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, 2004
OR
Transition report pursuant to Section 13 or 15(d) of the Securities
- --- Exchange Act of 1934
COMMISSION FILE NUMBER: 0-15245
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
WWW.ECHO-INC.COM
(Registrant's telephone 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 31, 2004, there were 6,375,812 shares of the Registrant's Common
Stock outstanding.
1
ELECTRONIC CLEARING HOUSE, INC.
INDEX
-----
PART I. FINANCIAL INFORMATION
Page No.
---------
Item 1. CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED):
Consolidated Balance Sheets 3
June 30, 2004 and September 30, 2003
Consolidated Statements of Operations 4
Three months and nine months ended
June 30, 2004 and 2003
Consolidated Statements of Cash Flows 5
Nine months ended June 30, 2004 and 2003
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of 10
Financial Condition and Results of
Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk 22
Item 4. Controls and Procedures 23
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 23
Signatures 24
2
PART I. FINANCIAL INFORMATION
- -----------------------------
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
ELECTRONIC CLEARING HOUSE, INC.
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
ASSETS
JUNE 30, SEPTEMBER 30,
2004 2003
------------ ---------------
Current assets:
Cash and cash equivalents $15,316,000 $ 5,641,000
Restricted cash 1,042,000 977,000
Settlement receivable 498,000 717,000
Accounts receivable less allowance of $157,000 and $91,000 1,916,000 1,918,000
Prepaid expenses and other assets 289,000 307,000
Deferred tax asset -0- 86,000
------------ ---------------
Total current assets 19,061,000 9,646,000
Noncurrent assets:
Property and equipment, net 2,135,000 2,928,000
Software, net 6,261,000 4,445,000
Deferred tax asset -0- 1,256,000
Other assets, net 384,000 500,000
------------ ---------------
Total assets $27,841,000 $ 18,775,000
============ ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Short-term borrowings and current portion of long-term debt $ 919,000 $ 901,000
Accounts payable 324,000 779,000
Settlement payable 8,320,000 3,429,000
Accrued expenses 1,487,000 1,336,000
Deferred income 20,000 -0-
Deferred tax liability 219,000 -0-
------------ ---------------
Total current liabilities 11,289,000 6,445,000
Long-term debt 888,000 1,961,000
------------ ---------------
Total liabilities 12,177,000 8,406,000
------------ ---------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.01 par value, 36,000,000 authorized:
6,408,081 and 5,920,174 shares issued; 6,369,812 and
5,881,905 shares outstanding 64,000 59,000
Additional paid-in capital 24,485,000 21,641,000
Accumulated deficit (8,419,000) (10,865,000)
Less treasury stock at cost, 39,269 common shares (466,000) (466,000)
------------ ---------------
Total stockholders' equity 15,664,000 10,369,000
------------ ---------------
Total liabilities and stockholders' equity $27,841,000 $ 18,775,000
============ ===============
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,
---------------- ----------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Revenues:
Processing revenue $ 6,217,000 $ 5,673,000 $18,152,000 $15,559,000
Transaction revenue 5,854,000 4,853,000 16,914,000 13,837,000
Other revenue 81,000 52,000 207,000 250,000
------------ ------------ ------------ ------------
12,152,000 10,578,000 35,273,000 29,646,000
------------ ------------ ------------ ------------
Costs and expenses:
Processing and transaction expense 7,587,000 7,135,000 21,945,000 19,809,000
Other operating costs 1,240,000 1,047,000 3,903,000 3,049,000
Research and development expense 363,000 375,000 1,090,000 1,101,000
Selling, general and administrative expenses 1,880,000 1,457,000 5,534,000 4,131,000
------------ ------------ ------------ ------------
11,070,000 10,014,000 32,472,000 28,090,000
------------ ------------ ------------ ------------
Income from operations 1,082,000 564,000 2,801,000 1,556,000
Interest income 19,000 6,000 49,000 21,000
Interest expense (31,000) (51,000) (146,000) (150,000)
Gain on sale of building -0- -0- 1,319,000 -0-
------------ ------------ ------------ ------------
Income before provision for income tax
and cumulative effect of an accounting change 1,070,000 519,000 4,023,000 1,427,000
Provision for income taxes (419,000) (211,000) (1,577,000) (617,000)
------------ ------------ ------------ ------------
Income before cumulative effect of an accounting change 651,000 308,000 2,446,000 810,000
Cumulative effect of an accounting change to adopt SFAS 142 -0- -0- -0- (4,707,000)
------------ ------------ ------------ ------------
Net earnings (loss) $ 651,000 $ 308,000 $ 2,446,000 $(3,897,000)
============ ============ ============ ============
Basic net earnings (loss) per share
Before cumulative effect of accounting change $ 0.10 $ 0.05 $ 0.39 $ 0.14
Cumulative effect of accounting change -0- -0- -0- (0.81)
------------ ------------ ------------ ------------
Basic net earnings (loss) per share $ 0.10 $ 0.05 $ 0.39 $ (0.67)
============ ============ ============ ============
Diluted net earnings (loss) per share
Before cumulative effect of accounting change $ 0.09 $ 0.05 $ 0.35 $ 0.14
Cumulative effect of accounting change -0- -0- -0- (0.80)
------------ ------------ ------------ ------------
Diluted net earnings (loss) per share $ 0.09 $ 0.05 $ 0.35 $ (0.66)
============ ============ ============ ============
Weighted average shares outstanding
Basic 6,347,919 5,810,787 6,289,843 5,802,802
============ ============ ============ ============
Diluted 6,977,897 6,039,990 6,890,389 5,917,532
============ ============ ============ ============
See accompanying notes to consolidated financial statements.
