------
2005 2004 2005 2004
------- ------- -------- --------
Cash paid for:
Interest $29,000 $31,000 $ 87,000 $146,000
Income taxes 42,000 1,000 154,000 8,000
Significant non-cash transaction for the nine months ended June 30, 2005 was as
follows:
- A note was issued for $39,000 for the purchase of capital equipment.
Significant non-cash transaction for the nine months ended June 30, 2004 was as
follows:
- Software purchases of $285,000 and capital equipment of $152,000 were
acquired under capital leases.
NOTE 6 - SEGMENT INFORMATION:
--------------------------------
The Company primarily operates in two business segments: Bankcard and
transaction processing and check-related products, all of which are located in
the United States.
The Company's reportable operating segments have been determined in accordance
with the Company's internal management structure, which is organized based on
the Company's product lines. The Company evaluates performance based upon two
primary factors, one is the segment's operating income and the other is based on
the segment's contribution to the Company's future strategic growth.
THREE MONTHS NINE MONTHS
ENDED JUNE 30, ENDED JUNE 30,
-------------------------- --------------------------
2005 2004 2005 2004
------------ ------------ ------------ ------------
Revenues:
Bankcard and transaction
processing $10,579,000 $ 9,519,000 $29,626,000 $27,598,000
Check-related products 3,702,000 2,837,000 10,736,000 8,224,000
------------ ------------ ------------ ------------
$14,281,000 $12,356,000 $40,362,000 $35,822,000
============ ============ ============ ============
Operating income:
Bankcard and transaction
processing $ 1,651,000 $ 1,564,000 $ 4,233,000 $ 4,406,000
Check-related products 624,000 463,000 1,577,000 1,112,000
Other - Corporate expenses (1,572,000) (945,000) (4,782,000) (2,717,000)
------------ ------------ ------------ ------------
$ 703,000 $ 1,082,000 $ 1,028,000 $ 2,801,000
============ ============ ============ ============
8
NOTE 6: CONTINUED
-------------------
JUNE 30, SEPTEMBER 30,
2005 2004
----------- -------------
Total assets:
Bankcard and transaction
processing $ 8,696,000 $ 8,014,000
Check-related products 25,995,000 23,933,000
Other - Corporate 6,485,000 7,481,000
----------- -------------
$41,176,000 $ 39,428,000
=========== =============
NOTE 7 - COMMITMENTS, CONTINGENT LIABILITIES, AND GUARANTEES:
--------------------------------------------------------------------
The Company currently relies on a cooperative relationship with, and sponsorship
by, one bank in order to process its Visa, MasterCard and other bankcard
transactions. The agreement between the bank and the Company requires the
Company to assume and compensate the bank for bearing the risk of "chargeback"
losses. Under the rules of Visa and MasterCard, when a merchant processor
acquires card transactions, it has certain contingent liabilities for the
transactions processed. This contingent liability arises in the event of a
billing dispute between the merchant and a cardholder that is ultimately
resolved in the cardholder's favor. In such a case, the disputed transaction is
charged back to the merchant and the disputed amount is credited or otherwise
refunded to the cardholder. If the Company is unable to collect this amount
from the merchant's account, and if the merchant refuses or is unable to
reimburse the Company for the chargeback due to merchant fraud, insolvency or
other reasons, the Company will bear the loss for the amount of the refund paid
to the cardholder. The Company utilizes a number of systems and procedures to
manage merchant risk. In addition, the Company requires cash deposits by
certain merchants which are held by the Company's sponsoring bank to minimize
the risk that chargebacks are not collectible from merchants.
A cardholder, through its issuing bank, generally has until the later of up to
four months after the date a transaction is processed or the delivery of the
product or service to present a chargeback to the Company's sponsoring bank as
the merchant processor. Therefore, management believes that the maximum
potential exposure for the chargebacks would not exceed the total amount of
transactions processed through Visa and MasterCard for the last four months and
other unresolved chargebacks in the process of resolution. For the last four
months through June 30, 2005, this potential exposure totaled approximately $403
million. At June 30, 2005, the Company, through its sponsoring bank, had
approximately $91,000 of unresolved chargebacks that were in the process of
resolution. At June 30, 2005, the Company, through its sponsoring bank, had
access to $10.6 million in merchant deposits to cover any potential chargeback
losses.
For the three month period ended June 30, 2005 and 2004, the Company processed
approximately $300 million (2005) and $265 million (2004) of Visa and MasterCard
transactions, which resulted in $1.9 million in gross chargeback activities for
the three months ended June 30, 2005 and $2 million for the three months ended
June 30, 2004. Substantially all of these chargebacks were recovered from the
merchants.
The Company's contingent obligation with respect to chargebacks constitutes a
guarantee as defined in Financial Accounting Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantee, Including Indirect
Guarantees of Others" ("FIN 45"). FIN 45 requires that guarantees issued or
modified subsequent to December 31, 2002 be initially recorded as liabilities in
the Statement of Financial Position at fair value. Since the Company's
agreement with its sponsoring bank, which establishes the guarantee obligation,
was entered into prior to December 31, 2002 and has not been modified since that
date, the measurement provisions of FIN 45 are not applicable to this guarantee
arrangement.
In accordance with SFAS No. 5, "Accounting for Contingencies", the Company
records a reserve for chargeback loss allowance based on its processing volume
and historical trends and data. As of June 30, 2005 and 2004, the allowance for
chargeback losses, which is classified as a component of the allowance for
uncollectible accounts receivable, was $58,000 and $157,000, respectively. The
expense associated with the valuation allowance is included in processing and
transaction expense in the accompanying consolidated statements of income. For
the three month period ended June 30, 2005 and 2004, the Company expensed $7,000
and $21,000, respectively.
9
NOTE 7: CONTINUED
-------------------
In its check guarantee business, the Company charges the merchant a percentage
of the face amount of the check and guarantees payment of the check to the
merchant in the event the check is not honored by the check writer's bank.
Merchants typically present customer checks for processing on a regular basis
and, therefore, dishonored checks are generally identified within a few days of
the date the checks are guaranteed by the Company. Accordingly, management
believes that its best estimate of the Company's maximum potential exposure for
dishonored checks at any given balance sheet date would not exceed the total
amount of checks guaranteed in the 10 days prior to the balance sheet date. As
of June 30, 2005, the Company estimates that its maximum potential dishonored
check exposure was approximately $1.6 million.
For the quarters ended June 30, 2005 and 2004, the Company guaranteed
approximately $12,039,000 (2005) and $5,616,000 (2004) of merchant checks, which
resulted in $47,000 (2005) and $29,000 (2004) of dishonored checks presented to
the Company for payments. The Company has the right to collect the full amount
of the check from the check writer. Based on its actual collection experience,
the Company collects approximately 50-60% of the total dishonored checks with
image and 10-20% without image. The Company establishes a reserve for this
activity based on historical and projected loss experience. As of June 30, 2005
and 2004, the reserve for check guarantee loss was $86,000 (2005) and $40,000
(2004). The expense associated with the valuation allowance is included in
processing and transaction expense in the accompanying consolidated statements
of income.
