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EDGAR FILINGS

Year 2004 / October 27

FREESTAR TECHNOLOGY CORPORATION (FSRC.OB)

Annual Report

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

The following discussion and analysis of financial condition and results of operations of the Registrant is based upon, and should be read in conjunction with, its audited consolidated financial statements and related notes included elsewhere in this Form 10-KSB, which have been prepared in accordance with accounting principles generally accepted in the United States

OVERVIEW.

The e-payments and e-commerce market is composed of debit and credit card issuers, switch interchanges, transaction acquirers and transaction generators, including Automated Teller Machine ("ATM") networks, retail merchant locations and the Internet. The routing, control and settlement of e-payments is a complex activity due to the large number of locations and variety of sources from which transactions can be generated, the large number of issuers in the market, high transaction volumes, geographically dispersed networks, differing types of authorization and varied reporting requirements. These activities are typically performed online and must be conducted 24 hours a day, seven days a week.

The Registrant's products and services are primarily focused on facilitating electronic payments ("e-payments") and electronic commerce ("e-commerce"). These products and services are used principally by financial institutions, retailers, and e-payment processors, both in domestic and international markets.

The Registrant intends to increase its operations from its core payment processing products, which include:
(1)Authorization: transaction fees it receives from processing online point of sale terminal transactions;
(2) Sale of Point of Sale Solutions: sales of Point of Sale terminals as well as integrated cash register systems;
(3) transaction fees stemming from its Internet Payment Gateway;
(4) Dynamic Currency Conversion credit card services to merchants and acquiring banks (the company will provide transaction gateway services and settlement with participating banking institutions);
(5) Private Label Cards: transaction management services provided for a private label card issuer; and
(6) Consulting Fees: consulting services provided to financial institutions and merchants. The Registrant's revenue for the 12 months ended June 30, 2004 was primarily generated from the transaction fees through its Finland operations.

For the Registrant to derive revenue outside of its Finnish operations, the Registrant first had to perform a major hardware and software upgrade at Rahaxi, as Rahaxi is the core operating system of the Registrant's products. This upgrade was completed in December 2003, and evolved the Registrant's business critical systems to the latest Hewlett-Packard ("HP") NonStop servers and BASE24 e-payment processing software. HP NonStop servers are estimated to run approximately 95% of the world's secure transactions, making the NonStop platform the backbone for the world's most demanding and critical environments and offering the Registrant a secure, continuously available processing platform. A vastly scalable platform, HP NonStop provides the Registrant with the ability to achieve an adaptive enterprise by enabling it to respond quickly and easily to changing business needs, such as managing the expected growing number of transactions and the need for increased capacity.

BASE24 software from ACI Worldwide provides the Registrant with a fast, powerful authorization system. BASE24 software offers high data integrity for mission-critical environments. ACI and HP have a strong and long-standing relationship in e-payment implementations worldwide.

The new system will enable the Registrant to meet the latest Visa and MasterCard standards and to pave the way for EMV Europay/MasterCard/Visa ("EMV") compliance. The Registrant will also be capable of supporting the latest Visa 3D secure payment technology. EMV is an agreed-upon protocol for the introduction of smart cards. Chip-based bank and payment cards provide a substantial increase in the security of consumer payment transactions, and the Registrant expects it will be the standard throughout Europe by 2005. EMV is also gaining momentum in Asia and America, and promises complete global interoperability of bankcards for consumers. All payment processors will have to be able to accept payments mediated by smart cards in order to remain competitive, and meeting EMV compliance has major implications for all aspects of the payment handling processes. Management believes that with the company's investment in the upgraded NonStop systems running the newest ACI software, it can meet its projected increasing capacity needs and ensure future volume growth.

The Registrant, under the current management, began generating more revenue since its acquisition of Rahaxi Processing Oy. in January 2003. Its business is rapidly changing, and it expects the coming twelve months to be quite different from the previous twelve months as the company makes ready and further rolls-out its products and services. This process will require the Registrant to react quickly to problems and opportunities as they arise, and may involve costs that it does not currently anticipate. The Registrant also expects that further acquisitions may help it to quickly move forward in achieving its goals.

