UNITED STATES

SECURITIES ANDEXCHANGE COMMISSION

WASHINGTON, D.C. 

FORM 10-KSB

 

[ X ] ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934

 

For the fiscal yearended December 31, 2004

 

or

 

[ ] TRANSITIONALREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File No.000-33037

 

NBO SYSTEMS, INC.

 

| STATE OF		MARYLAND

(State or		Other Jurisdiction of Incorporation or Organization)
55-0795927 

(IRS Employer		Identification Number)  
3676 West		California Avenue, Building D

Salt Lake		City, Utah 

(Address of		Principal Executive Offices)
84104

(Zip code)
    

(801) 746-8000

(Registrant'sTelephone Number, Including Area Code)

 

Securities registeredunder Section 12(b) of the Act: None

 

Securities registeredunder Section 12(g) of the Act:

common stock, ParValue $.0005

(Title of Class)

 

Check whether the issuer (1) filedall reports required to be filed by Section 13 or 15(d) of the Exchange Actduring the past 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes    X          No             

 

Check if disclosure of delinquentfilers in response to Item 405 of Regulation S-B is not contained in this form,and no disclosure will be contained, to the best of registrant's knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-KSB or any amendment to this Form 10-KSB. [ X ]

 

State issuer's revenues and otherincome for its most recent fiscal year: $12,007,468

 

The aggregate market value of thecommon stock held by non-affiliates as of March 31, 2005 was approximately$10,100,000.

 

As of March 31, 2005, there were17,124,944 shares of the issuer's common stock, $0.0005 par value, issued andoutstanding. 

 

DOCUMENTS INCORPORATED BY REFERENCE:Certain information required in Part III hereto is incorporated by reference tothe issuer's definitive proxy statement relating to its 2005 annual meeting ofstockholders to be filed with the Securities and Exchange Commission pursuant toRegulation 14A not later than 120 days after the end of the fiscal year coveredby this Form 10-KSB. 

 

Transitional Small BusinessDisclosure Format (check one):

Yes ____ No     X         
** 

 

NBO SYSTEMS, INC.

FORM10-KSB ANNUAL REPORT

TABLE OF CONTENTS**
   
   Page
**PART I**  		
 3
     ITEM		1. DESCRIPTION OF BUSINESS   
 3
     ITEM		2. DESCRIPTION OF PROPERTY   
 15
     ITEM		3. LEGAL PROCEEDINGS   
 16
     ITEM		4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS   
 17  
**PART II**  		
 17
     ITEM		5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS  		
 17
     ITEM		6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND		RESULTS OF OPERATIONS   
 18
     ITEM		7. FINANCIAL STATEMENTS   
 33
     ITEM		8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND		FINANCIAL DISCLOSURE   
 33
     ITEM		8A. CONTROLS AND PROCEDURES   
 33
     ITEM		8B. OTHER INFORMATION   
 34 
 
**PART III**  		
 34
     ITEM		9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;		COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT   
 34
     ITEM		10. EXECUTIVE COMPENSATION   
 34
     ITEM		11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT  		
 34
     ITEM		12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.   
 34
     ITEM		13. EXHIBITS   
 35
     ITEM		14. PRINCIPAL ACCOUNTANT FEES AND SERVICES   
 35
 

 
**Forward-looking Statements*** 

This Annual Report onForm 10-KSB, including information incorporated herein by reference, contains"forward-looking statements" within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended. These statements relate to expectations concerning matters that arenot historical facts. Words such as "projects," "believes," "anticipates,""will," "estimate," "plans," "expects," "intends," and similar words andexpressions are intended to identify forward-looking statements. Although webelieve that such forward-looking statements are reasonable, we cannot assureyou that such expectations will prove to be correct. Important languageregarding factors which could cause actual results to differ materially fromsuch expectations are disclosed in this Report, including without limitationunder the caption "Risk Factors" beginning on page 9 of this Report. Allforward-looking statements attributable to NBO Systems, Inc. are expresslyqualified in their entirety by such language. We do not undertake any obligationto update any forward-looking statements.

 

 *** 

PART I

ITEM 1. DESCRIPTION OF BUSINESS

 

Overview

 **
We were incorporatedin Utah on June 23, 1994 as Neighborhood Box Office, Inc. We changed our name toNBO Systems, Inc. on January 29, 2002 when we reincorporated in Maryland. Ourprincipal executive offices are located at 3676 West California Avenue, BuildingD, Salt Lake City, Utah 84104. Our telephone number is (801) 746-8000. Ourwebsite is located at www.nbo.com. We also operate the following websites inconnection with the operation of our business: www.thegiftcertificatecompany.com,www.thegiftcardcompany.com, www.giftcardbalance.com, www.myprepaidcard.info andwww.childrens-heroes.com. The reference to our website addresses does notconstitute incorporation by reference of the information contained on thesesites and such information should not be considered to be part of this report.

 

We have registeredthe following names and logos as trademarks in the United States: "NBO Systems,Inc." "NBO," "Children's Heroes," "Freedom Prepaid Card," and Community ScripCard." All other trademarks, service marks or trade names appearing in thisreport are the property of their respective owners.

 

We are a developer,marketer and supplier of prepaid stored-value card programs including giftcards, corporate incentive and membership reward cards, and fund-raising cards.We market our programs to mall owners/developers and operators, restaurantchains, retailers, corporate incentive providers, membership reward programs andfund-raising organizations throughout the United States. Our businesshistorically focused primarily on mall gift certificates, mall gift cards andthird party gift card order fulfillment services, which subject us to typicalretail seasonality curves. We historically experience sales for the majority ofour products and services in the last two months of the year, specifically theperiod between Thanksgiving and Christmas. We are in the process of introducingnewly developed products and services that may help smooth seasonality effectsand provide a more even distribution of cash flows from operating activitiesthroughout the year.

 

Our primary businessmodel is comprised of several revenue channels. The most mature revenue channelis the mall channel, which provides comprehensive gift card and gift certificateproducts to shopping mall managers that are accepted and redeemable at all mallretail stores. We administer the entire program including accounting, banking,reconciliation and compliance with all applicable state and federal regulations.The shopping mall program was initiated in October 1998 utilizing giftcertificates only. We transitioned to gift cards in 2001. Our gift certificateand gift card programs currently include malls managed by multiple developers invarious states across the nation.

 

Secondly, we provideall Call Center and Internet Fulfillment of gift certificates and gift cards forclients of ValueLink, a subsidiary of First Data Corp, and third-party providersof their own dedicated, closed-end gift card programs such as DardenRestaurants, Inc. ("Darden"), a subsidiary of General Mills Restaurant, Inc.("GMRI"). We are currently soliciting, negotiating, and finalizing additionalbusiness relationships with other national restaurant chains and retail outletsthat typically have store locations in or near shopping malls across the UnitedStates.

 

Finally, weimplemented the Children's Heroes fundraising channel using traditional scripproducts (discounted gift certificates used for fundraising purposes) in 2003.We developed and are currently testing the Community Scrip Card ("CSC"), amulti-merchant prepaid stored-value card used for fundraising purposes. The testis a pilot program with Great Lakes Scrip Company of Grand Rapids, Michigan thatbegan in the fourth quarter of 2004 and will end in the first quarter of 2005.We intend to complement and revolutionize the traditional scrip fundraisingindustry efforts with our CSC. We plan to distribute the CSC through licensingand distributorship agreements with existing traditional scrip companies acrossthe United States.

 

New businessinitiatives for 2005 and beyond are detailed in the sections below.
** 

Principal Productsand Services

 **
We develop and marketprepaid stored-value card programs that operate on the established paymentsystems operated by Visa and MasterCard (open networks) or on Discover (privatededicated networks). The cards that operate on the Visa and MasterCard paymentsystems are issued by national banks that are part of a national bankassociation and may be redeemed at any merchant that accepts Visa or MasterCard.Discover cards are issued by Discover and may be redeemed at any merchant thataccepts Discover. Our products and services address several different marketsegments for prepaid stored-value concepts, including universal mall gift cards,corporate incentive and membership reward cards, and cards utilized infund-raising efforts.

 

4

 

For consumers,prepaid stored-value cards may be better categorized as either "dedicated" or"universal" cards. Dedicated cards are typically "branded" with a retailbusiness's name and are accepted only by that retail business at its specificretail locations. For example, the Blockbuster Entertainment gift card is adedicated card that permits use only at Blockbuster retail locations. Bycontrast, multiple retail establishments accept universal cards as in the caseof the shopping mall gift card.

 

The universal cardsmay operate in an open network environment, such as Visa or MasterCard, or, maybe limited to multiple, specific retail establishments through the use ofinclusion tables on a private dedicated network environment such as Discover.Our ability to offer customers multiple network alternatives relieves us of thecosts of maintaining our own infrastructure to support card redemptionprocesses. Additionally, our development, marketing, and fulfillment servicesplace us in a central and neutral position among credit card associations,issuing banks and data processors. We intend to leverage this position and offercustomers with opportunities to design prepaid stored-value card programs thatmeet their individual needs.

 

We continue to offerpaper-based gift certificates to legacy customers, but over time, we expect thatthe paper-based gift certificate business will transition to card-basedtechnology. According to Bain & Co., sales of gift cards and paper giftcertificates have risen about 25% in each of the past four years, reaching anestimated $45 billion in 2003. The growing popularity of gift cards can beattributed, in part, to the convenience and flexibility provided to bothpurchasers and recipients. A gift card allows the purchase decision to be madeby the card recipient. The card recipient, in turn, may avoid the inconvenienceof exchanging or returning unwanted or duplicative merchandise.
* 

Target Markets

 *
Our primary targetmarkets for our card programs consist of:
-  owners and	operators of shopping malls;
-  consumers who	prefer to shop on-line via the Internet;
-  fulfillment		for third-party companies that develop and manage individual retailers'		dedicated card programs (i.e., programs in which the gift cards can only		be redeemed in the stores of the issuing retailer or its affiliates); 
-  businesses and	organizations that sponsor incentive and loyalty rewards programs;
-  high volume	retailers such as grocers, convenience stores and pharmacies; and
-  the non-profit	fund-raising sector, particularly K-12 and university-based educational	institutions.
*Shopping Mall Universal Gift Cards

 *
Our product deliveryto owners/developers and operators of shopping malls shifted from giftcertificate products to gift card products in 2001. Our gift card programs maybe tailored specifically to the larger owner/operators of multiple shoppingmalls, as well as individual, independent shopping malls.

 

A universal mall giftcard issued on an open network environment, such as Visa or MasterCard, may beused at a specific shopping mall (or a group of specific shopping malls) andwould be valid at any store within the shopping mall, as well as any retailestablishment that accepts Visa or MasterCard.

 

A universal gift cardissued on a private dedicated network environment, such as Discover, would bevalid only at specific retailers identified in a group, such as retail stores ina specific mall, through the use of inclusion tables, who accept Discover as apayment type for merchandise or services.
* 

Virtual Malls 

 *
Our experienceindicates that about 25% of mall gift card redemption activity occurs outside ofthe shopping mall that sold the mall gift card. This phenomenon is commonlyreferred to in the industry as "leakage." Leakage is applicable to mall giftcards sold on the VISA or MasterCard networks only, as the Visa or MasterCardlogos on the face of the card indicates to the retailer that the card may beaccepted at anywhere VISA or MasterCard are accepted. Leakage is not applicableto mall gift cards sold on the Discover platform because Discover uses inclusiontables to restrict the redemption activity of the card to only those merchantslocated in the mall property. We believe that leakage percentages will increaseas consumers recognize their ability to redeem cards at merchant locationsoutside the particular shopping mall property where the mall gift card was sold.

 

Leakage decreases themall's customer traffic and ultimately the mall's sales volume. Opportunityarises when recipients of mall gift cards are unable to find the merchandisethat they seek at that particular brick-and-mortar mall location, or when theyprefer to shop on-line via the Internet, versus making a trip to the actual malllocation. Our Virtual Mall website provides a solution to these challenges. Acustomized Virtual Mall website is established to complement the sales effortsof each brick-and-mortar mall location. Shoppers may access the Virtual Malleither through the mall's website or our own website.

 

5

 

Our Virtual Mallfulfillment partners receive merchandise in bulk, or are able to shipmerchandise to shoppers directly from the manufacturer. This greatly reduces theinventory handling costs and enables us to offer the same, high qualitymerchandise offered at the shopping mall, or elsewhere on the Internet, atdiscounts to the retail price offered at the physical mall location. In mostinstances, shipping to the shopper is free of charge, except for very largeitems.

 

To incentivize themall to promote the Virtual Mall, we pay a commission to the mall on all virtualmall sales. Mall owners/operators receive a benefit in the form of a commission,whereas they received no benefit before due to leakage.

 

For mall gift cardsissued on the Discover platform, the Virtual Mall is included as one of theparticipating merchants in the inclusion tables set up. 

 

In February 2005, weestablished an agreement with i-Carrots, a leading provider of Internet retailservices, as the engine behind our Virtual Mall. i-Carrots has directrelationships with the manufacturers of a broad range of consumer merchandise,ranging from consumer electronics to apparel to jewelry. i-Carrots also has anetwork of distribution centers to handle order fulfillment. GlimcherProperties, our largest shopping mall customer, has agreed to implement theVirtual Mall in connection with the gift card programs in Glimcher's shoppingmalls.
* 

Fulfillment Services

 *
We provide Internetand call-center fulfillment services for dedicated closed network gift cards forour partners such as ValueLink and Darden. In the fourth quarter of 2004, weadded 20 new ValueLink clients to our dedicated closed network card orderfulfillment program, bringing the total number of ValueLink clients to 29.
* 

Corporate Incentiveand Membership Reward Cards

 *
In September 2004, wedeveloped a multi-merchant prepaid stored-value card program. During thedevelopment process subsequent to marketing efforts, we entered into agreementswith over 180 national and regional retail merchants (i.e., Lowe's HomeImprovement Centers, Circuit City and Dillard's) having in excess of 35,000brick and mortar retail consumer locations, in addition to the merchant's onlineretail operations. Each of the participating merchants provides us with rebates,varying from 3%-30%, whenever the multi-merchant card is presented forredemption at their merchant locations.

 

Sponsors of corporateincentive and membership rewards programs are making increasing use of prepaidstored-value cards. For businesses, prepaid stored-value cards may be in theform of incentive and reward cards given to employees for achieving specificgoals or other general purposes. Our target customers for these cards arethird-party providers of incentive, promotion and loyalty programs for a widevariety of entities, including financial institutions, subscription-basedservices and membership clubs.

 

For example, amembership reward card may be given to a member or customer of a business whosatisfies the criteria of a particular program. Once these incentive andmembership rewards cards are distributed by the sponsors, they function in thesame manner as dedicated or universal gift cards.