4
ELECTRONIC CLEARING HOUSE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
NINE MONTHS
ENDED JUNE 30,
----------------
2004 2003
------------ ------------
Cash flows from operating activities:
Net income (loss) $ 2,446,000 $(3,897,000)
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Gain on sale of building (1,319,000) -0-
Depreciation 446,000 498,000
Amortization of software 1,061,000 649,000
Provision for losses on accounts and notes receivable 84,000 45,000
Fair value of stock issued in connection with
directors' compensation -0- 21,000
Deferred income taxes 1,561,000 571,000
Stock option compensation 25,000 20,000
Cumulative effect of an accounting change -0- 4,707,000
Changes in assets and liabilities:
Restricted cash (65,000) (206,000)
Accounts receivable (82,000) (340,000)
Settlement receivable 219,000 (559,000)
Accounts payable (455,000) (90,000)
Settlement payable 4,891,000 3,761,000
Deferred income 20,000 -0-
Accrued expenses 145,000 304,000
Prepaid expenses 68,000 (118,000)
------------ ------------
Net cash provided by operating activities 9,045,000 5,366,000
------------ ------------
Cash flows from investing activities:
Other assets 17,000 74,000
Purchase of equipment (398,000) (139,000)
Proceed from sale of building 2,233,000 -0-
Purchased and capitalized software (2,554,000) (1,990,000)
------------ ------------
Net cash used in investing activities (702,000) (2,055,000)
------------ ------------
Cash flows from financing activities:
Proceeds from issuance of notes payable 811,000 292,000
Repayment of notes payable (1,827,000) (133,000)
Repayment of capitalized leases (476,000) (339,000)
Proceeds from private placement 2,693,000 -0-
Proceeds from exercise of stock options 131,000 23,000
------------ ------------
Net cash provided by (used in) financing activities 1,332,000 (157,000)
------------ ------------
Net increase in cash 9,675,000 3,154,000
Cash and cash equivalents at beginning of period 5,641,000 2,409,000
------------ ------------
Cash and cash equivalents at end of period $15,316,000 $ 5,563,000
============ ============
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, 2004, 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,
2003. The results of operations for the three and nine months ended June 30,
2004 are not necessarily indicative of the likely results for the entire fiscal
year ending September 30, 2004. Certain reclassifications have been made to the
prior year financial statements to conform with the current year presentations.
NOTE 2 - STOCK-BASED COMPENSATION:
- ---------------------------------
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 Model. Therefore, pro forma compensation costs for employee
stock and stock options awards are measured as the excess, if any, of the fair
value of the common stock at the grant date over the amount an employee must pay
to acquire the stock and 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":
THREE MONTHS ENDED NINE MONTHS ENDED
JUNE 30, JUNE 30,
--------------------- -------------------------
2004 2003 2004 2003
---------- --------- ----------- ------------
Net income (loss), as reported $ 651,000 $308,000 $2,446,000 $(3,897,000)
Add: Stock-based employee
compensation expense included
in reported net income net of
related tax effect 5,000 -0- 15,000 -0-
Deduct: Total stock-based employee
compensation expense determined
under fair value-based method for
all awards, net of related tax effect (104,000) (92,000) (292,000) (262,000)
---------- --------- ----------- ------------
Pro forma net income (loss) $ 552,000 $216,000 $2,169,000 $(4,159,000)
========== ========= =========== ============
Net earnings (loss) per share:
Basic - as reported $ 0.10 $ 0.05 $ 0.39 $ (0.67)
Basic - pro forma $ 0.09 $ 0.04 $ 0.34 $ (0.72)
Diluted - as reported $ 0.09 $ 0.05 $ 0.35 $ (0.67)
Diluted - pro forma $ 0.08 $ 0.04 $ 0.31 $ (0.72)
6
NOTE 3 - EARNINGS (LOSS) PER SHARE:
- -----------------------------------------
The Company calculates earnings (loss) per share as required by Statement of
Financial Accounting Standard No. 128, "Earnings per Share".