RESULTS OF OPERATIONS FOR THE TWELVE MONTHS ENDED JUNE 30, 2004 COMPARED TO THE TWELVE MONTHS ENDED JUNE 30, 2003.

(a) REVENUE.

The Registrant had revenue of $1,333,826 for the twelve months ended June 30, 2004 compared to revenue of $563,832 during the twelve months ended June 30, 2003, an increase of $769,994, or approximately 136%. The increased revenue is mainly due to the revenue derived as a result of the acquisition of Rahaxi Processing Oy. The Registrant did not own Rahaxi Processing Oy. during the entire comparable period in the prior year.

The majority of the Registrants revenue for the twelve months ended June 30, 2004 was from indirect merchant services, where revenue is generated on services primarily priced on a specified amount per transaction. The Registrant believes that for fiscal 2005 it will also derive revenue from direct merchant services which revenue is generated on services primarily priced as a percentage of the transaction value.

During the twelve months ended June 30, 2004, revenue was primarily generated from its customers in Finland. The Registrant expects to derive a significant portion of its expected revenue for fiscal 2005 from customers outside of Finland with the introduction of its new Dynamic Currency Conversion services and its cross border acquiring activities

The Registrant believes that the concentration on revenue from indirect merchant services will be diluted in fiscal 2005 as the company introduces new products and services, such as the sale of Point of Sale terminals and transaction management services it provides for a private label card issuers,

The Registrant expects revenue levels to increase throughout the next twelve months as the company continues to roll out its service offerings; however, there can be no guarantee that our product will be accepted in the marketplace or that our sales effort will be successful. Please see "Factors That May Affect Operating Results."

(b) COST OF REVENUE.

Cost of revenue was $1,227,915 for the twelve months ended June 30, 2004 compared to $490,387 for the twelve months ended June 30, 2003, an increase of $737,528 or approximately 150%. Cost of revenue increased in the current year compared to the prior year because the Registrant generated revenue and incurred the costs of revenue during only six of the twelve months ended June 30, 2003 compared to the entire twelve month period ended June 30, 2004. The Registrant's Rahaxi subsidiary also upgraded its processing platform during the twelve months ended June 30, 2004, and this resulted in increased costs.

Cost of revenue can be expected to increase in the coming twelve months if the company continues its current trend of increasing sales. The Registrant also intends to expand its service offering, and its business mix will necessarily change; for this reason, gross margin as a percent of sales may not remain constant.

(c) NON-CASH COMPENSATION.

During the year ended June 30, 2004, the Registrant recorded $4,765,365 in non-cash compensation, which was a decrease of $3,839,703, or approximately 45%, compared to $8,605,068 in non-cash compensation recorded during the year ended June 30, 2003. The primary components of the decrease were fewer shares and options issued as compensation to consultants, as well as a decrease in the number of shares issued as compensation to officers and directors.

The Registrant expects non-cash compensation to increase during the coming twelve months. The Registrant's expected continued expansion in its various geographic markets will create a growing need for local consultants and advisors that will be satisfied in large part via non-cash compensation. Management intends to continue to utilize non-cash compensation in order to conserve cash.

(d) SELLING, GENERAL AND ADMINISTRATIVE EXPENSES.

Selling, general and administrative expenses ("SG&A") were $2,366,195 for the year ended June 30, 2004, an increase of $685,526, or approximately 41%, compared to $1,680,669 for the year ended June 30, 2003. During the twelve months ended June 30, 2004, the primary components of SG&A were: depreciation and amortization of approximately $530,000 as the Registrant upgraded its processing platform and continued to add to its infrastructure; payroll expenses of approximately $417,000; legal and accounting fees of approximately $330,000, primarily due to ongoing litigation, as well as the Rahaxi acquisition and as other potential acquisition due diligence; cash paid for consulting fees of approximately $349,000; travel and entertainment costs of approximately $222,000 due to the focus on its Finland subsidiary and the Finnish market; facilities expense (rent, telephone, utilities, and building maintenance) of approximately $142,000; merchant services of approximately $63,000 as the Registrant continued to roll out its services in the European market; and investor relations expenses of approximately $46,000.