 

We contract withprogram sponsors and administrators to provide the prepaid stored-value cardsand associated administration of the cards as an important component of theoverall corporate incentive and membership rewards programs. By using ourprepaid stored-value cards, program sponsors are not required to maintain andmanage the distribution of any inventory of goods, or the process to track theredemption of incentive or reward systems. Instead, the program sponsor simplydistributes the cards to the recipients, thereby relieving the sponsor of muchof the logistical time and cost of the traditional incentive and membershiprewards programs.

In November 2004, weestablished an agreement with Vertrue (formerly known as MemberWorks) to supplycards to Vertrue's membership rewards programs. There are other large firmsoffering membership rewards programs, including corporate incentive programproviders with ties to large credit card issuers. Vertrue operates severalmembership-based websites and other programs, where members receive discounts onproducts and services, such as merchandise and prescriptions, in return forsubscription payments. As of September 30, 2004, Vertrue had 5.5 million activeretail members.
* 

Retail IncentiveCards

 *
The retail incentivecard is another use for the multi-merchant prepaid stored-value card designedfor mass-market retail distribution. We are negotiating distribution agreementswith marketing firms and credit card processors experienced in the retailindustry. These third parties will market our retail incentive cards to highvolume retail locations such as grocery stores, drug stores or conveniencestores with which they already have relationships, or market our products to newretail outlets. Our retail incentive cards will be available in the checkoutlines near the cash registers. We do not load value on the cards distributedthrough this channel until they are purchased. In order to load value on thecards at the time of purchase, we provide a software interface between themerchant's point-of-sale terminal and our distribution partner or our data basesystem, allowing all parties access to all required transaction data. Ourdistribution partners for this channel have completed development of theinterface software into the point-of-sale terminals for many of the largestretail merchants in the country, making this a viable business channel for ourmulti-merchant card products. We believe our multi-merchant retail incentivecard provides additional convenience and benefits to the consumer oversingle-retailer incentive cards competing in the same space.
* *
6

 
*Fund-Raising Cards

 *
Non-profitorganizations, including school-based groups such as PTAs, booster groups,support foundations, youth sports organizations and churches use discounted giftcertificates and gift cards sold at face value to patrons to generate revenue tosupplement tuition and to support extra-curricular activities including trips,music programs, and athletic teams. These discounted certificates and cards areknown in the fund-raising industry as "scrip."

 

There is an inventoryand capitalization burden using traditional scrip products. Therefore, thecharitable fund-raising industry in the United States is increasingly making useof prepaid stored-value cards. We sell multi-merchant stored value cards in thefundraising channel as a supplement to traditional scrip products, redeemable ata variety of participating local and national merchants. We brand cards used inthe K-12 schools under the "Children's Heroes" name, and label them as CommunityScrip Cards (CSC). Other applications are under development for universities andspecific charitable foundations.

 

We have agreementswith merchants that allow us to receive rebates or discounts when our cards arepresented for redemption at participating merchants. Non-profit organizationspurchase the fundraising cards from us at face value and then re-sell the cardsto parents, members and other supporters at face value. When a card is redeemedat a participating merchant, the merchant receives the full value of the card asis typical in any debit card transaction. We track card redemption activity andinvoice the participating merchants for the agreed upon rebate or discount.Revenue sharing does not occur with the fundraising organization or thedistributor until we receive the rebates or discounts from the participatingmerchant. The use of a multi-merchant stored-value card accomplishes the samefundraising objectives as traditional scrip products, but without thecapitalization and inventory requirements.

 

In November 2004, wesigned an agreement with Great Lakes Scrip Company ("GLSC") of Grand Rapids,Michigan to operate a pilot program for distributing our fundraising cards inCalifornia, Minnesota, and Iowa in the first quarter of 2005. At the conclusionof the pilot, both parties will evaluate the sales data, and we intend to enterinto a long-term agreement with GLSC to distribute our fundraising cardsnationwide. We sell the cards to GLSC, which in turn, sells the cards to itscustomers - the schools in their traditional scrip programs.

 

In December 2004, welaunched the University Fundraising Card Program using a dedicated internalsales team. The target market is large public and private colleges anduniversities throughout the country. The program includes a university-brandedfundraising prepaid card and a university-branded virtual shopping mall. Theuniversity receives a percentage of the card purchases and virtual mallpurchases.
** 

Growth Strategy

 **
Our objective is tobecome the leading provider of prepaid stored-value card programs. We intend tobuild upon our expertise as a developer of prepaid stored-value card systems andservices to mall owners/developers, restaurant chains, incentive programproviders and fund-raising institutions. Key elements of our strategy includethe following:
*-  Expand Existing MallGift Card Programs*
We intend to	continue to provide gift card solutions to large and medium-sized shopping	center owner/operators by introducing new programs that are more	consumer-friendly, and more attractive revenue-sharing programs through the	use of our new virtual mall concept. Of the approximately 3,500 indoor	shopping malls located in the United States, we will concentrate our efforts	on those malls having a minimum annual gift certificate or gift card sales	volume of $250,000 or greater. We also plan to engage mall owner/operators	in the use of our Virtual Mall as a revenue enhancement device to their	existing operations.
*-  Continue to EstablishMerchant Rebate Agreements for use with the Multi-Merchant Card Applications 

As part of our	multi-merchant card strategy, we plan to continue to add additional anchor	merchants to our current list of 180 participating merchants. These	agreements are difficult and time-consuming to craft, and form one barrier	to entry in the channel for potential competitors. We believe our existing	relationships will facilitate further advancement in the marketplace. We	also believe that incremental volumes created for our participating	merchants will enable us to receive even larger discounts and rebates than	the initial agreements provide. This should increase our margins while at	the same time, provide additional or increased revenue sharing opportunities	for our distribution partners, thereby accelerating additional sales and	revenues.

7

 
*-  Expand CorporateIncentive and Membership Reward Card Programs

We currently	supply prepaid stored-value cards to providers of turnkey corporate	incentive and membership reward programs. We intend to expand our marketing	efforts of prepaid stored-value cards to companies that administer their own	incentive and membership reward programs.
*-  Establish a DirectRetail Presence for out Multi-Merchant Cards

We intend to	market our prepaid stored-value cards through high-traffic retail locations,	such as grocery stores, drug stores, and entertainment venues. These	companies market, distribute and manage card activation through the	point-of-sale systems for prepaid cards, such as individual merchant cards	or phone cards, for sale in grocery store checkout lines or in other retail	establishments. The sale of prepaid telephone cards at such locations is	well established, and an increasing number of open and closed network gift	cards are now being sold through direct retail locations.
*-  Expand the Gift CardFulfillment Program*
As we demonstrate	the power, flexibility, and economy of our fulfillment model, we attract	additional business from our existing partners such as ValueLink and we	entice new customers through word-of-mouth referrals. We plan to expand our	gift card order fulfillment business for dedicated prepaid stored-value gift	cards primarily through our exclusive arrangement with ValueLink for	ValueLink's customers. This increased volume of business has allowed us to	leverage economies of scale in our operations. We will also continue to	pursue order fulfillment business from outside ValueLink's existing customer	base where non-compete agreements allow for such activities.
*-  Promote ourFundraising Programs Through Distributorship Relationships*
Fund-raising for	schools, youth sports organizations, church and similar organizations is	primarily a grass-roots activity, and we are pursuing opportunities to	partner with firms who have already established strong distribution networks	to market our multi-merchant rebate cards. We are marketing our stored-value	multi-merchant cards as complementary or replacement products for	traditional scrip products. 
*-  Credit CardRegistration Program to Generate Rebates from Leading Retailers*
We developed a	program to supplement the multi-merchant cards with the standard	credit/debit cards that most consumers currently utilize for everyday	purchases. Under this program, we contract with leading merchants to provide	rebates on purchases made with regular credit/debit cards by those	individuals who have registered those credit/debit cards as part of our	program. We have already negotiated such agreements with approximately 15	retailers, constituting about 18% of the retailers who participate in the	multi-merchant card program. We do not expect material sales or revenues	from this new channel until 2006 or 2007. We must demonstrate traction with	our multi-merchant stored-value cards and sign up significantly more	merchants offering rebates before this becomes a material part of our	operations. However, the potential of this opportunity is large and, in our	opinion, is worth expending the additional time and resources to expand.
**Sales and Marketing

 **
Our approach to salesand marketing varies by product and target market. We maintain an internal salesteam supported by senior management, and also use third parties as distributionchannels and extensions of our own sales force. We market our gift card programsand services to shopping malls and other retail merchants. Our gift cards aresold at mall customer service desks through mall-staffed dedicated terminals,through Internet websites that we operate and maintain, and through telephoneorders to our in-house call center. Our marketing programs may be tailoredspecifically to one shopping mall, to a number of shopping malls owned by oneowner/operator, to one retailer, or to multiple retailers. We market ourmulti-merchant card to high-volume outlets such as grocery stores and drugstores. We market our incentive cards to businesses that use them for employeeincentive rewards programs and for customer loyalty rewards programs. We marketour fund-raising cards to primary and secondary schools, colleges anduniversities and to their affiliated support organizations, as well as singlepurpose non-profit fundraising organizations. Finally, we market our Internetand call-center gift card fulfillment services to businesses that useproprietary closed system gift cards. We maintain several websites such asnbo.com, thegiftcardcompany.com, thegiftcertificatecompany.com, andchildrensheroes.com to accommodate sales in each of the above-mentionedchannels. Additionally, purchasers or recipients of a gift card can access ourbalance inquiry websites, www.giftcardbalance.com and www.myprepaidcard.info, tocheck the outstanding balance of funds available on their cards.

 

8

 

Our sales in each ofthe above channels position us in the areas of strongest growth in the prepaidstored-value card industry. Each channel has its strengths, and in addition, wehave an underlying program that is common to each sales channel - our merchantrebate program. We have entered into rebate agreements with over 180 nationalretail merchants having more than 35,000 retail consumer locations, who pay us arebate on card redemptions in their stores in exchange for increasing customertraffic. Additionally, we created a virtual mall website that has more than3,000 brand name merchandise products available for purchase and delivery atprices typically below brick-and-mortar retail prices. We have the flexibilityto use the multi-merchant card rebates to enhance our own margins, or to createadditional or enhanced revenue sharing opportunities with our distributionpartners.

 
**Operations and Strategic Relationships

 **
We manage our prepaidstored-value card program operations in four basic categories: 
-  Program setup 
-  Sales and	distribution
-  Redemption 
-  Post-redemption	activity, including analysis, reporting, and billing 

In each of thesecategories, we leverage strategic relationships with industry leaders to ensuresmooth and robust operations for our customers.
* 

Program Setup

 *
Our operation stepsfor program setup vary, depending primarily on the platform or network that thecard program will employ. For open-network programs, those that rely on the Visaor MasterCard networks, our first step is to define the new program with anissuing bank, the financial institution that is ultimately responsible for theunderwriting of the card. We have relationships with several banks thatunderwrite our card programs, including Bank First, MetaBank, and MercantileBank. For dedicated-network programs, those that rely on the Discover network,we are considered the issuing partner through sponsorship by Discover.

 

Next, we work withthe issuing bank's or network's data processor to establish card number rangesand other details. We have agreements with First Data Corporation and MetavanteCorporation, two of the leading data processors in the industry, who handlelarge volumes of Visa, MasterCard, and Discover traffic. We secure networkapproval on the card design, including card artwork and terms and conditions. Wethen order the plastic cards themselves, through the data processors, and theprocessors prepare the cards for distribution by encoding their magnetic stripesand embossing card numbers.

 

Our setup steps for aclosed-network program, such as a ValueLink gift card program, require us toform a connection to the ValueLink client's data processor, and then establish ashopping cart on the client's website to effect internet and call center sales.
* 

Sales andDistribution

 *
We sell cards througha mall PC desktop counter-top unit ("CTU"), one of our websites, our callcenter, or in bulk to a business-to-business customer, corporate incentiveprogram provider, or fundraising group. These entities present a credit card,cashier's check, wire transfer, or other form of payment. In exchange, theyreceive a card or group of cards loaded with value, ready to use. In programswhere we are responsible for handling a credit card transaction in support of aprepaid card sale, we route the transaction through our credit card processor,Nova Information Systems ("NOVA"), an industry-leading gateway to the majorcredit card networks.

 

The mall CTU's areour primary mall gift card and gift certificate sales mechanism. The CTUsoftware gives the consumer the choice of purchasing a gift card or paper giftcertificate (where supported) by credit/debit card, check, or cash. When thecustomer presents a credit/debit card for payment, the most common paymentsource, the mall employee swipes the consumer's card at the CTU, which thentransmits an authorization request to NOVA. Upon receipt of the applicableauthorization, the CTU software charges the credit/debit card for the gift cardface value, plus any applicable point of sale fees and taxes. Deposits of thefunds are routed automatically, or presented manually by mall personnel, to abank account, often established with a bank directly in the mall. At the end ofeach business day, we sweep the funds from that depository bank account into aholding account designated specifically for gift card redemptions. Theserestricted bank accounts are maintained by the card-issuing bank or networkdesignate and are separate from our operating accounts. The funds are held inthese restricted bank accounts and are dispensed as necessary to supportredemption activity. We earn interest income on the deposited funds as well asinterchange on the redemption activity of the cards.

 

9

 
*Redemption

 *
The flow of fundsfrom redemption activity lies solely within the domain of the merchant's creditcard processors, the card networks, and the issuing bank's data processors. Whena cardholder presents one of our cards at a merchant, that merchant authorizesthe redemption using its own credit card processor and the network affiliatedwith the card. The data processor receives the authorization request, consultsits database, and either approves or denies the purchase. The merchant latersettles the transaction with the bank, triggering a transfer of funds from ourholding accounts to the merchant. The redemption transactions are high volume -we rely on the 'heavy iron' secure and redundant processing systems within thedata processors to accommodate this traffic.
* 

Post-RedemptionActivity

 *
The data processorsrelay redemption information to us on a regular basis. We use the redemptioninformation to add value for our clients by supplying them with store-by-storeredemption reports, information on the payment sources used by cardholders toload value on the cards, and rebate generation, where appropriate. Our customersuse this information to analyze spending trends and to gauge programperformance. We rely on redemption data to bill merchants for agreed-uponrebates, and to support our billing to our customers of account initiation andinterchange fees.

 

Another importantpost-redemption step is the calculation of merchant rebates. We match cardredemptions against our list of participating merchants, and determine therebate that relates to each transaction. The merchant rebates vary inpercentage, in general from 3% to 30%. We deduct a technical services fee fromeach rebate up front, and then, depending on the program and sales channel,either retain the rest of the rebate, or calculate a split with our distributionpartner from the appropriate channels mentioned above.