THREE MONTHS ENDED JUNE 30, NINE MONTHS ENDED JUNE 30,
------------------------------ -------------------------------
2004 2003 2004 2003
------------- --------------- --------------- --------------
Numerator:
Income before cumulative
effect of an accounting change $ 651,000 $ 308,000 $ 2,446,000 $ 810,000
Cumulative effect of an accounting
change to adopt SFAS 142 -0- -0- -0- (4,707,000)
------------- --------------- --------------- --------------
Net income (loss) $ 651,000 $ 308,000 $ 2,446,000 $ (3,897,000)
============= =============== =============== ==============
Denominator:
Weighted average shares outstanding
for basic earnings (loss) per share 6,347,919 5,810,787 6,289,843 5,802,802
Effect of dilutive stock options 629,978 229,203 600,546 114,730
------------- --------------- --------------- --------------
Adjusted weighted average shares
outstanding for diluted earnings
(loss) per share 6,977,897 6,039,990 6,890,389 5,917,532
============= =============== =============== ==============
Basic net earnings (loss) per share:
Before cumulative effect of accounting
change $ 0.10 $ 0.05 $ 0.39 $ 0.14
Cumulative effect of accounting change -0- -0- -0- (0.81)
------------- --------------- --------------- --------------
Basic net earnings (loss) per share $ 0.10 $ 0.05 $ 0.39 $ (0.67)
============= =============== =============== ==============
Diluted net earnings (loss) per share:
Before cumulative effect of
accounting change $ 0.09 $ 0.05 $ 0.35 $ 0.14
Cumulative effect of accounting change -0- -0- -0- (0.80)
------------- --------------- --------------- --------------
Diluted net earnings (loss) per share $ 0.09 $ 0.05 $ 0.35 $ (0.66)
============= =============== =============== ==============
For the three months ended June 30, 2004 and 2003, approximately 42,500 option
shares and 287,250 option shares, and for the nine months ended June 30, 2004
and 2003, approximately 42,500 option shares and 357,875 option shares,
respectively, attributable to the exercise of outstanding options were excluded
from the calculation of diluted EPS because the effect was antidilutive.
NOTE 4 - SUPPLEMENTAL CASH FLOW INFORMATION:
- --------------------------------------------------
THREE MONTHS NINE MONTHS
ENDED JUNE 30 ENDED JUNE 30
2004 2003 2004 2003
---- ---- ---- ----
Cash paid for:
Interest 31,000 51,000 146,000 150,000
Income taxes 1,000 -0- 8,000 -0-
8
NOTE 4: (CONTINUED)
- -------
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.
Significant non-cash transaction for the nine months ended June 30, 2003 was as
follows:
- Capital equipment of $279,000 was acquired under capital leases.
NOTE 5 - 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 ENDED NINE MONTHS ENDED
JUNE 30 JUNE 30
-------- --------
2004 2003 2004 2003
---- ---- ---- ----
Revenues:
Bankcard and transaction
processing $ 9,315,000 $ 8,612,000 $27,049,000 $23,927,000
Check-related products 2,837,000 1,966,000 8,224,000 5,719,000
------------ ------------ ------------ ------------
$12,152,000 $10,578,000 $35,273,000 $29,646,000
============ ============ ============ ============
Operating income:
Bankcard and transaction
processing $ 1,564,000 $ 1,081,000 $ 4,406,000 $ 2,966,000
Check-related products 463,000 96,000 1,112,000 304,000
Other (945,000) (613,000) (2,717,000) (1,714,000)
------------ ------------ ------------ ------------
$ 1,082,000 $ 564,000 $ 2,801,000 $ 1,556,000
============ ============ ============ ============
JUNE 30 SEPTEMBER 30
2004 2003
----------- -------------
Total assets:
Bankcard and transaction
processing $ 7,903,000 $ 7,051,000
Check-related products 12,981,000 6,794,000
Other 6,957,000 4,930,000
----------- -------------
$27,841,000 $ 18,775,000
=========== =============
NOTE 6 - COMMITMENTS, CONTINGENT LIABILITIES, AND GUARANTEES:
- -------------------------------------------------------------
The Company currently relies on cooperative relationships 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
9
NOTE 6: (CONTINUED)
- -------
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 cardholders. 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, 2004, this
potential exposure totaled approximately $368 million. At June 30, 2004, the
Company, through its sponsoring bank, had approximately $177,000 of unresolved
chargebacks that were in the process of resolution. At June 30, 2004, the
Company, through its sponsoring bank, had access to $9.9 million in merchant
deposits to cover any potential chargeback losses.
For the three-month period ended June 30, 2004 and 2003, the Company processed
approximately $265 million (2004) and $259 million (2003) of Visa and MasterCard
transactions, which resulted in $2 million in gross chargeback activities for
the three months ended June 30, 2004 and $2.2 million for the three months ended
June 30, 2003. 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, 2004 and 2003, the allowance for
chargeback losses, which is classified as a component of the allowance for
uncollectible accounts receivable, was $157,000 and $373,000, respectively. The
expense associated with the valuation allowance is included in processing and
transaction expense in the accompanying consolidated statements of income.