NOTE 8 - LITIGATION:
-----------------------
The Company is involved in various legal cases arising in the ordinary course of
business. Based upon current information, management, after consultation with
legal counsel, believes the ultimate disposition thereof will have no material
effect upon either the Company's results of operations or its financial
position.
In July 2004, LML Patent Corporation, a wholly-owned subsidiary of LML Payment
Systems, Inc. ("LML"), filed a patent infringement claim against the Company,
our subsidiary, XPRESSCHEX, Inc. and others, relating with respect to the
Company and its subsidiary, to the alleged infringement by the Company's check
conversion processes of three patents held by LML. The suit was filed in the
U.S. District Court for the District of Delaware. LML seeks an undisclosed
amount of damages in connection with the alleged infringement. In July 2005, the
parties completed their respective discovery procedures, with the exception of
one outstanding deposition. The case remains scheduled to go to trial in April
of 2006. The Company does not believe that any of its check conversion
processes infringe upon any valid or enforceable patent rights of LML and
intends to continue to vigorously defend its position against the claims made.
In light of all the facts and circumstances, the Company's management believes
that any damages award or royalty ordered against the Company, if any, would
have no material impact on the Company's results of operations, financial
position, or cash flows.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
------------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS
---------------------------------------
FORWARD-LOOKING STATEMENTS
The following discussion of the financial condition and results of operations of
Electronic Clearing House, Inc. should be read in conjunction with the
consolidated financial statements and notes thereto included elsewhere herein.
This discussion contains forward-looking statements, including statements
regarding the Company's strategy, financial performance and revenue sources,
which involve risks and uncertainties. The Company's actual results may differ
materially from those anticipated in these forward-looking statements as a
result of certain factors, including, but not limited to, those set forth
elsewhere herein, and in the Company's Annual Report on Form 10-K for the fiscal
year ended September 30, 2004.
OVERVIEW
Electronic Clearing House, Inc. is an electronic payment processor that provides
for the payment processing needs of merchants, banks and collection agencies.
We derive the majority of our revenues from two main business segments: bankcard
and transaction processing services, whereby we provide solutions to merchants
and banks to allow them to accept credit and debit card payments from consumers;
and check-related products, whereby we provide various services to merchants and
banks to allow them to accept and process check payments from consumers. The
principal services we offer within these two segments include the following:
With respect to our bankcard and transaction processing services:
- Debit and credit card processing
With respect to our check-related products:
- Check verification - prior to accepting a check, the merchant searches
our NCN database of negative and positive check writer accounts and
attempts to match a specific piece of information to determine whether
the check writer has current, delinquent check-related debts;
- Electronic check conversion - the conversion of a paper check at the
point of sale to a direct bank debit which is processed for settlement
through the Federal Reserve System's Automated Clearing House, or ACH,
network. The ACH is the electronic banking network through which the
vast majority of electronic fund transfers are made in the United
States;
- Check guarantee - if we approve a check transaction and a check is
subsequently dishonored by the check writer's bank, the merchant is
reimbursed by us and we acquire the rights to collect the delinquent
amount from the check writer;
- Check re-presentment - we convert a merchant's returned check to an
electronic ACH transaction for resubmission through the ACH network;
- Check collection - we provide national scale collection services for a
merchant or bank.
We operate our services under the following brands:
- MERCHANTAMERICA, our retail provider of payment processing services to
both the merchant and community bank markets;
- National Check Network(R), or NCN(R), our proprietary database of
negative and positive check writer accounts used for back-end check
verification, check authorization and check capture services, and for
membership to collection agencies. Negative check writer accounts
typically identify a check writer's delinquent history in the form of
non-sufficient funds and other negative transactions; and
- XPRESSCHEX(R), Inc., our registered collection agency that provides
retail check verification, check conversion, ACH services, check
collection and check guarantee services.
11
Overall, our ability to program and oversee the management of a merchant's
point-of-sale system, provide credit card and debit card processing, provide
multiple check services for the processing of checks, provide both electronic
and traditional collection services, and fully integrate all of these services
into a single Internet-based reporting capability allows us to provide for the
majority of the payment processing needs of our customers.
Bankcard and transaction processing services provide for the majority of our
revenues. We typically receive a percentage-based fee on the dollar amount
processed and a transaction fee on the number of transactions processed. For
the quarter ended June 30, 2005 and nine months ended June 30, 2005, the
bankcard and transaction processing business segment accounted for approximately
74.1% and 73.4% of the Company's total revenue, respectively.
Over the past several years, we have invested significant resources and
management focus in our check services business. Check services revenues are
primarily based on a fixed fee per transaction or a discount fee based on the
amount of the check for each transaction. For the quarter ended June 30, 2005
and nine months ended June 30, 2005, the check services business segment
accounted for approximately 25.9% and 26.6% of the Company's total revenue,
respectively. We are one of a few check processors in the nation with both an
ACH engine, which gives us the ability to transfer and settle funds using the
Automated Clearing House, and a robust check writer database (NCN), which
provides a valuable risk management service for merchants who accept checks.
NCN provides an ongoing revenue stream as collection agencies, major national
merchants, other transaction processors, and thousands of small merchants access
the NCN database daily to verify the status of a check writer in real time.
Check verification has been recognized as one of the lowest cost and most
effective ways for retailers to lower the risks and loss experience in accepting
checks as a form of payment. Our NCN database is one of only four major check
databases that serve merchants on a national level.
XPRESSCHEX revenues are growing due to the increased usage of our ACH and check
conversion services which include capturing of the necessary check data at the
merchant's point of sale. The merchant could also transmit the necessary check
data to us in a batch mode. We then submit the transaction electronically to
the ACH for settlement. Since we provide ACH and settlement services to the
merchants, all settlement funds received by us on behalf of the merchants are
recorded as settlement deposit and payable, and all settlement funds paid by us
in advance are recorded as settlement receivable. XPRESSCHEX also maintains an
active collection agency, registered in over 40 states, that serves primarily as
a referral agent to select NCN members that are collection agencies and are
located in various regions of the country.
In 2000, Visa U.S.A. announced its intention to utilize its processing network
(VisaNet), which connects to over 14,000 banks and about 5 million merchants, to
electronically process checks. This program is referred to as the Visa
Point-Of-Sale ("POS") Check Service. The Visa POS Check Service was offered as
a pilot program by Visa to its member banks from December 2000 to December 2002
over which time several banks electronically connected their check writer data
to the Visa network, making verification of the check writer's bank account
balance possible when checks drawn on these select banks were processed. In
December 2002, the program was officially released out of pilot and, as of June
2005, depending on the geographic location of a merchant in the U.S., anywhere
from 0% to as high as 30% of all the checking accounts are electronically
connected to the Visa network through the banks that are now participating in
the Visa POS Check Service.