 

To supportpost-redemption processing for the credit/debit card-registration program, werely on our agreement with Card Commerce International ("CCI"), a leadingsupplier of transaction filtering and fraud check services. CCI scans alltraffic from participating merchants, detects transactions from registeredcards, and relays the redemption activity to us for analysis, reporting, andbilling. Filtering the large number of transactions is a burdensome task,requiring significant infrastructure and association certification. Our 5-yearagreement with CCI, signed in 2002, relieves us of that burden.

 

In our strategicrelationships with issuing banks, data processors, and networks (either open orclosed), we have taken care to establish redundant agreements that assure smoothoperations in the event that one of the key relationships fails. As mentionedearlier, we offer customers a choice of platforms, and those multiple platformsgive us access to multiple issuing banks and data processors that can supportsimilar lines of business.
** 

Customers**
 

We have a broadcustomer base from a variety of product offerings, including mall owners anddevelopers, restaurant and retail chains, corporate incentive and rewardsponsors, and fund-raising organizations. As of March 2005, we provided giftcertificates and gift card programs to a total of 76 shopping malls in 31states. One mall customer, Glimcher Properties, represented 28% of totaltransaction volume in 2004. We expect to further diversify our customer base aswe execute our growth strategy.
** 

Competition**
 

We face competitionin each of our business channels, potentially from much larger financialservices companies, that may choose to enter the prepaid stored-value cardmarket.

 

With respect to mallgift cards in particular, we face competition from two basic sources: malldevelopers themselves, and alternate service providers. Many mall developerscurrently manage their own gift card and gift certificate programs in-house. Ourchallenge is to convert these in-house competitors into customers bydemonstrating the benefits of out-sourcing to us, and the cost savings andcustomer service benefits we can provide to the mall owners, thereby eliminatingmanpower and overhead associated with an in-house program.

 

We believe that withthe availability of stored-value gift cards, and the complexities ofadministering such a detailed program, mall developers who have chosen in thepast to manage their own paper gift certificate programs may see the benefits ofoutsourcing this service if they want to convert from paper gift certificates toplastic gift cards expeditiously and with a lower administrative burden. Ourstored-value gift card and gift certificate services provide a revenue sharingopportunity for the mall developer that did not exist with a paper giftcertificate program as recently as 2002, providing another incentive for malldevelopers to do business with us. We have established four long-term contractswith significant mall developers that previously managed their programsin-house.

 

10

 

The primary alternateservice provider that we compete with in the mall gift certificate/card space isMid-America Gift Certificate Company, or Mid-America, a subsidiary ofMid-America Bank, wholly owned by BB&T Corporation of Winston-Salem, NorthCarolina. Another direct competitor in the mall space is Store FinancialSystems, or SF, based in Chicago, Illinois, a recent entry into the gift cardprovider space.

 

The most directcompetitor to our universal multi-merchant gift card is the Persona card,marketed by American Express Incentive Services. This card offers rebates onpurchases made at participating merchants, similar to our multi-merchant card.

 

Other potential giftcard competitors include banks that already issue prepaid stored-value cards.Although most banks run only local or regional prepaid gift card programs, theseprograms are attracting the attention of national banks as well. Data processorsare also entering the market, with First Data Corp. offering a 'gift card in abox' program, designed to allow customers to quickly configure and launch acustomized gift card program.

 

In the orderfulfillment arena we have a variety of competitors including Gift CheckSolutions, GiftCertificates.com, and other primarily internet-based operations.

 

In the fundraisingchannel, in particular scrip fundraising, several firms compete with us,although we do not consider scrip fundraising to be a critical revenue channel.Great Lakes Scrip Center, ("GLSC"), is based in Grand Rapids, Michigan and hassignificant operations in Michigan, Indiana, Illinois, Ohio, and Wisconsin. GLSCis a potential national distribution partner for our CSC card, and is currentlyrunning a pilot CSC program scheduled to be completed in the first quarter of2005. The results will be evaluated in April 2005.

 

Other scripcompetitors are SchoolPop, (who in January 2004 purchased assets of The NationalScrip Center, or NSC, based in Santa Rosa, California), Scrip Advantage based inFresno, California, and eScrip based in Auburn, California.

 

We compete in ourtarget markets based primarily on cost, administrative efficiencies, processingcapabilities, technology, and rebate programs. 
** 

Technology**
 

We have developedand deployed proprietary software for our gift card and gift certificateprograms. Our software is contractually protected through licensing agreementswith the contracting entities (such as mall developers and merchants).
* 

Magnetic StripeStored-Value Gift Cards*
 

Magnetic stripe cardsare most commonly used as credit cards and debit/ATM cards. This technology hasan application in the gift giving industry as a "stored value" or debit card.The magnetic stripe card can be pre-loaded in fixed denominations or loaded atthe time of purchase for any amount the customer chooses. While the magneticstripe card is not as powerful or versatile as the latest smart card technology,magnetic stripe technology is widely accepted in the U.S. market, and is lesscostly than smart card technology. Accordingly, we believe magnetic stripetechnology will continue to replace paper gift certificates and be the preferredtechnology in many applications until smart cards or other card technologies aremore widely accepted and become less costly.
* 

Onsite Systems

 *
Our Onsite Systemsconsist mainly of multiprocessor Dell severs running Windows XP Advanced Serverand are used to provide services for MS-SQL databases, credit card processing, amodem pool offering a secured redundant connection method for point-of-saledevices, web services, anti-virus software management, accounting software ande-mail services. Servers running a UNIX operating system are used for securityand twenty-four hour network monitoring. Our network utilizes network-attachedstorage, a reliable tape backup system, a secure firewall and intrusiondetection system, and a virtual private network gateway. Many of our systemsutilize redundant servers and equipment to enhance reliability. We utilize threeT1 Internet connections from three separate providers to ensure redundantnetwork services. Failure on any T1 link is automatically detected and resolved.
* 

Software Methodology

 *
Our software designmethodology allows several modular applications to run on outlet computersystems (point-of-sale systems) simultaneously. This modular design approachallows us to develop custom point-of-sale solutions and can be configured toaccept a variety of payment methods. For example, one point-of-sale system canbe configured to accept cash only while another, running the same softwaremodules, can be configured to accept cash, credit and debit cards.

 

11

 

Our software usesindustry standards for both client-server deployment and for host-based systems.Additionally, where applicable, we interface to third party systems usingapplication program interfaces, or APIs. API's are used for real-timecommunication with software systems of strategic partners, credit cardprocessors and batched file transfers for other systems where real-time eventsare not required.

 

Furthermore, softwarehas been developed to connect with various networks using dial-up, DSL, framerelay and Ethernet. Additionally, many of our outlets contain local databases,allowing for temporary off-line operation in the event a network connectioninterruption occurs.
* 

Point-of-Sale Systems

 *
Our Point-of-SaleSystems deployed in the field consist of mall-employee manned systems residingon a desk or counter top, known as Dual-Advantage Counter Top Units, or CTU's.

 

CTU's arepoint-of-sale devices used for issuing gift cards or gift certificates in thefield. This system allows clients to move from paper gift certificates to giftcards at will. This design reduces the number of configurations deployed in thefield. This reduces technical support training and manpower costs for computerintegration. CTU's are configured to either use our credit card processingservices or free standing Verifones.
* 

Intellectual Property

 *
We currently rely ona combination of trademark, copyright, and trade secret law and contractualrestrictions with our customers, suppliers and consultants to protect ourintellectual property rights. We have filed for several federal applicationswith the US Patent and Trademark Office for the trademarks and service marksrelating to the marketing and sale of our products and services. Theseapplications include "Children's Heroes", "Freedom Prepaid Card" and "CommunityScrip Card."

 

We have licensed, andmay license in the future, elements of our trademarks, trade dress and similarproprietary rights to third parties. While we attempt to ensure that thesebusiness partners maintain the quality of our brand, they may take actions thatcould materially and adversely affect the value of our proprietary rights orreputation.
* 

Government Regulation

 *
The gift card and the gift certificate industries are regulated primarily bystate law and vary substantially from state to state. Some states under theirabandoned property laws seek to escheat unredeemed gift certificates and giftcards and some states exempt gift certificates and gift cards from the abandonedproperty laws. Some states regulate expiration dates of gift cards and giftcertificates and other states have no provisions for expiration dates. Somestates regulate the type and amount of charges that may be applied to giftcertificates and gift cards and other states have no regulations. Some statesapply money transmitter licensing regulations to issuers of gift cards and giftcertificates and others do not. In some states, the state Attorney General andprivate plaintiffs attempt to regulate gift certificates and gift cards throughlawsuits in an attempt to apply a state's unfair business practices laws orother consumer protection legislation to the gift certificates and gift cardbusiness. Finally, some members of Congress have suggested federal legislationto regulate gift cards, although no federal legislation has been enacted todate. We expect that a number of state legislatures will continue to be activein regulating gift cards and gift certificates.

 

Weare continually reviewing legislation enacted from time to time by the variousstates and we attempt to monitor material instances off litigation affectinggift certificates and gift cards. We make a concerted effort to comply with thelaws of the various states and to adapt our business practices from time to timein response to changes in the laws and the results of litigation.
** 

Employees**
 

As of December 31,2004, we had 58 total employees, consisting of 41 full-time employees and 17part-time seasonal temporary employees.****Our operationsstaffing varies with seasonal demand. Our employees are not represented by anycollective bargaining agreement and we have never experienced a work stoppage.We believe our relationship with our employees is good.
** 

Available Information**
 

Our primary Internetwebsite address is www.nbo.com. We make available, free of charge on or throughthis website, our Annual Reports on Form 10-KSB, Quarterly Reports on Form10-QSB, Current Reports on Form 8-K and all amendments to those reports as soonas reasonably practicable after such material is electronically filed with orfurnished to the Securities and Exchange Commission. We also operate thefollowing websites in connection with the operation of our business:www.thegiftcertificatecompany.com, www.thegiftcardcompany.com,www.giftcardbalance.com, www.myprepaidcard.info and www.childrensheroes.com.Information contained on these websites is not part of this Annual Report onForm 10-KSB.

 

12
** 

RISK FACTORS***Investing in our common stockinvolves a high degree of risk. Before purchasing ourcommon stock, you should carefullyconsider the risks described below in addition to theother information in this Report. Our business prospects, results of operations,liquidity or financial position may be materially and adversely affected due toany of the following risks. The risks described beloware not the only ones we face. Additional risks we arenot presently aware of or that we currently believe are immaterial may alsoimpair our business prospects, results of operations, liquidity or financialposition. The value of our commonstock could decline due to any of these risks, and youcould lose all or part of your investment. In assessing these risks, you shouldalso refer to the other information contained or incorporated by reference inthis Report, including our consolidated financial statements and related notes.

 

This Report contains forward-looking statements based on the currentexpectations, assumptions, estimates and projections about our industry and us.These forward-looking statements involve risks and uncertainties. Our actualresults could differ materially from those discussed in these forward-lookingstatements as a result of certain factors, as more fully described in thissection and elsewhere in this Report. We do not undertake to update publicly anyforward-looking statements for any reason, even if new information becomesavailable or other events occur in the future.

 ***Since inception, we have incurred net losses and negativecash flows from operating activities.**
Since inception of operations in June 1994, we haveincurred net losses and negative cash flows from operating activities. As ofDecember 31, 2004we have incurred cumulative losses of approximately $34.3 million. In recentyears, we have been financing our operations, in part, through loans extended byexisting stockholders, in exchange for which we have issued short-term andlong-term promissory notes providing for interest at annual rates of between 17and 30 percent. The aggregate amount of such loans was approximately $5 millionas of December 31, 2004. We may need to raise additional funds to continue tooperate our business if we are unable to generate positive cash flows from ouroperating activities. We may not be able to obtain such financing on termsfavorable to us, if at all. Any additional capital raised through the sale ofequity or convertible debt securities would dilute the ownership interests ofour then-existing stockholders. Any additional capital raised through debtfinancing would result in increased interest expense and would likely subject usto financial and other covenants that restrict our ability to operate ourbusiness. If financing is unavailable when required or is not available uponacceptable terms, we may not be able to develop or enhance our products andservices, marketing efforts or operational infrastructure, which may, in turn,prevent us from achieving profitability and/or continuing in business. 
** 

If we are not successful in marketing our products andservices, our results of operations will suffer.**
 

We have expended few funds on marketing and advertisingto date. We anticipate a significant increase in sales and marketingexpenditures particularly for our new products and services to be offered in2005. We have not developed or tested any targeted, integrated, multi-mediamarketing program that would include print, radio, television or on-linecomponents to build brand awareness and drive sales. Our future growth andprofitability will depend in large part upon our ability to:
-  create greater awareness of our	products and services and the ways in which consumers and corporations may	purchase them;
-  identify the most	effective and efficient level of spending for each product in each market; 
-  determine the	appropriate creative message and media mix for marketing expenditures; 
-  effectively		manage marketing costs (including creative and media) in order to		maintain acceptable operating margins and return on marketing		investment;
-  select the right	markets in which to market; and
-  convert consumer	awareness into actual store visits, on-line visits and product purchases. 

If we are not successful in implementing our marketingprogram, our results of operations will be adversely affected.
** 

At present, we have a fairly limited number of customers.To continue in business and achieve profitability, we need to expand ourcustomer base.**
There are a limited number of shopping mall properties inthe United States that would likely have sufficient gift card and giftcertificate volume for us to be able to establish profitable gift card programsat such properties. Our target market for gift card programs is further limitedas a result of owners/operators of some of the largest malls in the UnitedStates developing their own gift card and/or gift certificate programs, as havemany large retailers. Further, there has been a significant amount ofconsolidation in the shopping mall commercial real estate industry. The prospectof further consolidation creates the risk that we may lose some of our existingmall owner/operator customers.

 

13

 

The Company maintains anon-compete agreement with ValueLink, limiting the customer base available forfulfillment contract services. At this time, we are unable to offer fulfillmentservices to direct ValueLink competitors.
** 

Existing and/or proposed federal and state laws andregulations regarding gift certificates, gift cards and other prepaidstored-value cards have limited (and may further limit) the manner in which weoperate our gift, incentive and fund-raising card programs and our revenues.**
 

Existing and/or proposed federal and state laws andregulations have limited and may in the future further limit the manner in whichwe are able to operate our gift, incentive and fund-raising card programs. Forexample, in October 2004, a bill was introduced in the U.S. Senate and referredto the Committee on Banking, Housing and Urban Affairs. This proposedlegislation, referred to as the Fair Gift Card Act, would, if adopted, precludeus from being able to impose fees, such as the monthly maintenance fees wecharge, for non-use or inactivity of gift certificates or gift cards, except inlimited circumstances. Further, the proposed legislation would make it unlawfulfor gift certificates or gift cards to have an expiration date of less than fiveyears from the date of purchase. Some states have already enacted legislationeliminating expiration dates or maintenance fees, and additional states mayenact similar legislation in the future. In other states, the statute oflimitations before a gift certificate expires is minimally three years from thedate of issuance of the gift certificate. We cannot recognize revenue fromunused gift certificates until the statute of limitations expires. Accordingly,if the statute of limitations is increased or expiration dates are eliminatedthen this would extend the timebefore we would be able to recognize revenue from unused gift cards, which wouldnegatively affect our results of operations.