The rate of future SG&A will largely depend on the pace of the Registrant's growth in the market for payment processing products and upon the cost of outside services and professional fees, including legal fees relating to litigation and acquisitions. The company fully expects these costs to increase as it continues its expected rollout of product offerings. In addition, selling expenses will continue to increase due to increased focus on obtaining new customers. The Registrant intends to focus additional resources in the areas of sales personnel salaries, trade show participation, and other promotional expenses. In addition, the Registrant may pursue further acquisitions in order to facilitate its growth and exploit market opportunities, which would further drive up legal and accounting fees, payroll, and travel costs.

(e) LOSS ON INVESTMENT

Loss on investment was $100,000 for the year ended June 30, 2004, compared to $0 for the year ended June 30, 2003.

During the twelve months ended June 30, 2004, the Registrant advanced cash in the amount of $25,000 to Unipay, Inc., a potential acquisition target. In June 2004, the Registrant made the decision not to pursue Unipay, Inc. as an acquisition candidate and wrote-off the $25,000 advance to loss on investment in the consolidated statement of operations for the twelve months ended June, 2004.

On June 17, 2004, the Registrant terminated the TransAxis acquisition agreement and wrote-off a Note Receivable from TransAxis, Inc. in the amount of $75,000 as loss on investment in the consolidated statement of operations for the twelve months ended June 30, 2004.

(f) GAIN ON SETTLEMENT

Gain on settlement was $825,459 for the year ended June 30, 2004, compared to $0 for the year ended June 30, 2003.

In December 2002, a lender group exercised their rights against 14,400,000 shares pledged by the president of the Registrant in full satisfaction of outstanding notes payable to this lender group of $637,000, interest payable of $18,569, and accrued penalties of $24,300 totaling $679,869.

In March 2004, this lender group entered into a settlement agreement with the Registrant (see "Legal Proceedings"). As part of the settlement, this lender group returned the 14,400,000 pledged shares to the president of the company and the company is relieved from any other indebtedness to this lender group. Prior to this settlement, the Registrant considered the notes payable of $679,869 and related interest of $47,590 totaling $727,459 payable to the president related to the his 14,400,000 shares given to this lender group.

In addition, this lender group returned 1,000,000 shares to the Registrant that was issued to this lender group as collateral for borrowings in June 2002. The Registrant recorded an additional gain on legal settlement at cost based on the date of the issuance, or $98,000.

Thus, the Registrant recognized a gain on the settlement of the vFinance lawsuit of $825,459 during the twelve months ended June 30, 2004, and had no such gain during the comparable periods of the prior year.

(g) INTEREST EXPENSE.

The Registrant recognized net interest expense of $35,083 during the twelve months ended June 30, 2004, a decrease of $363,808 or approximately 91%,

compared to interest expense of $398,891 for the twelve months ended June 30, 2003. The reason for this decrease is lower borrowings during the year ended June 30, 2004. The Registrant had outstanding convertible debentures of approximately $600,000 during the year ended June 30, 2003 that were settled with common stock personally owned by the president of the company. The Registrant recorded a liability to its president in the amount of $679,869 and accrued interest on this amount at the rate of 7% per annum in 2003. This liability was eliminated during the twelve months ended June 30, 2004, pursuant to the vFinance settlement agreement. Also, during the twelve months ended June 30, 2004, the company had reduced balances due to related parties for amounts advanced to the Registrant. In addition, during the twelve months ended June 30, 2003, interest expense included substantially higher interest charges for the convertible debentures, including amortization of an amount attributable to the beneficial conversion feature of those instruments.

Currently, the Registrant is utilizing equity financing partly in order to avoid the interest charges associated with debt financing. Accordingly, the Registrant does not expect interest expense to materially increase in the coming twelve months. There can be no guarantee that this will be the case; however, as the market for the Registrant's stock could change, forcing the company to pursue alternative methods of financing the company's cash needs; in addition, the Registrant could receive an offer of attractive debt financing or could undertake additional financing with regard to an acquisition, in which cases interest expense would significantly increase.

(h) MISCELLANEOUS.

The Registrant recorded no miscellaneous income and expense during the twelve months ended June 30, 2004 compared to miscellaneous income of $68,404 during the comparable period of 2003. The Registrant received a non-refundable deposit of $50,000 during the twelve months ended June 30, 2003 (in connection with an informal agreement to enter into an alliance agreement, which was never finalized), and had no such transaction during the comparable period of 2004.