Being able to approve or decline a check in real time at the point of sale
requires some method to verify the check writer has either an adequate balance
in the bank to cover the check or, if that is not possible, to verify if the
check written has a match in a negative check account database. In order to
provide this check service on 100% of the checks received by a merchant, Visa
needed a solution to approve or decline (and for those approved, electronically
deposit) the checks that processed through the program on a bank that had not
yet connected its check writer data to the Visa network. We are currently one
of two companies that provide this service to Visa as a Third-Party Processor.
When a Visa member bank signs up to offer the Visa POS Check Service to its
merchants, it chooses a Third-Party Processor from the certified providers. We
are currently processing approximately 68% of the Visa POS volume as a
Third-Party Processor.
12
In addition to being a Third-Party Processor, we are one of only five companies
that are currently certified as an Acquirer Processor with Visa, a role that
accepts transactions from the merchant's point-of-sale terminal/systems and
reformats them for submission to the Visa network. To date, ECHO is the only
company to register as both a Third-Party Processor and an Acquirer Processor
with Visa under the Visa POS Check Service program.
We derive transaction revenue in our role as a Third-Party Processor and/or
Acquirer Processor by negotiating a transaction fee with Visa and/or the bank
that choose us as its Third-Party Processor and/or Acquirer Processor. This
transaction fee ranges from $0.05 to $0.09 per transaction. The party that
sells the service to the merchant (usually the bank) enjoys the largest mark-up
on the product, offering the service in the range of $0.30 to $0.60 per check,
with external cost in the $0.12 to $0.20 range, depending on what the bank
negotiates with Visa and any other third-party providers.
STRATEGY
Our strategy is to provide merchants, banks and industry-specific resellers with
electronic connectivity to various payment services in the credit card, debit
card and check-related markets. Our platform of services is very flexible,
enabling merchant customization and scalability to meet the requirements of high
transaction volumes, as well as access to the Visa POS Check Service program.
Our services enable merchants to maximize revenues by offering a wide variety of
payment options, reducing the costs associated with processing and handling
checks, improving collections and managing risk more effectively.
We have a strategy to bundle all of our services and market them to smaller
regional and community banks under what we call our Agent Bank program. We are
providing a solution to allow smaller banks to offer a full spectrum of bankcard
and check processing services to their customer base using ECHO's
MERCHANTAMERICA product offering. The program is being sold at a low incremental
cost to ECHO and still provides a better priced and a more integrated product
offering to small banks than they can currently receive from other providers.
Most significantly, our program allows the banks to retain ownership of their
merchants, which provides both stability and economic benefits to the bank that
other programs generally do not provide. To date, 21 banks have enlisted in the
program and the program is showing signs of continued growth for the balance of
the year.
We also plan to grow our check services business by aggressively cross-selling
to our credit card customers and continuing to train the sales teams and
associates of Visa member banks on the many benefits the Visa POS Check Service
program provides to merchants.
SALES AND MARKETING
We sell our bankcard and or check services through several marketing channels,
including independent sales organizations (i.e, authorized resellers of our
products and services), our own internal sales force and direct merchant
referrals by existing merchants. Overall, the Company dedicates approximately 20
employees to sales related activities. During the quarter ended June 30, 2005,
we hired several highly experienced sales staff. Some of the new sales staff
will focus on selling our check services directly to the merchants and some will
focus on our Agent Bank program.
Our marketing strategy is to maximize cross-selling opportunities to our
existing base of merchants and financial institutions in the Visa POS Check
Service program; sell integrated suites of payment services, bankcard and check
processing services to small banks; enhance and market MERCHANTAMERICA; and
develop the private label check service program.
COMPETITION
Bankcard processing and check processing services are highly competitive
industries and are characterized by rapid technological change, rapid rates of
product obsolescence and introductions of competitive products often at lower
prices and/or with greater functionality than those currently on the market.
We believe we are in the top 50 credit card processors in the nation based upon
total annual volume processed and in the top 10 based upon the extent of our
authorization and settlement capture abilities. We believe we are in the top
four check processors in the nation of check verification and conversion
transactions. Many of our competitors have much greater financial and marketing
resources than us. As a result, they may be better able to respond more quickly
to new or emerging technologies and changes in customer requirements. Many
competitors also have economies of scale cost advantages over ECHO due to their
high processing volumes that may make it difficult for ECHO to
13
compete. Our competitors also have the financial resources to offer services to
large merchants at a lower rate than us in order to gain market share. We
believe that our success will depend upon our ability to continuously develop
new products and services and to enhance our current products and to introduce
them promptly into the market.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2005
-------------------------------------
Financial highlights for the third quarter of fiscal 2005 as compared to the
same period last year were as follows:
--Total revenue increased 15.6% to $14.3 million
--Gross margin from processing and transaction revenue was 36.3% for the current
quarter as compared to 36.5% for the same prior year period
--Diluted EPS of $0.06 as compared to diluted EPS of $0.09
--Bankcard and transaction processing revenue increased 11.1% to $10.6 million
--Check-related revenue increased 30.5% to $3.7 million
--ACH transactions processed increased 29.5% to 7.9 million transactions
REVENUE. Total revenue increased 15.6% to $14,281,000 for the three months ended
June 30, 2005, from $12,356,000 for the same period last year. The increase can
be primarily attributed to the 11.1% growth in bankcard processing revenue and
30.5% growth in the check services business segment as compared to the same
period last year. This growth has occurred organically from our existing
merchants and from other marketing initiatives.
COST OF SALES. A major portion of our bankcard processing expense is fixed as a
percentage of the total processing volume, which is calculated by the total
dollar value processed, with the remaining costs based on the number of
transactions processed. A major component of the Company's bankcard processing
expense, the interchange fees paid to the card issuing banks, is normally fixed
as a percentage of each bankcard transaction dollar processed.
Processing-related expenses, consisting primarily of data center processing
costs, interchange fees, third-party processing fees, amortization of software
development expense, commission expense, and communication expense, increased
from $7,791,000 in the third fiscal quarter of 2004 to $9,051,000 in the quarter
ended June 30, 2005, a 16.2% increase. The increase was directly attributable to
the 15.6% increase in revenue for the current quarter and an $83,000 increase in
amortization of software development and a $277,000 increase in commission
expense.
Gross margin from processing and transaction services remained relatively
constant at 36.3% for the current quarter as compared to 36.5% for the same
period last year. This slight decrease was due to the higher commission expense
which was offset by the relatively fixed processing costs such as equipment
depreciation expense and data line costs.
EXPENSE. Other operating costs such as personnel costs, telephone and
depreciation expenses increased 20.4%, from $1,240,000 in the third quarter of
2004 to $1,493,000 for the current fiscal quarter as a result of the $159,000
increase in personnel costs due to higher volume in customer support costs.
Research and development expense remained relatively constant for the quarter
ended June 30, 2005 at $354,000 as compared to $363,000 for same period last
year. Research and development initiatives are critical in order for us to
maintain the technological advantages over our competitors and to strengthen our
infrastructure due to growth. We have been investing in several major software
development projects over the past few years. Several of these projects are in
the final phase of development and are scheduled to begin deployment in early
2006. Some of the projects were placed into production this quarter. We
anticipate that this level of investment will continue throughout the remainder
of this year.