 

We currently recognize revenue from unused giftcertificates and gift cards. Some states regulate the underlying funds fromunused gift certificates and gift cards through abandoned property laws orescheat laws. As a Maryland corporation, we are subject to the Marylandabandoned property laws, which do not apply to gift certificates. We have reliedon our Maryland domicile to determine that funds reflecting unredeemed giftcertificates and gift cards are not subject to escheatment. However, at least 15states have enacted "transactional jurisdiction" escheatment statutes, whichfocus on the location where a transaction occurs rather than the domicile of theholder of abandoned property. We do not know whether any of the states enactingsuch laws will attempt to apply them to the "breakage fees" we impose withrespect to our gift certificates and gift cards. If such states were successfulin applying such laws to breakage, our business prospects,results of operations, liquidity, and financial position would be adverselyaffected. 
**Since we do not have long-term agreements with ourvendors and suppliers, we may not be able to secure adequate supplies, whichcould disrupt our operations and have an adverse affect on our businessprospects, liquidity, financial positionand results of operations.

 **
We purchase 100% of our materials used for our productsand services from outside vendors. These vendors, in turn, contract for ourorders with multiple factories for the production of our certificate and cardstock. Our relationships with our vendors generally are on a purchase orderbasis and do not provide a contractual obligation to provide adequate supply,quality or acceptable pricing on a long-term basis. Our vendors coulddiscontinue sourcing products for us at any time. If the vendors were todiscontinue their relationship with us, or if the factories with which theycontract were to suffer a disruption in their production, we may be unable toreplace the vendors in a timely manner, which could result in short-termdisruption to our inventory flow as we transition our orders to new vendors orfactories. Disruption in inventory could, in turn, disrupt our operations andhave an adverse effect on our business, financialcondition and results ofoperations. 
** 

We may undertake acquisitions to expand our business thatmay pose risks to our business and dilute the ownership of our existingstockholders. 

 **
We may, in the future, evaluate opportunities to acquireother businesses, products or technologies that would complement our currentofferings, or enhance our capabilities. We have no experience makingacquisitions and we may not realize the anticipated benefits of any acquisitionswe do undertake. Acquisitions that we may potentially make in the future mayentail a number of risks that could materially and adversely affect our businessprospects, liquidity, financial position, and results of operations, including:
-  problems integrating the	acquired operations, technologies or products with our existing business and	products;
-  costs associated	with acquiring another business;
-  diversion of	management's time and attention from our core business;
-  the need for	financial resources above our planned investmfent levels;
-  overestimation of	potential synergies or a delay in realizing those synergies;
-  difficulties in	retaining business relationships with suppliers and customers of the	acquired company;
-  risks associated	with entering markets in which we lack prior experience;
-  the potential	loss of key employees of the acquired company; and
-  potential	litigation arising from the acquired company's operations before the	acquisition.

 

14

 

We could be required to use a substantial portion of ouravailable cash to consummate any acquisition. Any future acquisitions also couldcause us to incur debt or contingent liabilities or cause us to issue equitysecurities that would reduce the ownership percentages of existing stockholders.Furthermore, acquisitions could result in adverse tax consequences, substantialdepreciation, deferred compensation charges, in-process research and developmentcharges, impairment of goodwill or the amortization of amounts related todeferred compensation and to identifiable purchased intangible assets, any ofwhich would negatively affect our operating results. 
** 

Our success is highly dependent on general economicconditions since consumer gifts are highly discretionary.**
Our business is subject to changes in general economicconditions. Since purchases of our products and services are dependent upondiscretionary spending by the users of our gift, incentive and fund-raisingcards, our financial performance is sensitive to changes in overall economicconditions that affect consumer spending. Consumer spending habits are affectedby, among other things, prevailing economic conditions, levels of employment,salaries and wage rates, consumer confidence and consumer perception of economicconditions. A general or perceived slowdown in the United States economy oruncertainty to the economic outlook could reduce discretionary spending or causea shift in consumer discretionary spending to other products or services. Any ofthese factors would likely cause us to delay or slow our expansion plans, resultin lower transaction volumes and revenues and adversely affect our liquidity andprofitability. A nationwide economic downturn could adversely impact our busiestselling season and reduce the expected revenues and other income we expect toreceive to fund our operations.
** 

The execution of our growth strategy depends on ourability to retain key personnel, including our executive officers, and toattract qualified personnel.

 **
The successful implementation of our business model andgrowth strategy depends on the continued contributions of our senior managementand other key personnel, including Keith A. Guevara, our President and ChiefExecutive Officer. We have $2,000,000 in key man life insurance on Mr. Guevara.We believe future success will also depend, in part, upon the ability toattract, retain and motivate qualified personnel.
** 

If we are unable to protect our intellectual property,which is essential to our business, we may not be able to compete effectively.****
We believe our copyrights, service marks, trademarks,trade secrets, and similar intellectual property are critical to our success. Ina highly competitive industry with relative ease of entry into the marketplace,we rely on trademark, copyright and other intellectual property laws to protectour proprietary rights and maintain our product differentiation. We also dependon trade secret protection through confidentiality and license agreements withour employees, licensees, licensors and others. We may not have agreementscontaining adequate protective provisions in every case, and the contractualprovisions that are in place may not provide us with adequate protection in allcircumstances. The unauthorized reproduction or other misappropriation of ourintellectual property could diminish the value of our brands, products andservices and competitive advantages and result in decreased revenues. Despiteour efforts to protect our intellectual property rights, intellectual propertylaws afford us only limited protection. A third party could copy or otherwiseobtain information from us without authorization. Accordingly, we may not beable to prevent misappropriation of our intellectual property or to deter othersfrom developing similar products and services. Further, monitoring theunauthorized use of our intellectual property rights is difficult. Litigationmay be necessary to enforce our intellectual property rights or to determine thevalidity and scope of the proprietary rights of others. Litigation of this typecould result in further substantial costs and diversion of resources, may resultin counterclaims or other claims against us and could negatively impact ourfinancial position, liquidity, business prospects, andresults of operations. In addition, the laws of some foreign countries do notprotect our proprietary rights to the same extent as the laws of the UnitedStates.
** 

Damage or long-term disruption to our information systemswould substantially harm our business.**
 

We depend heavily on our communications and informationsystems, which, despite our adoption of industry-standard security measures, arevulnerable to potential systems failures, unauthorized file access,telecommunications provider failures, and power failures. Any damaging failureor long-term interruption of our systems, including those associated with newsystems implementations or system upgrades, will significantly harm ourbusiness, including our sales, distribution, purchasing, inventory control,merchandising and financial controls. 
** 

 **
15

 
**Consumer-information privacy regulations could subject usto state penalties or litigation, damage our reputation, and deter current andpotential users from using our products and services.**
 

Under certain circumstances, we currently obtain andretain personal information about consumers who purchase cards on our websites,phone in orders to our call center, or register cards on our websites fortheft-cancellation or loss-replacement services. Federal, state and foreigngovernments have enacted or may enact laws or regulations regarding thecollection and use of personal information, possibly including enforcement andredress provisions. We have implemented programs and procedures designed toprotect the privacy of consumers and have established security features toprotect our user database and websites. However, our security measures may notprevent all possible security breaches. If third persons were able to penetrateour network security and gain access to, or otherwise misappropriate, our users'personal information, it could harm our reputation and, therefore, our business,and we could be subject to liability. Such liability could include claims formisuse of personal information. These claims could result in litigation, ourinvolvement in which, regardless of the outcome, could require us to expendfinancial resources and limit our operational growth.
** 

Increased accounting and financial reportingrequirements, as an SEC reporting entity, could stress our internal accountingsystem and system of internal controls sufficient to potentially impair theaccuracy of our financial results or impair ourability to prevent fraud.**
 

The risks associated with financial reporting have cometo the forefront in recent years. Any failure to effectively implement adequatecontrols or meet the growing systems and staffing needs of our accounting andfinance functions could result in errors in our published financial reports orin other failures to comply with our obligations as a public company, includingthe requirements of the Sarbanes-Oxley Act of 2002. Based upon our size andscope of operations, we are not required to comply with Sarbanes-Oxley untilDecember 31, 2006. Effective internal controls are necessary for us to providereliable financial reports and effectively prevent fraud within the company. Ourintent is to operate within the confines of the requirement to ensure effectiveinternal controls within the organization. As we have been a non-listed publiccompany, we have had limited accounting personnel and other resources with whichto address our internal controls and procedures. Our reporting obligations willincrease significantly should we become a listed public company, placing aconsiderable strain on our management, operational and financial resources andsystems for the foreseeable future. We are currently developing and improvingour internal accounting systems, particularly our operational, financial,communications and management controls and our reporting systems and procedures.We expect to devote significant resources to ensure that our administrativeinfrastructure and system of internal controls remain adequate for a listedpublic company. We cannot be certain that these measures will ensure that weimplement and maintain adequate controls over our financial processes andreporting. Non-compliance with Sarbanes-Oxley can result in litigation, publicscrutiny, and/or lost revenues, significantly limiting opportunities for futuregrowth.

 
**ITEM 2. DESCRIPTION OF PROPERTY

 **
Our headquarters arelocated at 3676 West California Avenue, Building D, Salt Lake City, Utah, 84104.This facility consists of approximately 28,800 square feet of leased space,which is comprised of 22,820 square feet of office space and 5,980 square feetof warehouse facilities. Included in the office space is a 9,120 square footcall center that can accommodate up to approximately 190 employees. The term ofthe lease was five years, which expired on February 28, 2005. We recently signeda one-year extension, set to expire on February 28, 2006. We lease theheadquarters facility from 5B Bangerter LLC at a base monthly rent of $23,035.We believe that our facilities are adequate for our current needs. However, wemay require additional space in the future, which may not be available oncommercially reasonable terms or in the location we desire.

 
**ITEM 3. LEGALPROCEEDINGS**
 

a. Ripperda, et al v.NBO, Inc., et al, Circuit Court Twentieth Judicial Circuit of Illinois, St.Clair County, Case No. 04L91
**On February 13,	2004, Thomas Ripperda, et al, filed an action in Illinois State Court in St.	Clair County, Illinois, against us in connection with gift cards sold at the	St. Clair Square Mall in St. Clair County, Illinois. The plaintiffs'	complaint seeks to establish a class action. However, as of this date, the	plaintiff has not moved to certify a class. The complaint alleged that the	term "valid thru" appearing on the face of the gift card next to the	expiration date of the gift card is misleading in violation of the Illinois	unfair business practices laws. The plaintiff seeks a return of all	administrative fees charged against his gift card prior to the "valid thru"	date. If a class were certified, then the plaintiff would seek to recover	similar fees with respect to all gift cards that we have sold.

 

Under the terms	and conditions of the gift cards and the gift card program, we disclosed	that we may charge an administrative fee against a gift card if the gift	card is not used within 90 days from the date of purchase. The "valid thru"	date is typically between 12 months and 18 months after the date the gift	card is purchased. In some cases, the administrative fee reduces the amount	of the gift card prior to the "valid thru" date on the card. We disclosed	the charge of an administrative fee on the backside of the gift card and	again in the written terms and conditions that are distributed to customers	when they purchase the gift cards. We also disclosed that a gift card may be	renewed after the "valid thru" date with the payment of a renewal fee.

16

 

The lawsuit is	currently pending in state court in St. Clair County, Illinois. We have	filed a motion to dismiss, but the plaintiffs have not yet filed an	opposition. The parties are continuing to conduct discovery.

b. WildCard Systems,Inc., Claim for Indemnification

WildCard Systems,	Inc. ("WildCard") is a credit card transaction processor. We entered into an	agreement with WildCard for the right to use the MasterCard-branded gift	cards sold at the St. Clair Square Mall and for card transaction processing	in connection with these gift cards. WildCard in turn contracted with Bank	of America and Bank of America issued the gift cards that were sold at St.	Clair Square Mall. The term "valid thru" appearing on the face of the card	are words required by Bank of America on the face of the card.

 

Thomas Ripperda,	the plaintiff described above, named Bank of America as a defendant together	with us when he filed his complaint against us in connection with the gift	cards sold at St. Clair Square Mall. Bank of America has been defending the	lawsuit parallel to our own defense of the lawsuit. WildCard has not been	named as a defendant in the lawsuit.

 

WildCard has	informed us that Bank of America has asserted a claim for indemnification	against WildCard in connection with Bank of America's expenses and possible	liability arising from the lawsuit filed by Thomas Ripperda against Bank of	America. WildCard has in turn asserted a claim to indemnification against us	with respect to Bank of America's claim against WildCard.

 

Section 9.2 of	our agreement with WildCard sets forth the indemnification provisions in	clause (a) and (b). The obligation to indemnify only arises out of or	relating to the following: "(a) any act or omission by [NBO Systems, Inc.]	or its representatives in the performance of [NBO Systems, Inc.'s]	obligations under the Agreement, (b) any material breach in a	representation, covenant or obligation of [NBO Systems, Inc.] contained in	this Agreement". Our agreement with WildCard provides a similar reciprocal	indemnification requirement by WildCard in our favor.

 

WildCard asserts	that we have the responsibility to assure that all aspects of the gift card	program at St. Clair Square Mall complied with all laws, and since the	plaintiff alleges a breach of the Illinois unfair business practices laws in	connection with the sale of the gift cards, we should be responsible for	indemnifying WildCard for its expenses and liabilities incurred in	connection with the gift cards. We have denied liability based on several	grounds. First, WildCard is not a party to the litigation and we claim that	we should not be liable for expenses and liabilities incurred by WildCard	under a completely independent agreement with Bank of America. Second,	WildCard has not identified any specific act or omission by us or any breach	by us of a specific covenant or obligation. Third, the complaint focuses	specifically on the phrase "valid thru" on the front of the card, a phrase	required by Bank of America and therefore, we claim, indirectly required by	WildCard.

 

We have also	asserted a right to indemnification from WildCard for our costs and	liabilities, if any, incurred in the litigation with Thomas Ripperda.	WildCard has rejected our claim for indemnification.