The Registrant does not anticipate material increases in miscellaneous income or expense in the coming twelve months.

(i) NET LOSS.

For the reasons stated above, the Registrant recorded a net loss of $6,335,273 for the twelve months ended June 30, 2004, an improvement of $5,107,106 or approximately 45% compared to the net loss of $11,442,379 realized during the twelve months ended June 30, 2003.

A significant percentage of the Registrant's revenue for the year ended June 30, 2004 has been derived from a limited number of the Registrant's customers, primarily Finnish customers for the Registrant's transaction processing products. Approximately 55% of the Registrant's total revenue for the

year ended June 30, 2004 was attributable to the Registrant's ten largest customers, with the company's two largest customers accounted for approximately 13% and 11% of its sales for the year ended June 30, 2004. The future loss of any major customer could have a material adverse effect on the Registrant's business, financial condition and results of operations. The Registrant believes that this customer concentration may be diluted in fiscal 2005 as it pursues operations outside of Finland.

The majority of Registrant's revenues for the year ended June 30, 2004 has been generated by its operations outside of the United States, and the Registrant's future growth rates and success are in part dependent on continued growth and success in international markets. The Registrant expects this trend to continue through the fiscal year 2005.

The Registrant may continue to incur losses on both a quarterly and annual basis. In addition, the Registrant expects to continue to incur significant costs of services and substantial operating expenses. Therefore, the Registrant will need to significantly increase revenues to achieve profitability and a positive cash flow. The Registrant may not be able to generate sufficient revenues to achieve profitability. The Registrant expects losses to continue for at least the next twelve months.

The Registrant will attempt to continue to fund its operations through debt and equity financing until it achieves profitability, of which there is no guarantee. The Registrant expects these concerns regarding its perceived viability to continue throughout the fiscal year 2004.

	Total	Less Than One Year	One to Three Years	Three to Four Years	After Five Years
Employment Agreements	$ 810,000	$ 270,000	$ 540,000	$ --	$ --
Operating Leases	$ 620,862	$ 206,954	$ 413,908	$ --	$ --
Total	$1,430,862	$ 476,954	$ 953,908	$ --	$ --

FACTORS THAT MAY AFFECT OPERATING RESULTS.

The operating results of the Registrant can vary significantly depending upon a number of factors, many of which are outside the company's control. General factors that may affect the Registrant's operating results include:

- market acceptance of and changes in demand for products and services;
- a small number of customers account for, and may in future periods account for, substantial portions of the Registrant's revenue, and revenue could decline because of delays of customer orders or the failure to retain customers;
- gain or loss of clients or strategic relationships;
- announcement or introduction of new services and products by the Registrant or by its competitors;
- price competition;
- the ability to upgrade and develop systems and infrastructure to accommodate growth;
- the ability to introduce and market products and services in accordance with market demand;
- changes in governmental regulation; and
- reduction in or delay of capital spending by clients due to the effects of terrorism, war and political instability.

The Registrant believes that its planned growth and profitability will depend in large part on the ability to promote its services, gain clients and expand its relationship with current clients. Accordingly, the Registrant intends to invest in marketing, strategic partnerships, and development of its client base. If the Registrant is not successful in promoting its services and expanding its client base, this may have a material adverse effect on its financial condition and the ability to continue to operate the business.

The Registrant is also subject to the following specific factors that may affect the company's operating results:

(a) COMPETITION.

The market for electronic payment systems and electronic POS systems is intensely competitive and we expect competition to continue to increase. The Registrant's competitors for POS systems include VeriFone and Ingenico amongst others, and companies such as Global Payments, First Data and Euroconnex for the Registrant's electronic payment software. In addition, the companies with whom we have strategic relationships could develop products or services, which compete with the Registrant's products or services. In addition some competitors in the Registrant's market have longer operating histories, significantly greater financial, technical, marketing and other resources, and greater brand recognition than the company does. The Registrant also expects to face additional competition as other established and emerging companies enter the market for electronic payment solutions. To be competitive, the Registrant believes that it must, among other things, invest significant resources in developing new products, improve its current products and maintain customer satisfaction. Such investment will increase the Registrant's expenses and affect its profitability. In addition, if it fails to make this investment, the Registrant may not be able to compete successfully with its competitors, which could have a material adverse effect on its revenue and future profitability.