14
Selling, general and administrative expenses increased from $1,880,000 in the
third fiscal quarter of 2004 to $2,680,000 for the current fiscal quarter, an
increase of 42.6%. This $800,000 increase was primarily attributable to: 1)
$518,000 of legal expense primarily related to a patent litigation claim; and 2)
approximately $100,000 in one-time professional service expenses. As a
percentage of total revenue, selling, general and administrative expenses
increased from 15.2% in the third fiscal quarter of 2004 to 18.8% in the quarter
ended June 30, 2005. As a result of the completion of the discovery and
deposition phase of a patent lawsuit in July 2005, we anticipate that legal
expense related to this case should decrease for the second half of calendar
2005 until the case gets closer to trial in April 2006.
OPERATING INCOME. Operating income for the quarter ended June 30, 2005 was
$703,000, as compared to operating income of $1,082,000 in the same period last
year. The decrease in operating income was primarily due to the increase in
selling, general and administrative expenses described above.
INTEREST. Net interest decreased from a $12,000 expense for the three months
ended June 30, 2004 to an $8,000 income for the current three month period.
EFFECTIVE TAX RATE. The effective tax rate for the quarter ended June 30, 2005
was 39.1% as compared to 39.2% for the prior year quarter. The statutory rate is
approximately 40%.
SEGMENT RESULTS
Bankcard and Transaction Processing. Bankcard processing and transaction revenue
increased 11.1%, from $9,519,000 in the third fiscal quarter 2004 to $10,579,000
for the quarter ended June 30, 2005. This revenue increase was mainly
attributable to organic growth and new merchants generated from other marketing
programs.
Operating income from our bankcard and transaction processing segment was
$1,651,000 for the quarter ended June 30, 2005 as compared to $1,564,000 in the
same period last year. This increase in operating income was primarily
attributable to the increase in revenue for this segment.
Check-Related Products. Check-related revenues increased from $2,837,000 for the
third fiscal quarter 2004 to $3,702,000 for the current fiscal quarter, an
increase of 30.5%. This was attributable to the increase in ACH processing
which increased 29.5% in total ACH transactions processed for a total of 7.9
million transactions in the quarter ended June 30, 2005, as compared to 6
million in the prior year quarter.
Check services revenue made up 25.9% of total revenues in the quarter ended June
30, 2005, as compared to 23.0% in the prior year quarter. Check-related
operating income was $624,000 for the quarter ended June 30, 2005, as compared
to $463,000 in the same period last year. This increase in operating income in
this business segment was primarily attributable to the 30.5% increase in
revenue.
Other Corporate Expenses. Other corporate expenses increased from $945,000 for
the third fiscal quarter 2004 to $1,572,000 for the current quarter, an increase
of 66.3%. This increase was primarily attributable to a $518,000 increase in
legal expense related to a patent lawsuit.
NINE MONTHS ENDED JUNE 30, 2005 AND 2004
-----------------------------------------------
Financial highlights for the nine months ended June 30, 2005, as compared to the
same period last year, were as follows:
--Total revenue increased 12.7% from $35.8 million to $40.4 million
--Gross margins from processing and transaction revenue decreased from 36.8% to
35.7%
--Diluted EPS of $0.09 as compared to diluted EPS of $0.35
--Bankcard and transaction processing revenue increased 7.3% to $29.6 million
--Bankcard processing volume increased 6.7% to $842 million
--Check-related revenue increased 30.5% to $10.7 million
15
--ACH transactions processed increased 29.2% to 24.3 million transactions
REVENUE. Total revenue increased 12.7% to $40,362,000 for the nine months ended
June 30, 2005, from $35,822,000 for the same nine month period last year. This
revenue increase was the result of organic growth from our existing merchants
and new merchants generated from other marketing programs.
COST OF SALES. Processing-related expenses increased from $22,494,000 for the
nine month period in 2004 to $25,783,000 for the same nine months ended June 30,
2005, a 14.6% increase. This increase was directly attributable to the 12.7%
increase in revenue. Additionally, commission expense increased $927,000 for
this nine month period as compared to the same period last year.
Gross margin from processing and transaction services decreased to 35.7% in the
current nine month period from 36.8% for the nine month period last year.
EXPENSE. Other operating costs increased from $3,903,000 for the nine months
ended June 30, 2004 to $4,236,000 for the nine months ended June 30, 2005, an
increase of 8.5%. This was a result of the increase in personnel costs to
support our growth. Research and development expense increased from $1,090,000
in the nine months ended June 30, 2004 to $1,271,000 in the current nine month
period. We are continuing to invest in infrastructure improvement and software
enhancement to remain competitive in our industry.
Selling, general and administrative expenses increased from $5,534,000 for the
nine months ended June 30, 2004 to $8,044,000 in the current nine-month period,
an increase of 45.4%. This increase was primarily attributable to a $1,494,000
increase in legal and professional expenses and a $389,000 increase in salaries
expense. As a percentage of total revenue, selling, general and administrative
expenses increased from 15.4% for the nine months ended June 30, 2004 to 19.9%
in the current nine month period.
OPERATING INCOME. Operating income for the nine months ended June 30, 2005 was
$1,028,000, as compared to operating income of $2,801,000 for the same period
last year.
INTEREST. Net interest decreased from a $97,000 expense for the nine months
ended June 30, 2004, to an $8,000 income for the current nine-month period.
GAIN ON SALE OF BUILDING. During March 2004, we completed the sale of the
building located in Agoura Hills, California, which formerly held our principal
executive offices. The gain on the sale of this building was $1,319,000.
EFFECTIVE TAX RATE. Effective tax rate for the nine months ended June 30, 2005
was 39.3%, as compared to 39.2% for the nine months ended June 30, 2004 and the
statutory rate of approximately 40%.
SEGMENT RESULTS
Bankcard and Transaction Processing. Bankcard processing and transaction revenue
increased 7.3%, from $27,598,000 for the nine months ended June 30, 2004 to
$29,626,000 for the current nine month period. This revenue increase was mainly
attributable to a 6.7% increase in bankcard processing volume as compared to the
same nine month period last year. The processing volume increase was due to our
organic growth and other marketing initiatives.
The bankcard and transaction processing segment generated a gross margin of
27.9% for the nine months ended June 30, 2005 as compared to 29.5% in the same
period last year due to higher commission expense.
Check-Related Products. Check-related revenues increased from $8,224,000 for the
nine months ended June 30, 2004 to $10,736,000 for the current nine month
period, an increase of 30.5%. This was attributable to the growth in ACH revenue
and the increase in other electronic check processing and collection revenue.
Check services revenue accounted for 26.6% of our total revenue for the current
nine month period as compared to 23.0% in the same prior year period.
Check-related operating income was $1,577,000 for the current nine month period
as compared to $1,112,000 in the same period last year. The improvement in
operating income was primarily attributable to the 30.5% increase in check
services revenue.
