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EDGAR FILINGS

Year 2006 / September 29

FREESTAR TECHNOLOGY CORPORATION (FSRT.OB)

Annual Report

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

The following discussion and analysis of our financial condition and results of operations is based upon, and should be read in conjunction with, our 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 electronic payment transaction industry is composed of debit and credit card issuers, switch interchanges, transaction acquirers and transaction generators, including Automated Teller Machine networks, retail merchant locations and the Internet. The routing, control and settlement of electronic 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 must be conducted 24 hours a day, seven days a week.

Our products and services are primarily focused on facilitating electronic card transactions. These products and services are used principally by financial institutions, retailers, and payment processors, both in domestic and international markets.

We intend to increase revenue from our core payment processing products, which include: (1) Authorization: transaction fees derived from processing point of sale terminal transactions; (2) Dynamic Currency Conversion support services: we will provide support for transaction gateway services and settlement of credit card transactions utilizing dynamic currency conversion to merchants and participating banking institutions; (3) Consulting and Software Development Fees: consulting services and customized software development provided to financial institutions and merchants; (4) Sale of Point of Sale solutions: sales of point of sale terminals; (5) Internet Payment Gateway: transaction fees stemming from our Internet Payment Gateway; and (6) Private Label Cards:
transaction management services provided for a private label card issuer. Our revenue for the year ended June 30, 2006 was primarily generated from transaction fees and consulting fees through our Finland operations.

Due to our systems upgrade in December 2003 to the latest Hewlett-Packard NonStop servers and BASE24 e-payment processing software, we do not anticipate the need for any similar significant systems upgrades within the next 12 months. However, we are continuously reviewing our product and service offering to ensure we maintain our competitive position in our target markets.

Our business is continually evolving. Market conditions may require us to react quickly to problems and opportunities as they arise, and we may incur costs that we do not currently anticipate. Our business strategy to maximize growth and shareholder value may include future strategic acquisitions where we believe such acquisitions will help us quickly move forward in achieving our goals.

Management believes that our primary short-term growth opportunities will be derived form the European marketplace and a significant portion of our resources, both financial and personnel, will be directed towards developing those opportunities. We believe that our anticipated growth and ultimate profitability will depend in large part on the ability to promote our services, gain clients and expand our relationship with current clients. Accordingly, we intend to invest in marketing, strategic relationships, and development of our client base.

Results of Operations

Revenue

We reported revenue of $2,097,749 for the year ended June 30, 2006 compared to $1,602,819 for the year ended June 30, 2005, an increase of $494,930 or approximately 30%. The increase was due primarily to an increase in consulting and development fees by our subsidiary, Rahaxi Processing Oy. The other reason for the increase in revenue was an increase in transaction processing fees by Rahaxi due to an increase in the number of transactions processed. We expect this trend to continue throughout fiscal 2007 with the addition of new clients and a continued increase in consumers' preference to use credit and debit cards instead of cash.

For the year ended June 30, 2006, we processed approximately 18,000,000 transactions, an increase of 2,520,000, or approximately 16.2, over the approximate 15,480,000 transactions that were processed in the year ended June 30, 2005.

We expect revenue levels to increase throughout the next twelve months as we continue to increase our client base and introduce service offerings, such as EMV transaction processing and our Internet Payment Gateway. We believe that we will derive a higher price per transaction for processing EMV transactions as compared to non-EMV transactions; however, there can be no guarantee that our products will be accepted in the marketplace or that its sales efforts will be successful.

All of our revenue for the year ended June 30, 2006 has been derived from a limited number of its customers, primarily Finnish customers for its transaction processing products. Approximately 52% of our total revenue was attributable to our ten largest customers. The future loss of any major customer could have a material adverse effect on our business, financial condition and results of operations. We believe that this customer concentration will continue for much of fiscal 2007. We believe that this customer concentration will be diluted in the second half of fiscal 2007 as we pursues operations outside of Finland. All of our revenues for the twelve months ended June 30, 2006 have been generated by our operations outside of the United States, and our future growth rate is, in part, dependent on continued growth in international markets. We expect this trend to continue through fiscal year 2007.

Cost of Revenue

Cost of revenue was $2,078,698 for the year ended June 30, 2006, compared to $1,695,069 for the year ended June 30, 2005, an increase of $383,627 or approximately 23%, due to an increase in expenditures to enhance our transaction processing software and further develop our product line.