The Company currently has a relatively small 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 checkwriter'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 last 10
days prior to the balance sheet date. As of June 30, 2004, the Company estimates
that its maximum potential dishonored check exposure was approximately $624,000.
For the quarters ended June 30, 2004 and 2003, the Company guaranteed
approximately $5,616,000 (2004) and $4,112,000 (2003) of merchant checks, which
resulted in $29,000 (2004) and $106,000 (2003) of dishonored checks presented to
the Company for payments. The Company has the right to collect the full amount
of the check from the checkwriter. 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, 2004
and 2003, the reserve for check guarantee loss was $40,000 (2004) and $118,000
(2003). The expense associated with the valuation allowance is included in
processing and transaction expense in the accompanying consolidated statements
of income.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
------------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS
-----------------------------------
FORWARD-LOOKING STATEMENTS
The discussion of the financial condition and results of operations of the
Company 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,
2003.
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; and
- U-Haul transaction processing.
With respect to our check-related products:
- Check verification - where, prior to approving a check, we search
our negative and positive checkwriter database to determine
whether the checkwriter 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 - where, if we approve a check transaction and a
check is subsequently dishonored by the checkwriter's bank, the
merchant is reimbursed by us;
- Check re-presentment - where, upon a check not clearing after its
first presentment, we resubmit the check via the ACH network
prior to returning the check to the merchant in an effort to
increase the number of cleared check transactions; and
- Check collection - where 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 bank markets;
- National Check Network(R), or NCN(R), our proprietary database of
negative and positive checkwriter accounts used for back-end
check verification, check authorization and check capture
services, and for membership to collection agencies. Negative
checkwriter accounts typically identify a checkwriter'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, 2004, the bankcard and transaction processing
business segment accounted for approximately 76.7% of the Company's total
revenue.
Over the past three years, we have invested significant resources and management
focus in our check services business. Check services revenues are based on a
fixed fee per transaction or a fee based on the amount of the check for each
transaction. For the quarter ended June 30, 2004, the check services business
segment accounted for approximately 23.3% of the Company's total revenue. 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, and a robust checkwriter database
(NCN), which provides a valuable service for check risk management to merchants.
The NCN database includes over 30 million bad-checkwriter records, 130 million
positive records, and is generated and refreshed daily by 260 affiliated
collection agencies that continually contribute to the database to enrich its
depth and value.
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 checkwriter 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 and our NCN database is one of only four major
databases in the nation that can serve this market need on a national scale.
XPRESSCHEX revenues are growing due to the increased use of our check conversion
services, which include capture of the necessary check data at the point of sale
and submission of 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
payable and all settlement funds paid by the Company in advance are recorded as
settlement receivable. XPRESSCHEX also maintains an active collection agency,
registered in 48 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. This ability to provide local collection capability through one
national entity is a distinctive advantage we have over other check service
companies who operate centralized collection agencies and only go to local
agencies as a secondary or last option.
In 2000, Visa U.S.A. announced its intention to utilize its processing network
(VisaNet), that 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 of 2000 to December of
2002 over which time several banks electronically connected their checkwriter
data to the Visa network, making verification of the checkwriter's bank account
balance possible when checks drawn on these select banks were processed. In
December of 2002, the program was officially released out of pilot and, as of
June 2004, 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 checkwriter 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 checkwriter 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. At the present
time, sixteen financial services providers, who are actively participating in
the program, are using ECHO's services as a Third-Party Processor and are
beginning to actively sell check services to their merchants.
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. We were chosen by seven
financial services providers currently in the program to serve as their Acquirer
Processor. Most financial institutions presently in the Visa POS Check Service
are large national or regional banks and already had terminal management service
providers that could act as an Acquirer Processor for the Visa POS Check
Service. In the future, as smaller financial institutions make the decision to
enter the Visa POS Check Service, it is expected that many will have no prior
relationship with a terminal management provider and therefore, may potentially
choose us as their Acquirer Processor. 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 chose us as its Third-Party Processor and/or Acquirer Processor. This
transaction fee averages $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.
During the third quarter of fiscal 2003, a major national retail merchant with
approximately 3,000 storefronts initiated the Visa POS Check Service program in
all of its stores nationwide. We are the Third-Party Processor in this Visa POS
relationship. As of June 30, 2004, this retail merchant was the largest merchant
in the Visa POS Check Service program, measured by the volume of transactions
initiated by the merchant. The bank that sponsored this merchant into the Visa
POS Check Service program is still in the process of negotiating a multi-year
agreement with the merchant. While the outcome of these negotiations is still
unknown, the loss of this merchant would not significantly impact our
expectation of overall revenue for the remainder of fiscal 2004 and beyond.