16
Other Corporate Expense. Other corporate expense increased from $2,717,000 for
the nine months ended June 30, 2004 to $4,782,000 for the nine months ended June
30, 2005, an increase of 76.0%. This increase was primarily attributable to
$450,000 of legal settlement and a $971,000 increase in legal and professional
expense.
LIQUIDITY AND CAPITAL RESOURCES
As of June 30, 2005, we had available cash and cash equivalents of $6,800,000,
restricted cash of $1,225,000 in reserve with our primary processing bank and a
working capital of $7,557,000.
Accounts receivable net of allowance for doubtful accounts increased from
$1,943,000 at September 30, 2004 to $2,092,000 at June 30, 2005. Allowance for
doubtful accounts mainly reserved for chargeback losses increased to $126,000 at
June 30, 2005 from $111,000 at September 30, 2004.
Net cash provided by operating activities for the nine months ended June 30,
2005 was $2,681,000, as compared to net cash provided by operating activities of
$3,925,000 for the nine months ended June 30, 2004. This was mainly attributable
to the $1,817,000 decrease in net income.
Settlement receivable/payable represent amounts due to/from merchants and result
from timing differences in our settlement process with those merchants. These
timing differences account for the difference between the time that funds are
received in our bank accounts and the time that settlement payments are made to
merchants. Therefore, at any given time, settlement receivable/payable may vary
and ultimately depends on the volume of transactions processed and the timing of
the cut-off date. Settlement deposits represent cash deposited in our bank
accounts from the merchant settlement transactions.
In the nine months ended June 30, 2005, we used $623,000 for the purchase of
equipment and $2,896,000 for the acquisition and capitalization of software
costs. We paid off $703,000 of notes payable and capitalized lease obligations.
We also had proceeds of $329,000 from stock option exercises and $400,000 from
our equipment lease line.
As of this date, we have obtained a $3,000,000 line of credit and a $1,000,000
equipment lease line with Bank of the West. Both of these credit lines are
unused.
At June 30, 2005, we had the following cash commitments:
PAYMENT DUE BY PERIOD
---------------------
CONTRACTUAL LESS THAN AFTER
OBLIGATIONS TOTAL 1 YEAR 2-3 YEARS 4-5 YEARS 5 YEARS
-------------------- ---------- ---------- ---------- ---------- ---------
Long-term debt
including interest $1,136,000 $ 398,000 $ 570,000 $ 168,000 $ -0-
Capital lease
obligations 322,000 228,000 88,000 6,000 -0-
Operating leases 1,643,000 544,000 985,000 114,000 -0-
---------- ---------- ---------- ---------- ---------
Total contractual
cash obligations $3,101,000 $1,170,000 $1,643,000 $ 288,000 $ -0-
========== ========== ========== ========== =========
Our primary source of liquidity is expected to be cash flow generated from
operations and cash and cash equivalents currently on hand and the $3,000,000
line of credit which has yet to be utilized.
17
RISK FACTORS
Our business, and accordingly, your investment in our common stock, is subject
to a number of risks. These risks could affect our operating results and
liquidity. You should consider the following risk factors, among others, before
investing in our common stock.
RISKS RELATED TO OUR BUSINESS
---------------------------------
WE RELY ON COOPERATIVE RELATIONSHIPS WITH, AND SPONSORSHIP BY, BANKS, THE
ABSENCE OF WHICH MAY AFFECT OUR OPERATIONS.
We currently rely on a cooperative relationship with, and sponsorship by, one
bank in order to process our Visa, MasterCard and other bankcard transactions.
We also rely on several banks for access to the Automated Clearing House ("ACH")
for submission of both credit card and check settlements. Our banking
relationships are currently with smaller banks (with assets of less than
$500,000,000). Even though smaller banks tend to be more susceptible to mergers
or acquisitions and are therefore less stable, these banks find the programs we
offer more attractive and we believe we cannot obtain similar relationships with
larger banks at this time. A bank could at any time curtail or place
restrictions on our processing volume because of its internal business policies
or due to other adverse circumstances. If a volume restriction is placed on us,
it could materially adversely affect our business operations by restricting our
ability to process credit card transactions and receive the related revenue.
Our relationships with our customers and merchants would also be adversely
affected by our inability to process these transactions.
We currently maintain one primary bankcard processing and sponsorship
relationship with First Regional Bank in Agoura Hills, California. Our
agreement with First Regional Bank continues through the end of 2005. We also
maintain several banking relationships for ACH processing. While we believe our
current bank relationships are sound, we cannot assure that these banks will not
restrict our increasing processing volume or that we will always be able to
maintain these relationships or establish new banking relationships. Even if
new banking relationships are available, they may not be on terms acceptable to
us. With respect to First Regional Bank, while we believe our relationship will
cause us to extend our agreement beyond 2005 on mutually agreeable terms, there
can be no assurance that First Regional Bank will agree to such extension, or
that we would be able to agree to such extension on terms favorable to us.
Additionally, while its ability to terminate our respective relationship is
cost-prohibitive, it may determine that the cost of terminating the agreement is
less than the cost of continuing to perform in accordance with its terms, and
may therefore determine to terminate the agreement prior to its expiration.
Ultimately, our failure to maintain this and our other banking relationships and
sponsorships may have a material adverse effect on our business and results of
operations.
MERCHANT FRAUD WITH RESPECT TO BANKCARD AND ACH TRANSACTIONS COULD CAUSE US TO
INCUR SIGNIFICANT LOSSES.
We significantly rely on the processing revenue derived from bankcard and ACH
transactions. If any merchants were to submit or process unauthorized or
fraudulent bankcard or ACH transactions, depending on the dollar amount, ECHO
could incur significant losses which could have a material adverse effect on our
business and results of operations. ECHO assumes and compensates the sponsoring
bank for bearing the risk of these types of transactions.
We have implemented systems and software for the electronic surveillance and
monitoring of fraudulent bankcard and ACH use. As of June 30, 2005, we
maintained a dedicated chargeback reserve of $743,000 at our primary bank
specifically earmarked for such activity. Additionally, through our sponsoring
bank, we had access to approximately $10.6 million in merchant deposits to cover
any potential chargeback losses. Despite a long history of managing such risk,
we cannot guarantee that these systems will prevent fraudulent transactions from
being submitted and processed or that the funds set aside to address such
activity will be adequate to cover all potential situations that might occur.
We do not have insurance to protect us from these losses. There is no assurance
that our chargeback reserve will be adequate to offset against any unauthorized
or fraudulent processing losses that we may incur. Depending on the size of
such losses, our results of operations could be immediately and materially
adversely affected.
18
EXCESSIVE CHARGEBACK LOSSES COULD SIGNIFICANTLY AFFECT OUR RESULTS OF OPERATIONS
AND LIQUIDITY.
Our agreements with our sponsoring bank require us to assume and compensate the
bank for bearing the risk of "chargeback" losses. Under the rules of Visa and
MasterCard, when a merchant processor acquires card transactions, it has certain
contingent liabilities for the transactions processed. This contingent
liability arises in the event of a billing dispute between the merchant and a
cardholder that is ultimately resolved in the cardholder's favor. In such a
case, the disputed transaction is charged back to the merchant and the disputed
amount is credited or otherwise refunded to the cardholder. If we are unable to
collect this amount from the merchant's account, or if the merchant refuses or
is unable to reimburse us for the chargeback due to merchant fraud, insolvency
or other reasons, we will bear the loss for the amount of the refund paid to the
cardholders.