 

Since our	agreement with WildCard contains an arbitration clause, WildCard has invoked	the right to arbitrate the dispute. As of March 31, 2005, both WildCard and	we are in the process of appointing arbitrators. No lawsuit has been filed	and no discovery or other proceedings have been initiated in the arbitration	proceeding.

 

Except as	described above, we are not a party to any material threatened or pending	legal proceedings, which if adversely determined, would have an adverse	material effect on our business prospects, financial position, liquidity or	results of operations. From time to time, however, we may become subject to	legal proceedings, claims, and litigation arising in the ordinary course of	business, including, but not limited to, employee, customer and vendor	disputes.
**ITEM 4. SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS**
 

None.
** 

PART II

 

ITEM 5. MARKET FOR COMMON EQUITY ANDRELATED STOCKHOLDER MATTERS

 ****Market Information

 **
There is currently nopublic trading market for shares of our common stock.

 

17

 
**Holders

 **
As of March 31, 2005,there were approximately 691 stockholders of record of our common stock.
** 

Dividends

 **
We have not declarednor paid cash dividends on our common stock in the past two fiscal years or inany subsequent period. We do not anticipate paying cash dividends on our commonstock in the foreseeable future. We currently intend to retain all futureearnings, if any, to support operations and to finance the growth anddevelopment of our business. Any future determination relating to our dividendpolicy will be made in the discretion of our Board of Directors and will dependupon a number of factors including, our results of operations, financialposition, liquidity, capital requirements, contractual and legal restrictionsand other factors the Board of Directors may deem relevant. 
** 

Equity CompensationPlan Information

 **
The equity compensation plan information required by this Item is set forth inPart III, Item 11 of this Annual Report on Form 10-KSB.
** 

Recent Sales of UnregisteredSecurities 

 **
For the year endedDecember 31, 2004, we issued the following securities without registering thesecurities under the Securities Act of 1933, as amended:

 

We borrowed moneyfrom existing stockholders, all of whom are accredited investors, and issuedpromissory notes in return. In connection with these loans, we issued 118,742warrants to purchase shares of common stock at various strike prices. As ofDecember 31, 2004, borrowings from stockholders totaling $5,100,750 remainoutstanding. We relied upon the exemption from registration provided by Section4(2) of the Securities Act of 1933, as amended, and Regulation D.

 

In January 2004, weissued 17,782 shares of common stock at $2.75 per share to retire a $48,897outstanding note payable. The note holder is also a stockholder of the Companyand an accredited investor. We relied upon the exemption from registrationprovided by Section 4(2) of the Securities Act of 1933, as amended, andRegulation D.

 

In January 2004, weissued 889 shares of common stock for interest payable in the amount of $3,558.The note holder is also a stockholder of the Company and an accredited investor.We relied upon the exemption from registration provided by Section 4(2) of theSecurities Act of 1933, as amended, and Regulation D.

 

During November andDecember 2004, we issued 571,250 shares of common stock at $4.00 cash per sharein connection with a private placement offering totaling proceeds of $2,285,000.The Company incurred issuance costs of $67,352 to facilitate the sale. Eachinvestor is an accredited investor. We relied upon the exemption fromregistration provided by Section 4(2) of the Securities Act of 1933, as amended,and Regulation D.

 

We issued 6,515shares of preferred stock as stock dividends on previously issued preferredstock. This issuance did not constitute a sale because the recipients did notpay any consideration and did not make any election either to receive the sharesor to receive other payment. 

 

In April 2004, weissued 155,111 shares of common stock upon the exercise of 456,205 Class Bwarrants with an exercise price of $2.64 in a cashless exercise of thosewarrants. The warrant holders were accredited investors. We relied upon theexemption from registration provided by Section 4(2) of the Securities Act of1933, as amended, and Regulation D.

 

We granted options topurchase an aggregate of 1,700,625 common shares, vesting over a 5-year period,at an average exercise price of $4.00 per share to ourdirectors, executive officers, employees and consultants. These options wereissued under Section 4(2) of the Securities Act of 1933, as amended.

 
**ITEM 6. MANAGEMENT'S			DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF			OPERATIONS

 ***The followingdiscussion of our financial condition and results of operations should be readin conjunction with our financial statements and the related notes to suchfinancial statements included elsewhere in this Form 10-KSB. The followingdiscussion contains forward-looking statements that involve risks anduncertainties. Readers should not place undue reliance on these forward-lookingstatements. These forward-looking statements are based on current expectationsand actual results could differ materially from those discussed herein. Ouractual results could differ materially from those predicted in theseforward-looking statements, and the events anticipated in the forward-lookingstatements may not actually occur. Although we believe the expectationsreflected in these forward-looking statements are reasonable, we cannotguarantee future results, levels of activity, performance or achievements. Weare under no duty to update any of the forward-looking statements after the dateof this Form 10-KSB to conform these statements to actual results or to reflectthe occurrence of unanticipated events, unless required by law.

 *
18

 
**Basis of Presentation

 **
From our inceptionuntil 2003, our fiscal year end was March 31. In 2003, we changed our fiscalyear end to December 31. The change in fiscal year end resulted in auditedfinancial reporting for the nine-month transitional period from April 1, 2003through December 31, 2003. The financial statements included in this Form 10-KSBalong with the footnotes and this management's discussion and analysis presentunaudited results for the year ended December 31, 2003. We believe this providesthe reader with a clearer understanding when reviewing our financial statementsfrom a full calendar-year perspective. This management's discussion and analysisprovides a comparison of the years ended December 31, 2004 and 2003 (unaudited)and a comparison of the year ended December 31, 2004 with the nine-month periodended December 31, 2003.

 
**Critical Accounting Policies andEstimates**
 

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires the appropriate application of certain accounting policies,many of which require us to make estimates and assumptions about future eventsand their impact on amounts reported in our financial statements and relatednotes. Since future events and their impact cannot be determined with certainty,the actual results will inevitably differ from our estimates. Such differencescould be material to the financial statements.

 

We believe theapplication of accounting policies, and the estimates inherently required inconnection with the application of such policies, are reasonable. Theseaccounting policies and estimates are periodically reevaluated, and adjustmentsare made when facts and circumstances dictate a change. Historically, we havefound our application of accounting policies to be appropriate, and actualresults have not differed materially from those determined using necessaryestimates.
** 

How We Generate Revenues and OtherIncome**
With respect to	our various gift card programs, we derive revenue and other income from a	number of sources, including:
-  enrollment or		point of sale fees charged to purchasers of cards issued in connection		with one of our card programs, either at the time of purchase or during		the life of the card. These fees are an additional expense to the		consumer and are deposited with the proceeds from the card sales		regularly in accounts swept by us.
-  payment		system interchange and transaction fees in connection with redemption		transactions;
-  rebates paid		by merchants who participate in our card programs;
-  interest on		funds held in reserve for the redemption of the prepaid, stored-value		cards;
-  monthly		administrative fees and renewal fees charged on inactive prepaid,		stored-value cards;
-  balance		inquiry fees;
-  fees charged		to sponsors of employee incentive and customer rewards programs; and 
-  "breakage"		resulting from prepaid, stored-valued cards that expire or are never		redeemed.

Historically, we	expect to receive approximately 10% of the value loaded on our	multi-merchant cards back in the form of maintenance fees, expiration fees,	balance inquiry fees and other administrative fees.

With respect to	our various gift certificate programs, we derive revenue and other income	from a number of sources, including:
interest		income on funds held in reserve until utilized for gift certificate		redemption by the customer.
breakage		resulting from unredeemed or unredeemable gift certificates.

 

We also record	revenue from the sale of third-party closed-end gift cards and gift	certificates. We purchase these gift cards and gift certificates at a	discount as inventory and in turn resell them to customers or provide them	to clients of ValueLink, a subsidiary of First Data Corp., through our call	center and internet fulfillment website. We record revenue equal to the	sales price of the gift cards and gift certificates sold or the fulfillment	fee paid to us by Valulink and the shipping and handling charges.

19

 
**RevenueRecognition/Cost of Goods

 

*Gift Card Fees*

 

Our	multi-merchant cards are governed by the rules of, and approved by, the	member bank associations (Visa and MasterCard) and Discover. The member bank	associations and their related issuing financial institutions require us to	fund the value of the multi-merchant cards within 24 to 48 hours from the	sale of the multi-merchant card. We sweep the depository funds from the mall	owner/operator deposit accounts and hold them in restricted bank accounts.	The issuing bank or financial institution sweeps the funds reserved for gift	card redemptions from our restricted cash accounts to be held for future	multi-merchant card redemptions. We show the funds on our balance sheet as	restricted cash. We record an offsetting liability labeled gift	certificates/gift cards payable on our balance sheet. The multi-merchant	card-issuing bank makes a perpetual daily reconciliation to net new sales	against redemptions and fees owed to us.

 

We record	interchange transaction or processing fees earned in connection with card	redemption transactions as revenues when received. We begin to recognize	material revenues on multi-merchant card sales approximately 7 months from	the date of sale. The issuing bank and card processor calculate the fees	owed to us and submit the fee revenue to us from the restricted bank	accounts on a regular basis, typically monthly.

 

The	multi-merchant card has a maximum life of 18 months based on the "Valid	thru" (or other similar phrase) date imprinted on the face of the	multi-merchant card. The issuing banks mandate this expiration date.	However, for a period of up to 12 months after the expiration of the	multi-merchant card, the consumer may obtain a replacement multi-merchant	card with the remaining balance by calling us. All multi-merchant card fees	are charged against the value of the multi-merchant card after expiration as	described in the terms and conditions document provided to the consumer at	the point of sale. The issuing bank holding the funds for our multi-merchant	cards remits to us the funds remaining upon expiration of the multi-merchant	card, which we record as revenue when received. Our experience shows that	approximately 2% of the face value of all multi-merchant cards sold will be	returned to us in the form of expiration fees.

 

The average life	of all multi-merchant cards is approximately 3 to 4 months. Consumers redeem	most multi-merchant cards (approximately 85% to 90%) before any maintenance	fees or expiration fees are imposed. For those multi-merchant cards that are	not fully redeemed by a particular date (which may vary from mall to mall),	we charge a monthly maintenance fee (typically $2.50 per month) to the card	per the Terms and Conditions (imprinted on the multi-merchant card and in a	separate document provided at the point of sale) until the balance on the	multi-merchant card is zero. We deactivate the multi-merchant card account	12 months after the multi-merchant card expires. The monthly maintenance	fees and the expiration fees enable us to provide the multi-merchant card	service to consumers and cover our up-front costs. We record gift card	maintenance and expiration fees as revenue in the period earned.

 

We record rebate	income as revenue net of any revenue sharing agreements with third parties	in the period received. We apply estimates when compiling quarter-end or	year-end results due to timing of receipts of receivable invoices or amounts	due to us.

 

*Other Income -	Gift Certificate Breakage*

 

For gift	certificates, we record the gross transaction volume on our balance sheet as	restricted cash. We adjust the restricted cash liability as we offset new	gift certificate sales against our payment to retailers of gift certificates	they present to us for redemption. We earn and retain all of the interest	income from the restricted bank accounts. With interest rates at their	current levels, revenue from interest income is not material.

 

We do not record	the full amount of the mall gift certificate sale as revenue. We recognize	the majority of our other income from unredeemed or unredeemable gift	certificates, known in the industry as "breakage". We classify breakage as	"Other Income" in our statement of operations. We recognize income from	breakage upon expiration of the gift certificate, or when no expiration date	exists, upon the extinguishment of the liability per the applicable state	statute of limitations, for which we use an average of three years from the	date of issuance. We have tracked redemption and breakage patterns since	inception. Our historical analysis indicates that we receive approximately	4% of the gift certificate gross transaction volume in the form of breakage.	However, this breakage income is deferred a minimum of 12 months from the	sale date to several years from the sale date, based on the existence or	non-existence of an expiration date on the gift certificate. As we record	breakage income in the statement of operations in the applicable period, we	record a corresponding decrease in gift certificate liability.

 

*Gift	Certificate Processing Fees*

 

Our sales history	shows that typically 70% to 80% of the gift certificates are purchased with	a credit or debit card, with the remainder being purchased with either cash	or check. Each credit or debit card transaction is assessed a processing	fee, which we show as a cost of revenue shown as merchant fees and charges	in our statement of operations. We pay the processing fees and subsequently	invoice the mall operator for the processing fees in the following month. We	record revenue from the credit and debit card processing fees as merchant	fees earned from retailers in our statement of operations.

 

20

 
*Sale of	Third-Party Gift Certificates and Gift Cards and Related Fulfillment	Services

 *
Because we	pre-purchase third party gift certificate and gift card inventory, we bear	all the financial risk associated with that inventory. Therefore, we record	the entire transaction volume sold as revenue in our statement of	operations. The associated cost of revenue is the discounted price we pay to	the seller of the gift certificates and gift cards we purchase for re-sale.

 

Since we	pre-purchase the entire inventory for traditional scrip, we record the face	value amount of the scrip i as revenue when sold. We offer no terms on	traditional scrip products. Non-profit organizations purchasing the scrip	products pay for the scrip electronically or by check before we ship out the	product. Our cost of revenue is the pre-purchase amount of the scrip, less	the agreed upon discount provided by the retailers. We also share the	discount provided by the retailers with the non-profit organization.

 

We record all	fulfillment business transaction volume conducted for third parties as	revenue. This channel, reflected as sale of third party gift	certificates/cards in our statement of operations, currently constitutes	approximately 64% of our revenues. We derive the majority of the revenue	from this channel from our Darden relationship. We expect the percentage of	revenues in future periods to be reduced as we generate other revenue from	new products and services that we anticipate to sell through other business	channels in 2005.

 

ValueLink, our	leading fulfillment customer, pays us on a per card fulfilled basis, which	we recorded as revenue in the appropriate period. Typically, we ship	ValueLink's consumer orders from our facilities in Salt Lake City. Most	orders are placed by consumers and corporations via our website or call	center operators. We retain any shipping and handling margins from the	fulfillment of the ValueLink products.

 
**Stock Based	Compensation

 **
In accordance	with Statement of Financial Accounting Standards No. 123 (SFAS No. 123),	"Accounting for Stock Based Compensation", expense is recognized in	connection with the grant of stock options when issued to nonemployees using	the fair-value based method. The expense is equal to the fair value of the	options, based on the Black-Scholes option-pricing model, at the grant dates	and is expensed ratably over the vesting periods.

 

We account for	its employee based compensation plans using the intrinsic value method, as	prescribed by APB Opinion No. 25, *Accounting for Stock Issued to	Employees*, and related interpretations. Accordingly, we record deferred	compensation costs related to our employee stock options when the current	market price of the underlying stock exceeds the exercise price of each	stock option on the measurement date (usually the date of grant).