ECHO has invested significant resources and management focus in its check
services business, particularly with respect to the Visa POS Check Service
program, and regardless of the outcome of the negotiations with the national
retail merchant, we anticipate continued growth in the Visa POS Check Service
program as the marketing efforts of participating banks in the Visa POS Check
Service program become more widely implemented.
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.
For the balance of this fiscal year, we plan to grow our check services business
by training the sales teams and associates of Visa member banks on the many
benefits the Visa POS Check program provides to merchants. Using this strategy
over the past nine months, literally hundreds of sales people have been trained
and it is expected that this will result in an accelerated growth in the number
of new merchants coming on the service in the next three months. In addition to
providing sales training to Visa banks, our strategy is to focus part of our
sales team on mid-size retail chains that can benefit most from automating check
processing and verification. These mid-size accounts typically offer higher
margins than larger accounts and offer a less competitive marketplace.
The Company intends to also seek strategic relationships with other service
providers in related industries, believing it can increase the speed to market
of its check services using such existing channels. As the Visa POS Check
program continues to grow, new enhancements are requested. These include
enhanced fraud detection, check guarantee, decline reversal techniques, and
accelerated program set-up, to name a few, and the Company's strategy is to
focus on providing these types of enhancements to the program. As the market
gains acceptance of the Visa POS Check Service, it is expected that this will
create a new marketing channel for us to cross sell our other check products
such as electronic check re-presentment, check guarantee, and collections to the
Visa member banks participating in the Visa POS Check Service program.
13
We also 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. Over 20 banks have enlisted in the
program in the past year and the program is showing signs of continued growth
for the balance of the year.
SALES AND MARKETING
As a result of the growing interest in the Visa POS Check Service, we plan to
continue using our marketing and sales resources to aggressively promote the
Visa POS Check Service during the balance of this year. We sell our bankcard and
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. We
also offer merchant services through a direct online sales channel,
MERCANTAMERICA. Approximately 20% of our new accounts have historically been
generated through the authorized resellers of our products and services. We
have developed a comprehensive marketing plan to promote the MERCHANTAMERICA
brand name and it is expected that this marketing plan will be initiated in
early 2005.
Management believes that we are unique in the number of payment services that we
offer to our merchants, the combination of transaction types that we manage
directly, our ability to integrate additional services and our ability to
support each merchant through one vertically integrated source.
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 are not currently a major player in the industries in which we compete and
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 compete. Our
competitors also have the financial resources to offer services to large
merchants at a much 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, 2004
- --------------------------------
Financial highlights for the third quarter of 2004 as compared to the same
period last year were as follows:
- --Total revenue increased 14.9% to $12.2 million
- --Gross margins from processing and transaction revenue increased to 37.1% from
32.2%
- --Diluted EPS of $0.09 as compared to diluted EPS of $0.05
- --Bankcard and transaction processing revenue increased 8.2% to $9.3 million
14
- --Check-related revenue increased 44.3% to $2.8 million
- --ACH transactions processed increased 98.7% to 6 million transactions
REVENUE. Total revenue increased 14.9% to $12,152,000 for the three months
ended June 30, 2004, from $10,578,000 for the same period last year. The
increase can be primarily attributed to the 8.2% growth in the bankcard
processing revenue and 44.3% 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. Total
processing and transaction revenue for the quarter ended June 30, 2004 increased
14.7%, from $10,526,000 in fiscal 2003 to $12,071,000 in fiscal 2004.
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, and communication expense,
increased from $7,135,000 in the third fiscal quarter of 2003 to $7,587,000 in
the quarter ended June 30, 2004, a 6.3% increase. The increase reflects an
increase in the volume of transactions processed, and the associated 8.2%
increase in bankcard processing and transaction revenues for the quarter ended
June 30, 2004 and the 44.3% increase in check services revenue.
Gross margin from processing and transaction services increased from 32.2% in
the third fiscal quarter 2003 to 37.1% in the quarter ended June 30, 2004. This
increase in gross margin was mainly due to a rate adjustment to merchants
implemented in the current year quarter. The gross margin improvement was also
positively impacted from the higher growth generated from the check services
business segment which yields a higher overall margin.
EXPENSE. Other operating costs such as personnel costs, telephone and
depreciation expenses increased from $1,047,000 in the third fiscal quarter of
2003 to $1,240,000 in the quarter ended June 30, 2004, an increase of 18.4%.
This increase was primarily attributable to a 14.9% increase in total revenue.
We continue to invest in personnel costs to support the implementation and
training of the various financial institutions that have chosen us as their
Third-Party Processor. We have a team of risk management staff dedicated to
monitor and enhance our risk management tools in support of the Visa POS Check
program. Additionally, the cost of customer support increased substantially over
the prior year period as a result of significantly higher check volumes
processed by us.