A cardholder, through its issuing bank, generally has until the later of up to
four months after the date a transaction is processed or the delivery of the
product or service to present a chargeback to our sponsoring bank as the
merchant processor. Therefore, management believes that the maximum potential
exposure for the chargebacks would not exceed the total amount of transactions
processed through Visa and MasterCard for the last four months and other
unresolved chargebacks in the process of resolution. For the last four months
through June 30, 2005, this potential exposure totaled approximately $403
million. At June 30, 2005, the Company, through its sponsoring bank, had
approximately $91,000 of unresolved chargebacks that were in the process of
resolution.
For the three-month period ended June 30, 2005 and 2004, the Company processed
approximately $300 million (2005) and $265 million (2004) of Visa and MasterCard
transactions, which resulted in $1.9 million in gross chargeback activities for
the three months ended June 30, 2005 and $2 million for the three months ended
June 30, 2004. Substantially all of these chargebacks were recovered from the
merchants.
Nevertheless, if we are unable to recover these chargeback amounts from
merchants, having to pay the aggregate of any such amounts would significantly
affect our results of operations and liquidity.
FAILURE TO PARTICIPATE IN THE VISA POS CHECK SERVICE PROGRAM WOULD CAUSE US TO
SIGNIFICANTLY SHIFT OUR OPERATING AND MARKETING STRATEGY.
We have significantly increased our infrastructure, personnel and marketing
strategy to focus on the potential growth of our check services through the Visa
POS Check Service program. We currently provide critical back-end
infrastructure for the service, including our NCN database for verification and
our access to the Federal Reserve System's Automated Clearing House for funds
settlement for checks written on bank accounts with banks not participating in
the program.
Because we believe the market will continue to gain acceptance of the Visa POS
Check Service program, we have expended significant resources to market our
check conversion services and verification services to our merchant base, to
solidify our strategic relationships with the various financial institutions
that have chosen us as their Acquirer Processor and Third-Party Processor under
the program, and to sell our other check products such as electronic check
re-presentments and check collection services to the Visa member banks.
If we fail to adequately market our services through this relationship, this
could materially affect our marketing strategy going forward. Additionally, if
we fail to adequately grow our infrastructure to address increases in the volume
of transactions, cease providing services as a Third-Party Processor or Acquirer
Processor or are otherwise removed or terminated from the Visa program, this
would require us to dramatically shift our current operating strategy.
THE BUSINESS IN WHICH WE COMPETE IS HIGHLY COMPETITIVE AND THERE IS NO ASSURANCE
THAT OUR CURRENT PRODUCTS AND SERVICES WILL STAY COMPETITIVE OR THAT WE WILL BE
ABLE TO INTRODUCE NEW PRODUCTS AND SERVICES TO COMPETE SUCCESSFULLY.
We are in the business of processing payment transactions and designing and
implementing integrated systems for our customers so that they can better use
our services. This business is highly competitive and is characterized by rapid
technological change, rapid rates of product obsolescence, and rapid rates of
new product introduction. Our market share is relatively small as compared to
most of our competitors and most of these competitors have substantially more
financial and marketing resources to run their businesses. While we believe our
small size
19
provides us the ability to move quickly in some areas, our competitors' greater
resources enables them to investigate and embrace new and emerging technologies
quickly to respond to changes in customers needs, and to devote more resources
to product and service development and marketing. We may face increased
competition in the future and there is no assurance that current or new
competition will allow us to keep our customers. If we lose customers, our
business operations may be materially adversely affected, which could cause us
to cease our business or curtail our business to a point where we are no longer
able to generate sufficient revenues to fund operations. There is no assurance
that our current products and services will stay competitive with those of our
competitors or that we will be able to introduce new products and services to
compete successfully in the future.
IF WE ARE UNABLE TO PROCESS SIGNIFICANTLY INCREASED VOLUME ACTIVITY, THIS COULD
AFFECT OUR OPERATIONS AND WE COULD LOSE OUR COMPETITIVE POSITION.
We have built transaction processing systems for check verification, check
conversion, ACH processing, and bank card processing activity. While current
estimates regarding increased volume are within the capabilities of each system,
it is possible that a significant increase in volume in one of the markets would
exceed a specific system's capabilities. To minimize this risk, ECHO has
redesigned and upgraded its check-related processing systems and has purchased a
high-end system to process bankcard activity. This system is not yet
operational, and even when it becomes operational, no assurance can be given
that the current systems would be able to handle a significant increase in
volume or that the operational enhancements and improvements will be completed
in such time to avoid such a situation. In the event we are unable to process
increases in volume, this could significantly adversely affect our banking
relationships, our merchant customers and our overall competitive position.
Losses of such relationships would severely impact our results of operations and
financial condition.
WE INCUR FINANCIAL RISK FROM OUR CHECK GUARANTEE SERVICE.
The check guarantee business is essentially a risk management business. Any
limitation of a risk management system could result in financial obligations
being incurred by ECHO relative to our check guarantee activity. While ECHO has
provided check guarantee services for several years, there can be no assurance
that our current risk management systems are adequate to assure against any
financial loss relating to check guarantee. ECHO is enhancing its current risk
management systems and it is being conservative with reference to the type of
merchants to which it offers guarantee services in order to minimize this risk
but no assurance can be given that such measures will be adequate.
SECURITY BREACHES COULD IMPACT OUR CONTINUED OPERATIONS.
We process confidential financial information and maintain several levels of
security to protect this data. Security includes card-based identification
systems at our data center locations that restrict access to the specific
facilities, various employee monitoring and access restriction policies, and
various firewall and network management methodologies that restrict unauthorized
access through the Internet. While these systems have worked effectively in the
past, and while ECHO has secured various industry certifications regarding
internal control processes that address security issues, there can be no
assurance that ECHO systems will operate without a security breach in the
future. Depending upon the nature of the breach, the consequences of security
breaches could be significant and dramatic to ECHO's continued operations.
THE INDUSTRY IN WHICH WE OPERATE INVOLVES RAPIDLY CHANGING TECHNOLOGY AND OUR
FAILURE TO IMPROVE OUR PRODUCTS AND SERVICES OR TO OFFER NEW PRODUCTS AND
SERVICES COULD CAUSE US TO LOSE CUSTOMERS.
Our business industry involves rapidly changing technology. Recently, we have
observed rapid changes in technology as evidenced by the Internet and
Internet-related services and applications, new and better software, and faster
computers and modems. As technology changes, ECHO's customers desire and expect
better products and services. Our success depends on our ability to improve our
existing products and services and to develop and market new products and
services. The costs and expenses associated with such an effort could be
significant to us. There is no assurance that we will be able to find the funds
necessary to keep up with new technology or that if such funds are available
that we can successfully improve our existing products and services or
successfully develop new products and services. Our failure to provide improved
products and services to our customers or any delay in providing such products
and services could cause us to lose customers to our competitors. Loss of
customers could have a material adverse effect on ECHO.