 
**Restricted Cash

 **
Restricted cash	consists of funds held for the payment of issued and outstanding gift	certificates and gift cards to customers. We maintain these funds at several	financial institutions in depository bank accounts and associated sweep	accounts. We are restricted from withdrawing the funds except for the	redemption payment of issued and outstanding gift certificates and gift	cards. We may not transfer the funds into our operating accounts until such	time that the unredeemed gift certificates and gift cards qualify as	breakage or estimated breakage. We determine breakage based on (1)	expiration, (2) legal statute of limitations, or (3) the accumulation of	sufficient historical data upon which to make reliable estimates. We record	breakage by expiration or legal statute of limitations as income, and we	remove a corresponding amount from gift certificates and gift cards payable.	We remove the same amount from restricted cash and record it as unrestricted	cash. We base estimated unredeemed gift certificates and gift cards	("estimated breakage") on our historical breakage data and we do not record	it as income until the expiration date or the legal statute of limitations	passes. However, we may transfer all or a portion of estimated breakage from	restricted cash to unrestricted cash upon issuance of the gift certificate	or gift card. Any estimated breakage amount transferred to unrestricted cash	decreases the restricted cash balance but remains in gift certificates	payable, until such estimated cash decreases the restricted cash balance but	remains in gift certificates payable, until we recognize such estimated	breakage as income. At such time, we reduce the amount of gift certificates	and gift cards payable by a corresponding amount.

 

21

 
**Our Primary BusinessChannels

 ***The Shopping Mall	Channel*
 

The gift giving	industry in the U.S. amounted to approximately $350 billion in sales in	2003. Accurate figures for 2004 are not yet available. According to our	research, in 2003, sales of gift certificates and prepaid, stored-value gift	cards totaled approximately $60 billion, or 17.1% of the entire gift giving	industry. Gift certificate sales amounted to $43 billion or 71.7% of the $60	billion. Gift card sales were $17 billion or 28.3%. 97% or $58.2 billion of	the 2003 gift certificate and gift card sales consisted of sales derived	from individual retailers' closed network programs. The remaining 3% or $1.8	billion were in the form of universal mall gift certificates and gift cards.

 

Although gift	certificate sales have been growing at an annual rate of 11% to15% since	1993 and reached 20% annual growth in 2003, gift cards are rapidly replacing	traditional paper gift certificates because of their greater flexibility and	convenience. We anticipate by 2007, gift cards will represent 80% of the	total amount of sales of gift cards and gift certificates.

 

Approximately	3,500 covered or indoor shopping malls and 37,000 outdoor shopping centers	or outlets (often referred to as strip centers), representing over $1.8	billion in gift card and gift certificate sales in 2003, exist in the United	States. Approximately 15 major commercial property developers own about	1,500, or 42.9%, of the indoor malls. Smaller commercial property developers	or independent owner/operators own or manage the remaining mall properties.	Several of the larger indoor-mall property owners/developers, with interests	in roughly half of the indoor malls, manage their own gift certificate/card	programs, from which they generated an estimated $563 million in sales in	2003. The owner/operators of the remaining indoor malls either outsource	their gift certificate/card programs or do not currently have such programs.

 

We intend to grow	our mall gift card business as we have done over the last several years.	However, as a percentage of total transaction volume and total revenues, we	expect the mall channel percentages to decrease as other business channels	produce higher transaction volumes and revenues. We also anticipate a	decrease in mall gift certificate business as the industry shifts to mall	stored-value gift cards.

 

We have been	marketing our gift card programs, and related fulfillment services, to	targeted mall owner/operators since October 2001. Our typical mall	owner/operator does gift certificate/card volume averaging $500,000 per	year. We currently service 76 mall properties in 31 states across the	nation. We have serviced in excess of 100 malls in 38 states in recent	years; however, the commercial real estate market, particularly shopping	malls, has experienced a significant amount of consolidation. The largest	mall developers are buying even more shopping mall properties from large to	mid-size owner/operators. Typically, the largest mall developers have the	resources to manage their gift certificate or gift card programs in-house.	That consolidation has resulted in a loss of business for us each of the	last several years. We have been able to make up the losses by adding new	shopping mall clients to our portfolio, thereby maintaining essentially flat	transaction volumes in 2003 and 2004. The industry consolidation is outside	of our control. We collect termination fees when our contracts are not	renewed due to consolidation. We are contractually unable to force an	acquiring mall company to continue with our gift certificate or gift card	program.

 

As a result of	our efforts to convert our gift certificate customers to gift cards, our	gift certificate business has been declining, both in terms of volume and in	terms of the percentage of our business. We anticipate 2005 gift certificate	gross transaction volume will decrease compared to 2004 due to the number of	our mall owner/developer customers converting from paper gift certificate	programs to gift card programs. Our gift card programs may be tailored	specifically to the owners/developers of one or more shopping malls, as well	as individual and multiple retailers.

 

The introduction	of our Virtual Mall in 2005 should enhance revenue sharing opportunities	with our existing mall clients, as well as differentiate us from our	competition in acquiring new mall gift card business. Our multi-merchant	gift card approach allows us to receive rebates from gift cards sold at	participating merchants within the mall properties. These revenue enhancing	measures will be crucial to our sales efforts as the gift card regulatory	and legislative environment continues to change and become less friendly	towards monthly fees and expiration/breakage issues.
* 

Fulfillment	Services

 *
We provide	Internet and call-center fulfillment services for dedicated closed network	gift cards for our partners such as ValueLink and Darden. In the fourth	quarter of 2004, we added 20 new ValueLink clients to our dedicated closed	network card order fulfillment program, bringing the total number of	ValueLink clients to 29. We anticipate an increase in ValueLink clients in	2005 and a corresponding increase in revenues. We also plan to pursue	fulfillment opportunities on our own that do not infringe upon our	non-compete agreement with ValueLink.
* 

Incentive and LoyaltyRewards

 *
Many businesses,	large and small, use gift cards in connection with employee incentive and	customer loyalty rewards programs. In the past, businesses have typically	been unable to negotiate discounts on these gift card bulk purchases.

 

22

 

Beginning in late	2004, we began marketing our multi-merchant card programs to businesses that	use them for employee incentive and customer loyalty rewards programs. We	are negotiating distribution agreements with marketing firms and credit card	processors experienced with corporate incentive and customer loyalty rewards	programs. These third parties essentially act as resellers, marketing our	business-to-business multi-merchant card programs to businesses with which	they have or are seeking relationships. These third-party resellers either	pay for the cards prior to our shipment or pass on the prepaid cost to the	businesses sponsoring the incentive or customer loyalty rewards programs. We	believe a significant portion of our sales and revenues will be derived from	business-to-business multi-merchant card programs going forward. We believe	we can significantly improve the volume of orders for these programs by	providing revenue sharing (in the form of rebates provided by participating	merchants) to the program sponsors. 

 
*The Fund-RaisingChannel*
 

Our research	indicates that a $20 billion fund-raising industry currently exists for	school and youth non-profit organizations. There are approximately 120,000	K-12 schools in the United States. The average school participates in	multiple event-based fund-raisers that allow the schools the opportunity to	earn as little as a few thousand dollars to upwards of $100,000 per year, at	a substantial cost in volunteer time (e.g., children going door-to-door,	parent supervision, PTA and school administrator time). We believe that many	parents across the United States are no longer comfortable having their	children participate in fund-raising activities of this nature because of	the attendant safety and security issues.

 

We believe that	the use of "scrip" is a viable alternative to door-to-door and other	traditional forms of fund-raising. Scrip consists of gift certificates and	gift cards purchased below face value and resold at full face value. As it	exists today, this business is a high-volume, low-margin business. The face	value of sales derived from traditional scrip fund-raising has increased	dramatically in the limited geographic markets currently being serviced by	the various scrip providers. Scrip has become a valuable fund-raising tool	in California, the Midwest and Mid-Atlantic regions of the United States. We	believe the largest scrip company in the industry, Great Lakes Scrip Center,	based in Grand Rapids, Michigan, achieved face value sales of scrip products	in excess of $400 million in 2004, generating revenue of approximately 1.5%	to 2% of this amount (roughly $4.5 million to $6 million).

 

Today, in excess	of 350 national merchant organizations, consisting of supermarkets, gas	stations, restaurants and many other retail merchants, sell gift	certificates and gift cards at discounts to support various non-profit	organizations. The majority of merchants providing discounts to fund-raising	organizations typically require full payment prior to shipment of the scrip.	Large scrip companies during peak scrip ordering seasons must cover	significant cash outflows. For example, assume a scrip company with $200	million in annual sales, did 60% of its annual volume in the Thanksgiving	and Christmas season, as is typical of most retailers. The building of	physical scrip inventory for hundreds of various merchants required to meet	the holiday demand could require approximately $120 million of capital to	finance the inventory. That is a significant cash flow concern and a	security risk based on the value of the inventory itself.

 

We currently	maintain a traditional scrip inventory through approximately 100 of the	largest merchants in the country, supplying scrip products to approximately	100 schools in 15 states. Our traditional scrip sales were in excess of $1	million in 2004. The traditional scrip business is not profitable for us, as	it requires us to carry scrip inventory, which is capital and labor	intensive. However, we intend to continue this business on a limited scale	to further our marketing efforts for our Community Scrip Card programs. We	intend to exit the traditional scrip business and to refer out our	registered schools to existing scrip companies in exchange for their	entering into distribution agreements for our fund-raising card programs. We	also intend to enter into licensing agreements with existing traditional	scrip companies to augment their own offerings with products such as our	Community Scrip Card programs. We anticipate that the licensing revenues	will offset the cost of card production and provide greater revenues than	those achieved with traditional scrip.

 

To pursue	non-traditional scrip opportunities in the non-profit, fund-raising market,	we introduced our multi-merchant "Community Scrip Card" program in late	2004. We entered into an agreement with Great Lakes Scrip Center to test	this product on a three-month pilot basis beginning in January 2005. During	this test period, Great Lakes Scrip Center has been marketing the Community	Scrip Card to its non-profit organization customers in the states of	California, Minnesota and Iowa. If this pilot program is successful, we	anticipate signing a distribution agreement with Great Lakes Scrip Center	for a national rollout of the program to its entire customer base,	consisting of more than 10,000 public and private schools and their	affiliated support organizations, in approximately the second quarter of	2005. We will complete our evaluation of the pilot program in the second	quarter of 2005.

 

In primary and	secondary schools, the Community Scrip Card program is intended to	complement or replace traditional scrip programs. We believe the Community	Scrip Card has an advantage over other traditional fundraising	products/services for the following reasons:

 

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-  consumers		shop where they normally shop;
-  consumers buy		what they normally buy;
-  consumers do		not spend a penny more for normal purchases;
-  consumers can		conveniently raise funds for schools or causes for which they have an		interest;
-  children		remain in the classroom, not going door-to-door selling candy, wrapping		paper, trinkets and other non-essential products, generally at higher		than average prices;
-  the program		eliminates scrip inventory requirements for various fund-raising		organizations; and
-  the program		increases the efficiency of the ordering, distribution and managing		process of scrip products. 

Our Community	Scrip Card program is designed to drive increased transactions, monthly	visits, and incremental profit for shopping centers, restaurants and local	merchants, while concurrently raising funds for community schools, youth	sports, youth groups and other local non-profit organizations. We expect	that the discounts/rebates offered by participating merchants will vary by	product category and volume. High volume merchants such as supermarkets and	gas stations typically offer discounts that average 3% to 5%. Other	retailers such as clothing stores offer discounts that average 10% to 15%,	with restaurants offering discounts that can be as high as 15% to 30%. The	merchant discounts realized will be split between the school, our	distribution partner and us.

 

We have also	recently introduced "University Card" program, which is the marketing of a	multi-merchant card very similar to the Community Scrip Card branded with a	university or college theme on the face of the card. We are currently	negotiating with universities and colleges in Utah and will begin marketing	efforts to universities and colleges outside of Utah in 2005. University or	college supporters will purchase the University Card through the university	or college, its alumni association, other fund-raising organizations	affiliated with the university or college, or through us via the Internet or	our call center. We will provide the university or college with part of the	revenues derived from the University Card program, in the form of	convenience or enrollment fees and rebates provided by participating	merchants. We believe our multi-merchant University Card provides the	opportunity to supplant existing programs because we generate more revenue	for sharing with colleges and universities than our competitors.

 

Our Community	Scrip Card and University Card multi-merchant card programs eliminate all	capitalization requirements because the cards are loaded with value when the	schools order the cards. Upon redemption at a specific merchant, the	merchant is paid in the same manner it is paid in any other credit/debit	card transaction. We invoice the merchants for the applicable rebates and	then share the revenue with the schools and our distribution partners. We	believe that the benefits of our multi-merchant fund-raising card programs,	including the elimination of the capitalization required for traditional	scrip products, the increase in the profit margins available to fund-raising	organizations and other efficiencies will appeal to fund-raising	organizations. We intend to pursue this channel in 2005.
** 

Results of Operations

 **
The following figures are includedfor informational purposes only and are not included in the Company's statementsof operations.

 
***Transaction Volume***
 

Year Ended		December 31,

Dollar

Percentage

2004

2003

Change

Change
Mall gift certificates 

$ 20,108,000 

$ 46,541,000 

$ (26,433,000)

-56.8%
Mall gift cards 

24,611,000 

9,897,000 

14,714,000 

148.7%
NBO fulfillment (excluding		ValueLink and Scrip) 

4,895,000 

3,565,000 

1,330,000 

37.3%
ValueLink 

1,226,000 

303,000 

923,000 

304.6%
Scrip 

2,831,000 

1,191,000 

1,640,000 

137.7%

$ 53,671,000 

$ 61,497,000 

$ (7,826,000)

-12.7%
 

In 2004, weexperienced a major shift from mall gift certificate sales to mall gift cardsales. This was primarily a result of The Rouse Company being purchased byGeneral Growth Properties. Our gift certificate sales for The Rouse Companyceased in mid-2004. The Rouse Company had been our largest mall customer. Wereplaced most of the lost Rouse sales with gift card sales by GlimcherProperties, now our largest mall client, as well as other new independent mallowner/operators. We anticipate a further reduction in gift certificate sales asmore properties convert to stored-value mall gift cards.

 

With the decline ingift certificate sales, we have developed new products and services to providediversification away from the mall channel. We will continue to grow our mallgift card business, but anticipate less of a reliance on the mall channel forfuture growth in sales and revenue. 