Research and development expense remained relatively constant from $375,000 in
the prior year quarter to $363,000 in the quarter ended June 30, 2004. Research
and development initiatives are critical in order for us to maintain the
technological advantages over some of our competitors and improve our
infrastructure due to growth. We anticipate that this level of investments will
continue throughout the remainder of this fiscal year.
Selling, general and administrative expenses increased from $1,457,000 in the
third fiscal quarter 2003 to $1,880,000 in the quarter ended June 30, 2004, an
increase of 29.0%. This increase was primarily attributable to: 1) an increase
in personnel costs due to cost of living adjustments and an increase in the
costs of employee benefits such as health insurance and worker's compensation
insurance; 2) an increase in sales and marketing expenses to implement our sales
and marketing strategies; and 3) an increase in rent due to the new corporate
relocation in October 2003. As a percentage of total revenue, selling, general
and administrative expenses increased from 13.8% in the third fiscal quarter
2003 to 15.5% in the quarter ended June 30, 2004.
OPERATING INCOME. Operating income for the quarter ended June 30, 2004 was
$1,082,000, as compared to operating income of $564,000 in the same period last
year, a 91.8% increase. The increase in operating income was primarily due to
the 14.9% revenue growth, the gross margin improvement during the quarter ended
June 30, 2004 as compared to the prior year and for the reasons identified
elsewhere in this report.
INTEREST EXPENSE. Net interest expense decreased 39.2% as compared to the prior
year quarter, from $51,000 for the fiscal quarter ended June 30, 2003 to $31,000
in the quarter ended June 30, 2004. This was primarily due to the repayment of
loans associated with the sale of the Company's prior corporate office building
in March 2004.
EFFECTIVE TAX RATE. The effective tax rate for the quarter ended June 30, 2004
was 39.2% as compared to 40.7% for the prior year quarter and the statutory rate
of approximately 40%.
15
SEGMENT RESULTS
Bankcard and Transaction Processing. Bankcard processing and transaction revenue
increased 8.2%, from $8,612,000 in the third fiscal quarter 2003 to $9,315,000
for the quarter ended June 30, 2004. This revenue increase was mainly
attributable to the organic growth from our existing merchants and new merchants
generated from other marketing programs. This growth was somewhat offset by the
departure of two high volume bankcard merchants during the quarter ended June
30, 2004, one of which departed as a result of its sale to another company and
the other of which departed due to our concern regarding the merchant's
excessive chargeback. This negatively impacted our revenue this quarter.
Despite these departures, we anticipate our bankcard growth will continue in the
fourth fiscal quarter.
The bankcard and transaction processing segment generated a gross margin of
30.1% in the quarter ended June 30, 2004 as compared to 25.6% in the same period
last year. This increase in gross margin was due to the rate adjustment
implemented in the current year. Operating income for this business segment was
$1,564,000 for the quarter ended June 30, 2004, up 44.7% from $1,081,000 in the
same period last year. The increase in operating income is attributable to the
8.2% increase in bankcard processing revenue in the quarter ended June 30, 2004
over the prior year quarter combined with the improvement in gross margin.
Check Related Products. Check-related revenues increased from $1,966,000 for the
third fiscal quarter ended June 30, 2003 to $2,837,000 for the quarter ended
June 30, 2004, an increase of 44.3%. This was attributable to the increase in
ACH processing revenue, which increased as a result of a 98.7% increase in total
ACH transactions processed, 6 million transactions in the quarter ended June 30,
2004, as compared to 3 million in the prior year quarter, the increase in check
conversion revenue as a result of the growth in the Visa POS Check Service
program and the increase in check verification revenue. The growth in these
services arose from our continued focus on check services in general, and on the
Visa POS Check Service program specifically.
Check services revenue made up 23.3% of total processing and transaction
revenues in the quarter ended June 30, 2004 as compared to 18.6% in the prior
year quarter. Check-related operating income was $463,000 for the quarter ended
June 30, 2004 as compared to $96,000 in the same period last year. The
improvement in this business segment was primarily attributable to the 44.3%
increase in revenue.
NINE MONTHS ENDED JUNE 30, 2004 AND 2003
- -----------------------------------------------
Financial highlights for the nine months ended June 30, 2004, as compared to the
same period last year, were as follows:
- --Total revenue increased 19.0% to $35.3 million
- --Gross margins from processing and transaction revenue increased to 37.4% from
32.6%
- --Diluted EPS of $0.35 as compared to diluted EPS of $0.14 before cumulative
effect of accounting change
- --Bankcard and transaction processing revenue increased 13.0% to $27.0 million
- --Check-related revenue increased 43.8% to $8.2 million
- --ACH transactions processed increased 251.3% to 18.7 million transactions
REVENUE. Total revenue increased 19.0% to $35,273,000 for the nine months ended
June 30, 2004, from $29,646,000 for the same nine-month period last year. Total
processing and transaction revenue for this nine-month period increased 19.3%,
from $29,396,000 for the nine months ended June 30, 2003 to $35,066,000 for the
same period this fiscal year. This increase has resulted from organic growth
from our existing merchants and other marketing initiatives.