We expect cost of revenue to increase in the coming year as we continue our current trend of increasing sales and expanding our product offering. As our service offerings and business mix changes, gross margin as a percent of sales may not remain constant.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $13,913,969 for the year ended June 30, 2006 compared to $21,299,941 for the year ended June 30, 2005, a decrease of $7,385,972 or approximately 34%. During the year ended June 30, 2005, we completed the long-term incentive compensation package for our senior executives consisting of 20,000,000 shares of restricted common stock valued at $4,600,000; 1,500,000 shares of Series B Preferred stock valued at $4,140,000; and options to purchase 5,000,000 shares of common stock at price of $0.01 per share, valued at $1,100,000, and options to purchase 500,000 shares of common stock at a price of $0.15 per share, valued at $125,000. We also forgave the conversion cost (exercise price) of $50,000 related to 5,000,000 of these options. The total value of this long-term incentive package was $10,015,000, which was charged to the twelve months ended June 30, 2005; there was no comparable charge during fiscal year 2006. The primary components of selling, general, and administrative expenses for the year ended June 30, 2006 were:
consulting fees of $10,187,299 to service providers for financial consulting and other professional services; $10,109,934 of this amount consisted of non-cash compensation in the form of stock, stock options, and warrants. Other components of selling, general, and administrative expenses for fiscal year 2006 included payroll and related costs of $1,791,390; travel and entertainment costs of $480,478; facilities expense (rent, telephone, utilities, and maintenance) of $475,248; legal and accounting fees of $283,314; depreciation and amortization of $259,599; other professional services of $139,472; and $80,062 for investor relations.

The amount of future selling, general, and administrative expenses will largely depend on the pace of our 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. We fully expect these costs to increase as we continues our expected rollout of product offerings. We also intend to continue to build out our infrastructure, which may include adding support staff and branch offices. Selling expenses may also continue to increase due to increased focus on obtaining new customers. We intends to focus additional resources in the areas of sales personnel salaries, trade show participation, and other promotional expenses. In addition, we may pursue further acquisitions in order to facilitate our growth and exploit market opportunities, which would further drive up legal and accounting fees, payroll, and travel costs.

Gain on Settlement

During the year ended June 30, 2005, we recorded a non-recurring gain of $350,000, representing the recovery and cancellation of 714,286 shares of common stock which had been issued as compensation to our prior investment banker. The gain was recorded at the fair value of the shares when they were originally issued. There was no such gain during the year ended June 30, 2006.

Cost of Legal Settlement

Cost of legal settlements was $53,261 for the year ended June 30, 2006, a decrease of $979,028 or approximately 95% compared to $1,032,289 during the year ended June 30, 2005. During the year ended June 30, 2006, we charged to operations the amount of $53,261 representing the cost of settling a legal dispute. This amount consists of 108,695 shares of common stock. During the year ended June 30, 2005, we charged to operations the amount of $1,032,289 representing the cost of settling a legal dispute. This amount consists of warrants with a fair value of $431,717 and a convertible note payable with a fair value, net of the discount associated with the beneficial conversion feature, of $600,572.

Interest Expense

Interest expense (net) was $53,807 for the year ended June 30, 2006, compared to $26,774 for the year ended June 30, 2005, an increase of $27,033 or approximately 101%. The increase is due to a note payable in the amount of $650,000 which the Company had during the year ended June 30, 2006; interest of $ 42,798 related to this note was charged to the year ended June 30, 2006 and $6,450 related to the year ended June 30, 2005.

Currently, we are utilizing equity financing partly in order to avoid the interest charges associated with debt financing. Accordingly, we do not expect interest expense to materially increase in the coming year. There can be no guarantee that this will be the case, however, as the market for our common stock could change, forcing us to pursue alternative methods of financing our cash needs. In addition, we 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.

Net Loss

We recorded a net loss of $13,999,773 for the year ended June 30, 2006 compared to $22,102,463 for the year ended June 30, 2005, a decrease of $8,102,690 or approximately 36%. As stated above, the primary reason for the decrease in net loss was due to the reduction in selling, general, and administrative expenses, which was primarily due to the absence in fiscal year 2006 of expenses related to the long-term incentive compensation package for our senior executives that was adopted in fiscal year 2005.