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OUR INABILITY TO PROTECT OR DEFEND OUR TRADE SECRETS AND OTHER INTELLECTUAL
PROPERTY COULD HARM OUR BUSINESS.
We have expended a considerable amount of time and money to develop information
systems for our merchants. We regard these information systems as trade secrets
that are extremely important to our payment processing operations. We rely on
trade secret protection and confidentiality and/or license agreements with
employees, customers, partners and others to protect this intellectual property
and have not otherwise taken steps to obtain additional intellectual property
protection or other protection on these information systems. We cannot be
certain that we have taken adequate steps to protect our intellectual property.
In addition, our third-party confidentiality agreements can be breached and, if
they are, there may not be an adequate remedy available to us. If our trade
secrets become known, we may lose our competitive position, including the loss
of our merchant and bank customers. Such a loss could severely impact our
results of operations and financial condition.
Additionally, while we believe that the technology underlying our information
systems does not infringe upon the rights of any third parties, there is no
assurance that third parties will not bring infringement claims against us. We
also have the right to use the technology of others through various license
agreements. If a third party claimed our activities and/or these licenses were
infringing their technology, while we may have some protection from our third-
party licensors, we could face additional infringement claims or otherwise be
obligated to stop utilizing intellectual property critical to our technology
infrastructure. If we are not able to implement other technology to substitute
the intellectual property underlying a claim, our business operations could be
severely affected. Additionally, infringement claims would require us to incur
significant defense costs and expenses and, to the extent we are unsuccessful in
defending these claims, could cause us to pay monetary damages to the person or
entity making the claim. Continuously having to defend such claims or otherwise
making monetary damage payments could materially adversely affect our results of
operations.
IF WE DO NOT CONTINUE TO INVEST IN RESEARCH AND DEVELOPMENT, WE COULD LOSE OUR
COMPETITIVE POSITION.
Because technology in the payment processing industry evolves rapidly, we need
to continue to invest in research and development in both the bankcard
processing business segment and the check-related products segment in order to
remain competitive. Research and development expenses remained relatively
constant from $363,000 for the quarter ended June 30, 2004 to $354,000 for the
quarter ended June 30, 2005. Most of our research and development project costs
were capitalized once we entered into coding and testing phases. We continue to
evaluate projects, which we believe will assist us in our efforts to stay
competitive. Although we believe that our investment in these projects will
ultimately increase earnings, there is no assurance as to when or if these new
products will show profitability or if we will ever be able to recover the costs
invested in these projects. Additionally, if we fail to commit adequate
resources to grow our technology on pace with market growth, we could quickly
lose our competitive position, including the loss of our merchant and bank
customers.
FAILURE TO OBTAIN ADDITIONAL FUNDS CAN IMPACT OUR OPERATIONS AND FUTURE GROWTH.
We use funds generated from operations, as well as funds obtained through credit
facilities and equity financing, to finance our operations. In light of our
recent financing efforts, and as a result of the cash flow generated from
operations, we believe we have sufficient cash to support our business
activities, including research, development and marketing costs. However,
future growth may depend on our ability to continue to raise additional funds,
either through operations, bank borrowings, or equity or debt financings. There
is no assurance that we will be able to continue to raise the funds necessary to
finance growth or continue to generate the funds necessary to finance
operations, and even if such funds are available, that the terms will be
acceptable to us. The inability to generate the necessary funds from operations
or from third parties in the future may require us to scale back our research,
development and growth opportunities, which could harm our overall operations.
WHILE WE MAINTAIN INSURANCE PROTECTION AGAINST CLAIMS RELATED TO OUR SERVICES,
THERE IS NO ASSURANCE THAT SUCH PROTECTION WILL BE ADEQUATE TO COVER POTENTIAL
CLAIMS AND OUR INABILITY TO OTHERWISE PAY SUCH CLAIMS COULD HARM OUR BUSINESS.
We maintain errors and omissions insurance for the services we provide. While
we believe the limit on our errors and omissions insurance policy is adequate
and consistent with industry practice, if claims are brought by our customers or
other third parties, we could be required to pay the claim or make significant
expenditures to defend against such claims in amounts that exceed our current
insurance coverage. There is no assurance that we will have the money to pay
potential plaintiffs for such claims if they arise beyond the amounts insured by
us. Making these
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payments could have a material adverse effect on our business.
INVOLVEMENT IN LITIGATION COULD HARM OUR BUSINESS.
We are involved in various lawsuits arising in the ordinary course of business.
Although we believe that the claims asserted in such lawsuits are without merit,
the cost to us for the fees and expenses to defend such lawsuits could have a
material adverse effect on our financial condition, results of operations or
cash flow. In addition, there can be no assurance that we will not at some time
in the future experience significant liability in connection with such claims.
For the three months ended June 30, 2005, we have spent approximately $518,000
in legal fees and expenses defending these claims.
OUR INABILITY TO RECOVER FROM NATURAL DISASTERS COULD HARM OUR BUSINESS.
We currently maintain two data centers: one in Camarillo, California and one in
Albuquerque, New Mexico. Should a natural disaster occur in any of the
locations, it is possible that ECHO would not be able to fully recover full
functionality at one of its data centers. To minimize this risk, ECHO has
started to centralize its data processing functionality in Camarillo in 2004 and
intends to make Albuquerque a fully redundant site as early as possible. Prior
to that time, it is possible that a natural disaster could limit or completely
disable a specific service offered by ECHO until such time that the specific
location could resume its functionality. Our inability to provide such service
could have a material adverse effect on our business and results of operations.
INCREASES IN THE COSTS OF TECHNICAL COMPLIANCE COULD HARM OUR BUSINESS.
The services which ECHO offers require significant technical compliance. This
includes compliance to both Visa and MasterCard regulations and association
rules, NACHA guidelines and regulations with regard to the Federal Reserve
System's Automated Clearing House and check-related issues, and various banking
requirements and regulations. ECHO has personnel dedicated to monitoring our
compliance to the specific industries we serve and, when possible, ECHO is
moving the technical compliance responsibility to other parties, as is the case
with our prior purchase of the Oasis Technologies bankcard processing system
wherein the vendor, Oasis Technologies, assumes much of the compliance
obligations regularly updated by Visa and MasterCard. As the compliance issues
become more defined in each industry, the costs associated with that compliance
may present a risk to ECHO. These costs could be in the form of additional
hardware, software or technical expertise that ECHO must acquire and/or
maintain. While ECHO believes it currently has these costs under control, we
have no control over those entities that set the compliance requirements so no
assurance can be given that ECHO will always be able to underwrite the costs of
compliance in each industry wherein we compete.
THE BUSINESS ACTIVITIES OF OUR MERCHANTS COULD AFFECT OUR BUSINESS AND RESULTS
OF OPERATIONS.