COST OF SALES. Processing-related expenses increased from $19,809,000 for the
nine-month period in 2003 to $21,945,000 for the corresponding nine months ended
June 30, 2004, a 10.8% increase. The increase reflects a 19.3% increase in
processing and transaction revenues for the nine months ended June 30, 2004 as
compared to the same period in the prior year. These increases arise because a
majority of our bankcard processing expenses are
16
fixed as a percentage of our total processing volume, with the remaining costs
based on the number of transactions processed. As our volume of transactions
grows, our processing-related expenses will continue to increase.
Gross margin from processing and transaction services increased from 32.6% in
the nine-month period last year to 37.4% for the current nine-month period. This
increase in gross margin was primarily due to a rate adjustment pass- through to
the merchant, and also as a result of the 43.8% revenue increase in the check
services segment, which normally yields a higher gross margin than the bankcard
processing segment.
EXPENSE. Other operating costs increased from $3,049,000 for the nine months
ended June 30, 2003 to $3,903,000 for the nine months ended June 30, 2004, an
increase of 28.0%. This increase was primarily attributable to a 19.0% increase
in total revenue and the higher customer support costs associated with the
growing Visa POS Check Service program. Research and development expense
remained constant at $1,101,000 in the nine months ended June 30, 2003 to
$1,090,000 in the current nine-month period. This trend indicates the continued
investments being made by us to remain competitive in our industry and to invest
in certain internally used software to support our growth.
Selling, general and administrative expenses increased from $4,131,000 for the
nine months ended June 30, 2003 to $5,534,000 in the current nine-month period,
an increase of 34.0%. This increase was primarily attributable to: 1) an
increase in personnel costs due to cost of living adjustments and an increase in
the costs of employee benefits such as health insurance and worker's
compensation insurance; 2) higher annual performance bonuses paid to managers
and executives; 3) an increase in sales and marketing expenses to implement our
sales and marketing strategies; and 4) an increase in rent due to our new
corporate relocation in October 2003. As a percentage of total revenue, selling,
general and administrative expenses increased from 13.9% for the nine months
ended June 30, 2003 to 15.7% in the current nine-month period.
OPERATING INCOME. Operating income for the nine months ended June 30, 2004 was
$2,801,000, as compared to an operating income of $1,556,000 for the same period
last year, an increase of 80.0%. The improvement in operating income was
primarily attributable to the 19.0% increase in revenue and improvement in gross
margin described above.
INTEREST EXPENSE. Net interest expense remained constant, from $150,000 for the
nine months ended June 30, 2003, to $146,000 for the current nine-month period.
EFFECTIVE TAX RATE. Effective tax rate for the nine months ended June 30, 2004
was 39.2%, as compared to 43.2% for the nine months ended June 30, 2003 and the
statutory rate of approximately 40%.
SEGMENT RESULTS
Bankcard and Transaction Processing. Bankcard processing and transaction revenue
increased 13.0%, from $23,927,000 for the nine months ended June 30, 2003 to
$27,079,000 for the current nine-month period. This revenue increase was mainly
attributable to approximately 10.8% increase in bankcard processing volume as
compared to the same nine-month period last year. The processing volume increase
was a result of organic growth from the Company's existing merchants and other
marketing initiatives.
The bankcard and transaction processing segment generated a gross margin of
30.4% for the nine months ended June 30, 2004 as compared to 26.5% in the same
period last year. This increase in gross margin was attributable to the rate
adjustment implemented in the current fiscal year.
Check Related Products. Check-related revenues increased from $5,719,000 for the
nine months ended June 30, 2003 to $8,224,000 for the current nine-month period,
an increase of 43.8%. This was attributable to the increase in ACH processing
revenue, which increased as a result of a 251.3% increase in total ACH
transactions processed, 18.7 million transactions for the nine month period
ended June 30, 2004, as compared to 5.3 million for the same nine month period
in the prior year, and the growth in the check conversion revenue and the
increase in other electronic check processing and collection revenue. The
growth in these services arose from our continued focus on these services, in
general, and on the Visa POS Check Service program specifically.
Check services revenue accounted for 23.3% of the total revenue for the current
nine-month period as compared to 19.3 % in the same period prior year.
Check-related operating income was $1,112,000 for the current nine-month period
as compared to $304,000 in the same period last year. The improvement in
operating income was primarily attributable to the 43.8% increase in check
services revenue.
17
LIQUIDITY AND CAPITAL RESOURCES
As of June 30, 2004, we had available cash and cash equivalents of $15,316,000,
restricted cash of $1,042,000 in reserve with our primary processing bank and a
working capital of $7,772,000.