 

24

 

We also experienced a37.3% increase in the number of third party gift certificates fulfilled. Themajority of this transaction volume resulted from year-over-year increases inDarden sales (Red Lobster, Olive Garden and Bahama Breeze). This transactionvolume could decrease in 2005 if Darden changes its current fulfillment processDarden has expressed an intent from time to time in the year 2004 to change itsfulfillment process in a manner that would affect how we record revenue. Thecontemplated change would be similar to our current processing of our ValueLinktransactions. Under the contemplated change, we would not record as revenue thefull amount of the value of the gift cards sold on behalf of Darden. Instead, wewould record as revenue an amount approximating the discount at which wepurchase the Darden gift cards. Accordingly, our recorded revenue would declinesignificantly, possibly as much as $4,000,000 or more. We would have also acorresponding decrease in our cost of sales. The change contemplated by Dardenwould not have a material effect on our cash available for operations or on ourprofitability.

 

ValueLink transactionvolume increased over three-fold in 2004. We gained 22 new ValueLink clients inthe fourth quarter of 2004. We expect 2005 ValueLink transaction volume tosubstantially exceed 2004 volumes.

 

Scrip transactionvolume showed large year-over-year increases since we started with a smallvolume of scrip in late 2003. 2004 was our first full year of scrip operations.We will be exiting the traditional scrip business by the end of the secondquarter 2005 in favor of selling our Community Scrip Card .

 

We anticipateincreases in our transaction volume in 2005 compared to 2004 arising from ourfundraising card, loyalty and incentive cards, retail incentive cards as well assales from our virtual mall.
** 

Comparison of yearended December 31, 2004, with the nine months ended December 31, 2003

 
*Revenues and Other Income

 ***
We recorded revenues and other incomefrom the various channels as follows:

 

Year Ended		December 31,

Nine Months		Ended December 31,

Dollar

Percentage

2004

2003

Change

Change
Sale of third party gift		certificates/cards

$ 7,701,000 

$ 4,133,000 

$ 3,568,000 

86.3%
Merchant fees earned from		retailers

1,191,000 

1,234,000 

(43,000)

-3.5%
Fees earned from customers

914,000 

539,000 

375,000 

69.6%
Miscellaneous Income

623,000 

393,000 

230,000 

58.5%
Interest on restricted cash

50,000 

26,000 

24,000 

92.3%
Gift certificate breakage

1,528,000 

2,358,000 

(830,000)

-35.2%
    		Total revenues and other income

$ 12,007,000 

$ 8,683,000 

$ 3,324,000 

38.3%
 

Our Company issubject to typical retail seasonality. We sell the majority of our giftcertificates and gift cards between Thanksgiving and Christmas every year. Wehave specific holiday spikes such as Easter, Mother's Day and Father's day, butthe first three calendar months of the year typically represent only 10% of ourtransaction volume and revenues and other income. Approximately 90% of our fullyear revenues and other income are represented by the nine month period endedDecember 31, 2003.

 

The apparent increasein revenue and other income is due to the comparison of the full year for 2004with the nine months ended December 31, 2003. However, as noted above, our firstcalendar quarter revenues and other income generally represent 10% or less ofour total annual revenues and other income.

 

The increase in feesearned from customers of $375,000, or 69.6%, is partly due to the comparison oftwelve months with nine months, but the continuing trend of significantincreases in the sale of mall gift cards also contributed to the increase. Asnoted in the transaction volume table above, we have achieved a significantincrease in the volume represented by the sale of mall gift cards. We have alsobeen able to negotiate with malls to retain all or a portion of thepoint-of-sale fees assessed by malls upon the sale of the gift cards. Incontrast, in our past contracts we generally allowed the malls to retain theseadministration fees. We expect the trend of increased fees to continue as wecomplete new mall contracts going forward.

 

We receive immaterialrevenue on gift cards sold until approximately 7 months from the date of sale.In some instances, we defer gift card fee revenue over a period of time thatcould range from 7 months to 18 months or longer from the date of sale of thegift card. When gift cards are sold, we hold the funds for redemption inrestricted bank accounts maintained by the issuing bank and the card processor.We do not have access to these funds, which adds a security feature for theconsumers and the malls selling the gift cards. We record gift card fee revenuein the period it is earned and recouped. The issuing bank and card processorcalculate the fees owed to us and remit the fees to us from the restricted bankaccounts on a regular basis, typically monthly.

 

25

 

We anticipate thesale of third party gift cards and gift certificates to continue to increase.However, we expect that these revenues will represent a lesser percentage of thetotal revenues and other income in future periods. We also expect giftcertificate breakage to continue to decline as our customers phase out the useof gift certificates and replace them with gift cards.

 

We sell gift cardsand gift certificates at a stated face value. We do not recognize the face valueas revenue unless we bear the financial risk and liability for the giftcertificates and gift cards sold. We record revenue for each product line.

 

We purchase andre-sell third party retailer gift certificates and gift cards (primarily fromDarden). The line item "Sale of third party gift certificates/cards" alsoincludes our ValueLink operations, as well as our traditional scrip fulfillmentbusiness. We had a corresponding increase in revenues from transaction volumes,from the sale of third party gift certificates and gift cards, primarily fromthe increase in Darden fulfillment operations. We generate additional revenuesthrough call center and Internet order fulfillment primarily ValueLinkcustomers.

 

Merchant Fee revenuesearned from retailers represent dollars collected to cover expenses associatedwith the mall products. When customers purchase gift certificates and gift cardsusing their credit cards, we collect an additional fee to cover processingcosts. Credit card processors seek to create agreements with service providersto share the revenue generated through redemption interchange. We, in turn,receive revenue from redemption interchange sharing agreements related to giftcards. We will continue to pursue and foster these opportunities. The reductionin merchant fees earned from retailers for the nine-month period ended December31, 2003, corresponds with the reduction in transaction volume as describedabove, as fewer consumers purchased gift certificates and gift cards overall,thereby reducing the number of credit/debit card transactions we typicallyprocess relating to those sales.

 

Our miscellaneousincome is comprised of service income collected from our third party and mallcustomers. We charge our customers for additional services provided by ouremployees, through technology development, special reporting, and/or postage andhandling associated with our products. As our customers seek to differentiatethemselves within the industry, we expect these revenues to grow. 

 

We experienced adecrease in breakage income of 35.2% or $830,000 for the year ended December 31,2004, compared to the nine-month period ended December 31, 2003. We recordedbreakage for gift certificate transactions only. We record breakage as otherincome, as set forth in Critical Accounting Policies described above. Werecorded a decrease in gift certificates issued for the year ended December 31,2004, due to the termination of The Rouse Company contract and a shift to giftcard sales. Based on current trends and the expansion of our gift card business,we expect breakage income from gift certificates to continue to decrease inensuing years.
** **
These increases werepartially offset by a decrease of approximately $634,000 or 29.3% from giftcertificate breakage. This decrease reflects the continuing industry shift awayfrom gift certificates toward gift cards and the loss of our largest giftcertificate vendor, The Rouse Company.  We recorded a 57% decrease in giftcertificate issuances for the year ended December 31, 2004 due to the mallindustry consolidation and the above-mentioned shift to gift card sales. Based on current trends and gift card expansion, we expect breakage income tocontinue to decrease in ensuing years.
** 

Cost of Revenues

 **
Cost of Revenues andOther Income:

 

Year Ended December 31,
Nine Months Ended December 31,
Dollar
Percentage
2004
2003
Change
ChangeThird party gift		certificates/cards$ 7,118,000		$ 3,776,000		$ 3,342,000		
88.5%Merchant fees and charges1,604,000 1,233,000 371,000 
30.1%Rebates544,000 201,000 343,000 
170.6%Other		910,000 		511,000 		399,000 
78.1%    		Total cost of revenues and other income		$ 10,176,000 		$ 5,721,000 		$ 4,455,000 
77.9%
 
****
Cost of Revenues associated with third party gift certificates and gift cardsrepresent the costs associated with providing outside gift certificates to ourfulfillment and scrip customers. We purchase our inventory of outside vendors'cards and certificates directly from the vendors at a discount and then weresell them to outside customers. We experienced an 86.3% increase in sales ofthird party gift cards and gift certificates. We incurred a corresponding 88.5%increase in costs associated with these sales. We are focused on increasing ourmargins on these products in future periods.

 

26

 

We incur costs inprocessing customer transactions, particularly credit/debit card transactions,through our merchant processor, Nova Information Systems, Inc. The shopping malloperator reimburses us for the credit/debit card processing costs. We recognizethe reimbursement as revenue. We record the fees we pay to Nova InformationSystems, Inc. to process the credit card as merchant fees.

 

In 2003 and for thefirst nine months of 2004, we used the services of First Data Company and BankFirst to process our Nova Information Systems, Inc. credit card transactions.During the fourth quarter of 2004, we began processing credit/debit cardtransactions through Solspark and/or MetaPayment Systems. Merchant Fees recordedduring the fourth quarter decreased as a result of this vendor change. We expectto see costs associated with processing customer transactions continue todecrease as we migrate all of our mall clients to our new processors.

 

We offer rebates tomall owner/operators as an incentive to use our card programs. We accumulatethese fees and we pay the fees to the malls approximately one year following thecompletion of the card transaction year. These fees are transaction based, andas transaction volume grows , the rebates we pay to mall owner/operators willincrease. Rebates also comprise a portion of the discounts we receive inexchange for re-selling traditional scrip to the various non-profitorganizations such as the K-12 schools participating in our Children's Heroesprogram.

 

Other Costs includeprimarily postage and physical costs associated with providing gift cards andcertificates to our mall clients. The largest change in these accounts from theprior year is due to the inventory costs associated with providing our products.We incur all of the up-front costs of the raw plastic, the embossing andencoding of the mall and multi-merchant CSC cards. As the number of gift cardsissued increases annually, these inventory costs increase proportionately.
** 

Gross Profit**
 

Gross Profit for therelated periods:

 

Year Ended December 31,
Nine Months Ended December 31,
Dollar
Percentage
2004
2003
Change
ChangeRevenues$ 12,007,000		$ 8,683,000		$ 3,324,000		
38.3%Cost of Revenues		(10,176,000)		(5,721,000)		(4,455,000)
77.9%Gross Profit 		$ 1,831,000 		$ 2,962,000 		$ (1,131,000)
-38.2%Gross Profit %
15%
34%
 
****
We experienced adecrease in gross profit (total revenues and other income less total cost ofrevenues and other income) due primarily to:
-  the increased		up-front costs associated with issuance of gift cards; 
-  the deferral		of revenue from gift card sales until subsequent periods; and
-  the decrease		in gift certificate breakage realized during the respective periods. 

Gross Profitdecreased approximately $822,000 in the year ended December 31, 2004, comparedto the nine-month period ended December 31, 2003. The decrease in breakagerevenue reflects approximately $830,000 of this reduction. The remainingdifference reflects the nature of the gift card industry, in which costs areincurred in the contract origination period and revenue streams matureapproximately 7 months thereafter.
** 

Selling, General andAdministrative

 

Year Ended		December 31,

Nine Months		Ended December 31,

Dollar

Percentage

2004

2003

Change

Change        
Personnel 
$ 3,205,000 

$ 2,514,000 

$ 692,000 

27.5%
Non-qualified stock options		
- 

1,250,000 

(1,250,000)

-100.0%
Other Selling, General and		Administrative Expenses 
1,280,000 

1,019,000 

261,000 

25.6%
Professional Fees 
483,000 

220,000 

263,000 

119.5%

$ 4,968,000 

$ 5,003,000 

$ (34,000)

-0.7%
 

27

 

For the year endedDecember 31, 2004, compared to the nine-month period ended December 31, 2003, weexperienced a decrease in selling, general and administrative expenses due to anon-cash expense of $1,250,000 for non-qualified stock options that wereextended to one of our original employees who terminated employment in February2003. Selling, general and administrative expenses for the nine-month periodended December 31, 2003, excluding this expense for non-qualified stock options,totaled approximately $3,800,000. The corresponding increase in selling, generaland administrative expense for the year ended December 31, 2004, excepting the$1,250,000 non-cash expense form the nine-month period ended December 31, 2003,amounted to approximately $1,200,000 or 31.6%.

 

Personnel expensesincreased due to the hiring of several executives. However, the increases inexecutive salaries were offset by the reduction in the number of employeesneeded during our heavy holiday season, as shown in the full year comparativeresults displayed below. We have employed nearly half of our employees for morethan five years. Our experience will continue to benefit us in the marketplace.We expect personnel expenses to remain constant or to increase slightly based onnormal attrition as new employees are hired to meet the growing demand for ourproducts and services.

 

Other selling,general and administrative expenses include rent, travel, and depreciationexpenses. We experienced a 0.7% reduction in selling, general and administrativeexpenses, while at the same time experiencing a 38.3% growth in revenue. We arecommitted to controlling selling, general and administrative expenses byutilizing cost control measures and implementing process improvements.