(b) TECHNOLOGICAL AND MARKET CHANGES.

The markets in which the Registrant competes are characterized by rapid technological change, frequent new product introductions, evolving industry standards and changing needs of customers. There can be no assurance that the Registrant's existing products will continue to be properly positioned in the market or that the company will be able to introduce new or enhanced products into the market on a timely basis, or at all. Currently, the Registrant is focusing on upgrading and introducing new products. There can be no assurance that enhancements to existing products or new products will receive customer acceptance. As competition in the electronic payments industry increases, it may become increasingly difficult for the company to be competitive.

Risks associated with the development and introduction of new products include delays in development and changes in payment processing, and operating system technologies that could require the Registrant to modify existing products. There is also the risk to the Registrant that there may be delays in initial shipments of new products. Further risks inherent in new product introductions include the uncertainty of price-performance relative to products of competitors, competitors' responses to the introductions and the desire by customers to evaluate new products for longer periods of time.

(c) NEW VERSIONS OF REGISTRANT'S PRODUCTS MAY CONTAIN ERRORS OR DEFECTS.

The Registrant's electronic payment software products and point of sale devices are complex and, accordingly, may contain undetected errors or failures when first introduced or as new versions are released. This may result in the loss of, or delay in, market acceptance of the Registrant's products. The Registrant has in the past discovered software errors in its new releases and new products after their introduction. The Registrant has experienced delays in release, lost revenues and customer frustration during the period required to correct these errors. The Registrant may in the future discover errors and additional scalability limitations in new releases or new products after the commencement of commercial shipments or be required to compensate customers for such limitations or errors, as a result of which the Registrant's business, cash flow, financial condition and results of operations could be materially adversely affected.

(d) NO ASSURANCE OF SUCCESSFUL AND TIMELY PRODUCT DEVELOPMENT.

The Registrant's products and proposed enhancements are at various stages of development and additional development and testing will be required in order to determine the technical feasibility and commercial viability of the products.

There can be no assurance that the Registrant's product development efforts will be successfully completed. The Registrant's proposed development schedule may be affected by a variety of factors, many of which will not be within the control of the Registrant, including technological difficulties, access to proprietary technology of others, delays in regulatory approvals, international operating licenses, and the availability of necessary funding. In light of the foregoing factors, there can be no assurance that the Registrant will be able to complete or successfully commercialize its products. The inability of the Registrant to successfully complete the development of new products or to do so in a timely manner, could force the Registrant to scale back operations, or cease operations entirely.

(e) MARKET ACCEPTANCE.

The Registrant's success is dependent on the market acceptance of its products. Despite the increasing demand for security devices, the Registrant's products represents an advanced approach to the industry, and market acceptance of the company's products will be dependent, among other things, upon its quality, ease of use, speed, reliability, and cost effectiveness. Even if the advantages of the Registrant's products are established, the company is unable to predict how quickly, if at all, the products will be accepted by the marketplace.

(f) PROTECTION OF PROPRIETARY RIGHTS.

The Registrant's success and ability to compete will be dependent in part on the protection of its potential patents, trademarks, trade names, service marks and other proprietary rights. The Registrant intends to rely on trade secret and copyright laws to protect the intellectual property that it plans to develop, but there can be no assurance that such laws will provide sufficient protection to the Registrant, that others will not develop a service that are similar or superior to the Registrant's, or that third parties will not copy or otherwise obtain and use the Registrant's proprietary information without authorization. In addition, certain of the Registrant's know-how and proprietary technology may not be patentable.

The Registrant may rely on certain intellectual property licensed from third parties, and may be required to license additional products or services in the future, for use in the general operations of its business plan. There can be no assurance that these third party licenses will be available or will continue to be available to the Registrant on acceptable terms or at all. The inability to enter into and maintain any of these licenses could have a material adverse effect on the Registrant's business, financial condition or operating results.

There is a risk that some of the Registrant's products may infringe the proprietary rights of third parties. In addition, whether or not the Registrant's products infringe on proprietary rights of third parties, . . .