Accounts receivable net of allowance for doubtful accounts was relatively
unchanged, from $1,918,000 at September 30, 2003 to $1,916,000 at June 30, 2004.
Allowance for doubtful accounts mainly reserved for chargeback losses increased
to $157,000 at June 30, 2004 from $91,000 at September 30, 2003.
Net cash provided by operating activities for the nine months ended June 30,
2004 was $9,045,000, as compared to net cash provided by operating activities of
$5,366,000 for the nine months ended June 30, 2003. A significant portion of
this increase was attributable to a $5,110,000 net increase in settlement
receivable/payable from/to merchants.
Cash amounts classified as settlement receivable/payable are 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. The balance of our
net cash provided by operating activities was generated by the net income of
$2,446,000, the changes in deferred income taxes of $1,561,000 and other
operating activities.
In the nine months ended June 30, 2004, we used $398,000 for the purchase of
equipment and $2,554,000 for the acquisition and capitalization of software
costs. During the nine months ended June 30, 2004, we received net proceeds of
$2,693,000 from a $3 million private placement, which was completed in October
2003. We also received net proceeds of $2,233,000 from the sale of the building
holding our former principal executive offices during this nine-month period.
Also during this nine-month period, we paid off $1,827,000 of notes payable,
primarily in connection with the sale of the building.
In October 2003, we negotiated a secured $3,000,000 line of credit and a
$1,000,000 equipment lease line with Bank of the West. As of June 30, 2004, we
have drawn down $600,000 against the $1 million equipment lease line. We have
not drawn down against the $3,000,000 line of credit.
At June 30, 2004, 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 $1,053,000 $ 419,000 $ 415,000 $ 219,000 -0-
Capital lease
Obligations 914,000 590,000 279,000 45,000 -0-
Operating leases 1,492,000 482,000 652,000 358,000 -0-
---------- ---------- ---------- ---------- -------
Total contractual
cash obligations $3,459,000 $1,491,000 $1,346,000 $ 622,000 -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 secured
$3,000,000 line of credit which has yet to be utilized.
18
RISK FACTORS
We are subject to a number of risks, which could affect operating results and
liquidity including, among others, the following:
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 2005. Additionally, we
have reached a tentative agreement with Woodforest Bank in Woodforest, Texas, to
sponsor our bankcard activity. We also maintain several banking relationships
for ACH processing. While we believe our current bank relationship is 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 and Woodforest Bank, while we believe their respective ability to
terminate our respective relationships is cost-prohibitive, they may
independently determine that the cost of terminating their agreements is less
than the cost of continuing to perform in accordance with their terms, and may
therefore determine to terminate those agreements prior to their expiration.
Ultimately, our failure to maintain these 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, 2004, we
maintained a dedicated chargeback reserve of $670,000 at our primary bank
specifically earmarked for such activity. Additionally, through our sponsoring
bank, we had access to approximately $9.9 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.
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
19
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. We have
also increased our personnel to handle the increased volume of transactions
arising directly from our participation in the program.
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 products 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 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 services 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.
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SECURITY BREACHES COULD IMPACT OUR CONTINUED OPERATIONS.
We process confidential financial information and maintain several levels of
security to protect this data. Security includes hand and 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, there can be no assurance that they will
continue to 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.
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 $375,000 for the quarter ended June 30, 2003 to $363,000 for the
quarter ended June 30, 2004. 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
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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 required 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 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 nine months ended June 30, 2004, we have spent approximately $144,000 in
legal fees and expenses defending these claims.
OUR INABILITY TO RECOVER FROM NATURAL DISASTERS COULD HARM OUR BUSINESS.
We currently maintain three data centers: one in Camarillo, California, one in
Albuquerque, New Mexico and one in Boulder, Colorado. 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
22
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.
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 propertly 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 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, 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, 2004, the market price of our common stock has
been as high as $11.47 and as low as $8.80. Additionally, over the course of
the year ended September 30, 2003, the market price of our common stock was as
high as $9.59 and as low as $1.09. 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. There was an outstanding balance of
$600,000 against the $1,000,000 equipment lease line as of June 30, 2004. A
hypothetical 1% interest rate change would have no material impact on our
results of operations.
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ITEM 4. CONTROLS AND PROCEDURES
-------------------------
As of June 30, 2004, 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.
There have been no significant changes in our internal controls or in other
factors, which could significantly affect internal controls subsequent to the
date that we carried out our evaluation.
PART II. OTHER INFORMATION
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, 2004, 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, 2004, 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, 2004, 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, 2004, 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, 2004 On May 10, 2004, the Registrant issued a press release
announcing its financial results for the quarter
ended March 31, 2004.
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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, 2004 By: /s/ Alice Cheung
--------------------------
Alice Cheung, Treasurer and
Chief Financial Officer
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