 

Professional Feesinclude expenses for legal and accounting fees. We expect these expenses toincrease as we enhance our disclosure controls and procedures and to strengthenour internal control over financial reporting. We will contract with independentconsultants to assist us with our disclosure and financial controls. We cannotpredict how federal and state regulatory activity may affect us, especially asstate governments address the legal requirements associated with unclaimedproperty. We expect to incur additional expenses for professional fees forcompliance. We also expect to incur additional legal fees in connection withlitigation and other legal matters.
** 

Net Income (Loss)**
 

Net Income (Loss) forthe related periods is as follows:

 

Year Ended

Nine Months		Ended

December 31,

December 31,

Dollar

Percentage

2004

2003

Change

Change

NET LOSS ATTRIBUTABLE TO		COMMON STOCKHOLDERS

$ (4,128,000)

$ (2,423,000)

$ 1,705,000 

-70.4%
 
****
Our transactionvolume decreased in the year ended December 31, 2004 from the nine-month periodended December 31, 2003, primarily due to the termination of our contract withThe Rouse Company. However, revenues and other income increased in thecomparable periods, as our gift card programs generated revenue more quicklythan our gift certificate programs. Our gift card program costs are"front-loaded", meaning we bear the cost of providing the card services, but donot receive material revenues until several quarters later. Accordingly, we showa greater increase in cost of revenues than an increase in revenues. Weanticipate this trend to continue until new product offerings and programsresult in greater revenue throughout the year and decrease our upfront cost ofcards prior to sale. As we become less dependent upon maintenance fees,expiration fees and breakage, revenues and costs will be recorded nearer intime. We have decreased selling, general and administrative expenses throughattrition and cost cutting measures. However, our generation of cash flows fromoperating activities has not been sufficient to cover operations. Therefore, wehave raised working capital through equity and debt offerings. The equityofferings dilute existing stockholders and the debt offerings increase ourinterest expense, which has negatively affected our net income (loss). Wecontinually strive to increase sales of higher profit margin products and expectthis to increase cash flows from operating activities in the future. We expectour need for raising capital from outside sources to fund operations willdecrease.
** 

Comparison of year ended December 31,2004 with the year ended December 31, 2003

 

*Revenues and Other Income*

 

Revenues and other income from thevarious channels are recorded as follows: 

 

Year Ended December 31,
Dollar
Percentage
2004
 
2003
Change
ChangeSale of third party gift		certificates/cards$ 7,701,000		$ 4,604,000		$ 3,097,000		
67.3%Merchant fees earned from		retailers1,191,000 1,409,000 (218,000)
-15.5%Fees earned from customers914,000 567,000 347,000 
61.2%Miscellaneous Income623,000 444,000 179,000 
40.3%Interest on restricted cash50,000 35,000 15,000 
42.9%Gift certificate breakage		1,528,000 		2,162,000 		(634,000)
-29.3%Total revenues and other		income		$ 12,007,000 		$ 9,221,000 		$ 2,786,000 
30.2%
 

28

 

The main reason forthe increase in revenue and other income in 2004 compared to 2003 is thesignificant increase in the sale of third party gift cards and giftcertificates. Sales of gift cards and gift certificates increased approximately$3,000,000, or 67.3%, mainly related to an increase in the Darden fulfillmentoperations. We also reflected an increase of approximately $347,000, or 61.2%,from fees earned from customers. This increase represents the continuing trendof significant increases in the sale of mall gift cards. As noted in thetransaction volume table above, we have seen a significant increase in thevolume represented by the sale of mall gift cards. We have also been able tonegotiate with malls to retain all or a portion of the point-of-sale feesassessed by malls upon the sale of gift cards. Our contracts in the pastgenerally allowed malls to retain these administration fees. Point-of-sale feesthat we retain represented an increase of approximately $280,000 in 2004compared to 2003. We expect this trend to continue as we complete new mallcontracts.
** **
These increases werepartially offset by a decrease of approximately $634,000 or 29.3% from giftcertificate breakage. This decrease reflects the continuing industry shift awayfrom gift certificates toward gift cards and the loss of our largest giftcertificate vendor, The Rouse Company.  We recorded a 57% decrease in giftcertificate issuances for the year ended December 31, 2004 due to the mallindustry consolidation and the above-mentioned shift to gift card sales. Based on current trends and gift card expansion, we expect breakage income tocontinue to decrease in ensuing years.

 
**Cost of Revenues**
 

Cost of revenues forthe various revenue channels are as follows: 

 

Year Ended December 31,
Dollar
Percentage
2004
2003
Change
ChangeThird party gift		certificates/cards$ 7,118,000		$ 4,251,000		$ 2,867,000		
67.4%Merchant fees and charges1,604,000 1,523,000 81,000 
5.3%Rebates544,000 209,000 335,000 
160.3%Other		910,000 		585,000 		325,000 
55.6%Total cost of revenues and		other income		$ 10,176,000 		$ 6,568,000 		$ 3,608,000 
54.9%
 
****
Cost of Revenuesassociated with third party gift certificates and cards represent the costsassociated with providing outside gift certificates to our fulfillment and scripcustomers. Our inventory of outside vendors' cards and certificates arepurchased directly from the vendors at a discount and then resold to outsidecustomers. As noted above, we experienced a 67% increase in sales associatedwith third party cards and certificates. We incurred a corresponding 67%increase in costs associated with these sales. We are focused on increasing ourmargins on these products in future periods. 

 

We incur costs inprocessing customer transactions, particularly credit/debit card transactions,through our merchant processor, Nova Information Systems, Inc. The shopping mallowner/operator reimburses us for the credit/debit card processing costs. Thereimbursement is recognized as revenue. The fees paid by us to Nova InformationSystems, Inc. to process the credit card are recorded as Merchant Fees.

 

In 2003 and for thefirst nine months of 2004, we were using First Data Company and Bank First asthe infrastructure to process our Nova Information Systems, Inc. credit cardtransactions. During the fourth quarter of 2004, we began processingcredit/debit card transactions through Solspark and/or MetaPayment Systems.Merchant Fees recorded during the fourth quarter decreased as a result of thisvendor change. We expect to see costs associated with processing customertransactions continue to decrease as we migrate all of our mall clients to ourinfrastructure partners. 

 

Rebates are offeredto mall owner/operators as an incentive to use our card programs. These fees areusually accumulated and paid by us to the malls approximately one year followingthe completion of the card transaction year. These fees are transaction based,and as transaction volume grows (as discussed above), the rebates paid to mallowner/operators will increase. Rebates also comprise the portion of thediscounts we receive in exchange for re-selling traditional scrip to the variousnon-profit organizations such as the K-12 schools participating in ourChildren's Heroes program. Rebates paid to Scrip non-profit organizations grewfrom approximately $55,000 in 2003, to $117,000 during the year ended December31, 2004.

 

29

 

Other Costs iscomprised primarily of postage and physical costs associated with providing giftcards and certificates to our mall clients. The largest change in these accountsfrom the prior year is due to the "hard costs" associated with providing ourproducts. We incur all of the up-front costs of the raw plastic, the embossingand encoding of the mall and multi-merchant CSC cards. As the number of giftcards issued increases annually, these hard costs increase proportionately. 
** 

Gross Profit**
 

Gross Profit for therelated periods is as follows:
****
 

Year Ended December 31,
Dollar
Percentage
2004
 
2003
Change
ChangeRevenues$ 12,007,000		$ 9,221,000		$ 2,786,000		
30.2%Cost of Revenues		(10,176,000)		(6,567,000)		(3,609,000)
55.0%Gross Profit 		$ 1,831,000 		$ 2,654,000 		$ (823,000)
-31.0%Gross Profit %
15%
29%
 

The Companyexperienced a decrease in gross profit (total revenues and other income lesstotal cost of revenues and other income) due primarily to:
-  the increased		up-front costs associated with issuance of gift cards; 
-  the deferral		of revenue from gift card sales until subsequent periods; and
-  the decrease		in gift certificate breakage realized during the respective periods due		to decreased gift certificate sales. 

Gross Profitdecreased approximately $822,000 from December 31, 2003 to December 31, 2004. Thedecrease in breakage revenue (discussed above) reflects approximately $624,000of this reduction. The remaining difference can be explained by the nature ofthe gift card industry. Costs are incurred in the contract origination period,while revenue streams mature approximately 7 months following, as describedabove. Therefore, as the gift card transaction volume grows, we continue toexperience declining margins since the majority of the costs to generate thegift card volume are recorded before or at the time the card is sold and themajority of the revenues related to such cards do not begin to be recorded untilapproximately 7 months later.
** 

Selling, General andAdministrative**
 

Year Ended December 31,
Dollar
Percentage
2004
2003
Change
Change        Personnel $ 3,205,000		$ 3,453,000		$ (247,000)
-7.2%Non-qualified stock options		- 1,250,000 (1,250,000)
-100.0%Other Selling, General and		Administrative Expenses 1,280,000 1,441,000 (161,000)
-11.2%Professional Fees 		483,000 		308,000 		175,000 
56.8%		$ 4,968,000 		$ 6,452,000 		$ (1,483,000)
-23.0%
 

For the year endedDecember 31, 2003, we experienced an increase in selling, general andadministrative expenses due to a non-cash expense of $1,250,000 fornon-qualified stock options that were extended and transitioned from a qualifiedplan to a non-qualified plan for one of the original employees of the Companythat ceased employment in February 2003. Selling, General and Administrativeexpenses for the year ended December 31, 2003, without considering this expensefor non-qualified stock options, totaled approximately $5.2 million.

 

Personnel expensesdecreased due to normal attrition, and process improvements in our fulfillmentbusiness that required less man-power during our peak holiday season. We haveemployed nearly half of our personnel for over five years. Our experience willcontinue to benefit us in the marketplace. 

 

Other Selling,General and Administrative expenses are comprised of rent, travel, anddepreciation expenses. We experienced a 23% reduction in selling, general andadministrative expenses, while at the same time experiencing a 30.2% growth inrevenue. We are committed to keeping selling, general and administrativeexpenses at a minimum by utilizing cost control measures and implementingprocess improvements. 

 

Professional Feesconsists of expenses for Legal and Accounting fees. These expenses are expectedto continue to grow as we enhance our operating and controls environment.Internal controls are critical to achieve strong performance over time. We willcontract, as appropriate, with independent consultants to further strengthen ourinternal control environment. We cannot predict how federal and state regulatoryactivity may affect us, especially as state governments address the legalrequirements associated with unclaimed property. We expect additionalexpenditures to protect and further our interests in this area. We also expectadditional expenditures to defend ourselves in the matters of litigation we area party to.

 

30

 
**Net Income (Loss)

 **
Net Income (Loss) forthe related periods is as follows:

 

Year Ended

Year Ended

December 31,

December 31,

Dollar

Percentage

2004

2003

Change

Change

NET LOSS ATTRIBUTABLE TO		COMMON STOCKHOLDERS

$ (4,128,000)

$ (4,487,000)

$ (359,000)

8.0%
 

Transaction volumedecreased 12.7% in the year ended December 31, 2004 from the comparable periodended December 31, 2003, primarily due to the shopping mall industryconsolidation discussed above. However, Revenues and other income increased30.2% in the comparable periods, as our gift card programs are more profitablethan our gift certificate programs. As discussed above, our gift card programcosts are "front-loaded", meaning we bear the cost of providing the cardservices, but do not receive material revenues until several quarters later.This has the effect of showing a greater increase in cost of revenues than thegrowth rate in revenues. We anticipate this trend to continue until new productofferings and programs result in more even revenue recognition throughout theyear and minimize the upfront cost of cards to us prior to sale. As we becomeless dependent upon maintenance fees, expiration fees and breakage, revenues andcosts will be recorded at approximately the same time. We have consistentlydecreased Selling, General and Administrative expenses through attrition andcost cutting measures. However, our generation of cash flows from operatingactivities has not been sufficient and therefore, we have raised working capitalthrough equity and debt offerings. The equity offerings dilute existingstockholders and the debt offerings increase our interest expense, which hasnegatively impacted our net income (loss). We continually strive to increasesales of higher profit margin products and expect this to increase cash flowsfrom operating activities in the future. This will minimize or eliminate theneed for raising capital from outside sources. We are currently in discussionswith several institutional level financial companies in order to obtain theworking capital we need to market and distribute our new products and executeour business plan. We are also in discussions with investment bankers to assistus with the completion of a public offering of our common stock. The timing andsuccess of these events is not certain. 
** 

Recent AccountingPronouncements

 **
In December 2004, theFinancial Accounting Standards Board ("FASB") issued Statement of FinancialAccounting Standards ("SFAS") No. 123R, *Share-Based Payment*, whichestablishes standards for the accounting for transactions in which an entityexchanges its equity instruments for goods or services. A key provision of thisstatement is the requirement to measure the cost of employee services receivedin exchange for an award of equity instruments (including stock options) basedon the grant-date fair value of the award. That cost will be recognized over theperiod during which an employee is required to provide service in exchange forthe award (i.e., the requisite service period or vesting period). This standardbecomes effective on January 1, 2006 for small business issuers. The Companywill adopt SFAS No. 123R beginning in the Company's first fiscal quarter of2006. The Company is assessing the impact of this statement and believes theadoption of SFAS No. 123R may have a material effect on the Company's financialposition and results of operations.

 

We do not believethat other recently issued, but not yet effective, accounting standards ifapplicable to us would have a material affect on our financial position, resultsof operations or liquidity.
** 

Liquidity and Capital Resources

 **
Our total costs andexpenses are currently greater than revenues and other income. In addition, ouroperating activities have used cash rather than provided cash. We have had ahistory of losses and our accumulated deficit (since inception June 23, 1994)through December 31, 2004 was approximately $34.3 million. During the year endedDecember 31, 2004, we utilized $2,144,400 in cash from operating activities. AtDecember 31, 2004 we had a deficit in working capital of $4,546,863. Our abilityto meet our obligations as they com due is dependent upon obtaining additionalfinancing as may be required and ultimately attaining sustained profitability.Our net losses decreased by 8.0% or approximately $0.4 million to $4.1 millionfrom $4.5million for the year ended December 31, 2004, when compared to the yearended December 31, 2003.

 

31

 

Subsequent toDecember 31, 2004, we entered into four financing agreements that provide uswith an additional $700,000 we can use at our discretion for operations. We alsocompleted a $2.285 million, or 571,250 common share private equity offering. Theproceeds are for general operating purposes. We incurred offering costs in theform of commissions of $50,600. In March 2005, we renegotiated the terms ofcertain financing agreements, extending their maturities past December 31, 2005.

 

We continue toattempt to raise capital through private equity or debt offerings, as well asinstitutional investors until our operations provide sufficient cash to meet ourneeds. We are taking steps to improve profitability by restructuring contractsto increase the amount of revenue generated by each contract, and to pass alongcertain costs to our customers that we previously absorbed; and increasing salesefforts to obtain contracts with mall developers and national retailers notcurrently under contract. We can give no assurance that we will be successful inexecuting our plans to improve operations or obtain additional debt and equityfinancing. If we are unable to improve operations or obtain additional debt andequity financing, we may be required to restructure operations during 2005. Webelieve that if we are not able to obtain additional financing for thedevelopment of our overall business, we could restructure our operations to beprofitable at the current level of sales. However, we can give no assurance thatwe will be able to continue operating without additional financing.

 

Our ability to meetour debts as they come due is dependent on our obtaining additional financing asrequired, and ultimately on our ability to achieve our business plan and attainprofitability. We currently operate without a line of credit and occasionallyenter into short and long-term promissory notes with accredited investors,typically existing stockholders. These promissory notes often have conversionprivileges into our common stock, easing debt service requirements. However,conversion privileges and warrants issued in conjunction with the notes couldpotentially dilute existing stockholders and increase our operating losses.
** 

Beneficial ConversionInterest Expense

 **
The beneficialconversion feature is the difference between the market value of the commonstock and the conversion rate of the debt into common stock, limited to theamount of debt. The beneficial conversion feature is recognized as interestexpense over the period from the date of the note to the date when theconversion of the debt into common stock may first take place.
** 

Off BalanceSheet Arrangements

 **
The Company does nothave any interests in off-balance sheet variable interest entities nor does ithave any interests in non-exchange traded commodity contracts.
** 

ContractualObligations

 **
The following table summarizes theCompany's outstanding borrowings and long-term contractual obligations atDecember 31, 2004, and the periods in which these obligations are scheduled tobe paid in cash.

 

 
Payments Due		By Period
Contractual		Obligations
Total

Less Than

1 Year

1-3

Years

3-5

Years

More Than

5 Years
 
 
 
 
 
 
 
 
 
 
Current debt
$1,346,668
 
$1,346,668
 
 
 
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