We provide direct and back-end bankcard and check processing services to
merchants across many industries. To the extent any of these merchants conduct
activities which are deemed illegal, or otherwise become involved in activities
that incur civil liability from third parties, legal authorities or those third
parties could attempt to pursue claims against us for aiding the activities of
those merchants. While we believe that the services we provide do not directly
aid in the activities of our merchants, and while we have no intent to assist
any such activities, other than to provide general processing services
consistent with past practice, any claims by legal authorities or third parties
would require us to expend financial and management resources to address and
defend such claims, the aggregate effect of which could have an adverse impact
on our business and results of operations.
RISKS ASSOCIATED WITH OUR COMMON STOCK
------------------------------------------
IF WE NEED TO SELL OR ISSUE ADDITIONAL SHARES OF COMMON STOCK OR ASSUME
ADDITIONAL DEBT TO FINANCE FUTURE GROWTH, OUR STOCKHOLDERS' OWNERSHIP COULD BE
DILUTED OR OUR EARNINGS COULD BE ADVERSELY IMPACTED.
While management believes that our cash flow from operations together with cash
on hand and our established lines of credit will be sufficient to meet our
current working capital and other commitments, our business strategy may include
expansion through internal growth, by acquiring complementary businesses or by
establishing strategic relationships with targeted customers and suppliers. If
we choose to execute on these business strategies, to properly fund these
strategies and our other activities, we may issue additional equity securities
that could dilute our stockholders' stock ownership. We may also assume
additional debt and incur impairment losses related to goodwill
22
and other tangible assets if we acquire another company and this could
negatively impact our results of operations.
WE HAVE ADOPTED A NUMBER OF ANTI-TAKEOVER MEASURES THAT MAY DEPRESS THE PRICE OF
OUR COMMON STOCK.
Our rights agreement, as amended, our ability to issue additional shares of
preferred stock and some provisions of our articles of incorporation and bylaws
could make it more difficult for a third party to make an unsolicited takeover
attempt of us. We also have staggered three-year terms for our directors. These
anti-takeover measures may depress the price of our common stock by making it
more difficult for third parties to acquire us by offering to purchase shares of
our stock at a premium to its market price.
OUR STOCK PRICE HAS BEEN VOLATILE.
Our common stock is quoted on the NASDAQ SmallCap Market, and there can be
substantial volatility in the market price of our common stock. Over the course
of the quarter ended June 30, 2005, the market price of our common stock has
been as high as $10.35 and as low as $7.10. Additionally, over the course of
the year ended September 30, 2004, the market price of our common stock was as
high as $13.06 and as low as $6.15. The market price of our common stock has
been, and is likely to continue to be, subject to significant fluctuations due
to a variety of factors, including quarterly variations in operating results,
operating results which vary from the expectations of securities analysts and
investors, changes in financial estimates, changes in market valuations of
competitors, announcements by us or our competitors of a material nature, loss
of one or more customers, additions or departures of key personnel, future sales
of common stock and stock market price and volume fluctuations. In addition,
general political and economic conditions such as a recession, or interest rate
or currency rate fluctuations may adversely affect the market price of our
common stock.
WE HAVE NOT PAID AND DO NOT CURRENTLY PLAN TO PAY DIVIDENDS, AND YOU MUST LOOK
TO PRICE APPRECIATION ALONE FOR ANY RETURN ON YOUR INVESTMENT.
Some investors favor companies that pay dividends, particularly in general
downturns in the stock market. We have not declared or paid any cash dividends
on our common stock. We currently intend to retain any future earnings for
funding growth, and we do not currently anticipate paying cash dividends on our
common stock in the foreseeable future. Because we may not pay dividends, your
return on this investment likely depends on your selling our stock at a profit.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
----------------------------------------------------------------
We could be exposed to market risk from changes in interest rates on our lease
lines. Our exposure to interest rate risk relates to the $3,000,000 line of
credit and $1,000,000 equipment lease line which was fully utilized as of June
30, 2005. A hypothetical 1% interest rate change would have no material impact
on our results of operations.
ITEM 4. CONTROLS AND PROCEDURES
-------------------------
As of June 30, 2005, the end of the period covered by this report, we carried
out an evaluation, under the supervision and with the participation of our
management, including our Chief Executive Officer and Chief Financial Officer,
of the effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Rule 13a-14(c) and 15d-14(c) of the Securities Exchange
Act of 1934. Based upon that evaluation, our Chief Executive Officer and our
Chief Financial Officer concluded that our disclosure controls and procedures
are effective in causing material information to be recorded, processed,
summarized and reported by our management on a timely basis and to ensure that
the quality and timeliness of our public disclosures complies with our
Securities and Exchange Commission disclosure obligations.
During the quarter ended June 30, 2005, there was no change in our internal
control over financial reporting that materially affects, or that is reasonably
likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
------------------
We are involved in various legal cases arising in the ordinary course of
business. Based upon current information, management, after consultation with
legal counsel, believes the ultimate disposition thereof will have no material
effect upon either the Company's results of operations or its financial
position.
In July 2004, LML Patent Corporation, a wholly-owned subsidiary of LML Payment
Systems, Inc. ("LML"), filed a patent infringement claim against the Company,
our subsidiary, XPRESSCHEX, Inc. and others, relating to the alleged
infringement by our point-of-sale check conversion processes of three patents
held by LML. The suit was filed in the U.S. District Court for the District of
Delaware. LML seeks an undisclosed amount of damages in connection with the
alleged infringement. In July 2005, the parties completed their respective fact
discovery procedures, with the exception of one outstanding deposition. The case
remains scheduled to go to trial in April of 2006. We do not believe that any
of our check conversion processes infringe upon any valid or enforceable patent
rights of LML and intend to continue to vigorously defend our position against
the claims made. In light of all the facts and circumstances, our management
believes that any damages award or royalty ordered against us, if any, would
have no material impact on our results of operations, financial position, or
cash flows.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
-------------------------------------
(a) Exhibits:
31.1 Certification of Joel M. Barry, Chief Executive Officer of the
Registrant, dated August 12, 2005, pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of Alice L. Cheung, Chief Financial Officer of the
Registrant, dated August 12, 2005, pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification of Joel M. Barry, Chief Executive Officer of the
Registrant, dated August 12, 2005, in accordance with 18 U.S.C. 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Alice L. Cheung, Chief Financial Officer of the
Registrant, dated August 12, 2005, in accordance with 18 U.S.C. 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K:
Date of Filing Item Reported
---------------- --------------
May 10, 2005 On May 10, 2005, the Registrant issued a press release
Announcing its financial results for the quarter ended
March 31, 2005.
May 10, 2005 On May 5, 2005, the Registrant appointed Mr. Eugene
Lockhart as a director of the Corporation and amended
its bylaws to enable Mr.Lockhart to be appointed.
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SIGNATURES
Pursuant to the requirements 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.
ELECTRONIC CLEARING HOUSE, INC.
----------------------------------
(Registrant)
Date: August 12, 2005 By: /s/ Alice Cheung
------------------------------
Alice Cheung, Treasurer and
Chief Financial Officer
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