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

Commitments

Our total commitments under non-cancelable operating leases at June 30, 2006 are
as follows:

                               Years ending June 30,

                               2007            $  433,300
                               2008            $  226,103
                               2009            $  214,103
                               2010            $  178,103
                               2011            $  138,893

                               Total           $ 1,190,502

Operating Activities

The net cash used in operating activities was $4,112,305 for the year ended June 30, 2006 compared to $1,422,247 for the year ended June 30, 2005, an increase of $2,690,058 or approximately 189%. The primary reason for the increase in cash used in operating activities is the increase in product development costs as we continue to upgrade our software platform and expand our line of product offerings. The primary components of cash used in operating activities during the current period are the net loss of $13,999,773, partially offset by the non-cash charges of non-cash compensation of $10,109,934; depreciation and amortization of $655,000; common stock issued for legal settlement of $53,260; amortization of discount on note payable of $42,978; bad debt expense of $20,291; and gain on disposal of assets of ($2,211). The non-cash components of working capital changed in the aggregate amount of $991,784 which was offset by a decrease in cash.

Investing Activities

Net cash used in investing activities was $996,511 during the year ended June 30, 2006 compared to $625,064 for the year ended June 30, 2005, an increase of $371,447 or approximately 59%. This change was primarily due to our increased investing in software enhancement to our transaction processing system.

Liquidity and Capital Resources

The independent auditors report on our June 30, 2006 financial statements included in this Form 10-KSB states that our difficulty in generating sufficient cash flow to meet our obligations and sustain operations raise substantial doubts about the our ability to continue as a going concern.

Table of Contents

As of June 30, 2006, we had total current assets of $3,518,739 and total current liabilities of $1,071,245, resulting in working capital of $2,447,494. We had cash and cash equivalents of $2,972,135 at June 30, 2006, and an accumulated deficit of $58,113,714.

The accompanying financial statements have been prepared assuming that the we continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. However, our ability to continue as a going concern will be dependent upon our ability to generate sufficient cash flow from operations to meet our obligations on a timely basis, to obtain additional financing, and ultimately attain profitability.

On January 27, 2006, we signed subscription agreements with a group of offshore investors for the sale of an aggregate of $9.2 million in Company common stock, plus warrants, which we refer to as the January Financing. Due to the failure of the investment group to timely fund in full the first payment required for the purchase of shares and warrants, we terminated the January Financing; all shares and warrants issued thereunder were returned by the escrow holder to the Company for cancellation, and any funds received pursuant to the January Financing were returned by the escrow holder to the investors.

In March 2006, a group of European investors, which we refer to as the March Investors), lead by Olympia Holding AS, informed us that they were willing to invest on the same terms and conditions that were negotiated for the terminated January Financing, and we agreed to this financing transaction with the March Investors, which we refer to as the March Financing.

Pursuant to the March Financing, we agreed to issue 46 million shares of restricted common stock under Regulation S at $0.20 per share, plus warrants to purchase 50 million shares of common stock with two-year exercise periods and strike prices ranging from $1.50 to $8.50, as set forth below. The shares which will be held in escrow by Carl Hessel, one of our directors and major stockholders based in Geneva, Switzerland, along with the warrants. Pursuant to the terms of the March Financing, the first payment of $4.6 million was due immediately, with a second payment of $4.6 million due within three months thereafter. As of June 30, 2006, we had received cash in the net amount $4,063,924 pursuant to the March Financing, and had issued 22,850,000 shares of common stock and warrants to purchase an additional 24,836,957 shares. We also issued to consultants as a commission for the March Financing the following:
7,600,000 shares of unregistered common stock with a fair value of $2,912,000; warrants to purchase 12,000,000 shares of common stock at a price of $1.00 per share with a fair value of $2,212,681; and warrants to purchase an additional 1,000,000 shares of common stock at a price of $1.50 per share with a fair value of $148,086. We charged the amount of $5,272,770 to operations during the year ended June 30, 2006 for these shares and warrants issued as commission.

The warrants to be issued pursuant to the investors in the March Financing are as follows:

Number of shares of Company Common Stock underlying Warrants Exercise Price

            Per Share         When fully subscribed     At June 30, 2006

            $1.50               14,000,000                     6,954,348
            $2.50               11,000,000                     5,464,130
            $4.50                7,000,000                      3,477,174
            $5.50                7,000,000                      3,477,174
            $6.50                7,000,000                      3,477,174
            $8.50                4,000,000                      1,986,957
                                  50,000,000                     24,836,957

All warrants have a two-year exercise period from the date of issuance of the warrants. No registration rights were granted to the March Investors in connection with the March Financing and the shares and warrants issued in the March Financing will be restricted securities, subject to the applicable restrictions set forth in Regulation S promulgated under the Securities Act of 1933, as amended.

In April 2006, we signed subscriptions agreements with a group of offshore investors led by Swedish Credit and Finance .AB for the sale of an aggregate of 25,000,000 shares of the Company's common stock plus warrants to purchase an additional 25,000,000 shares of common stock for the aggregate price of $10,000,000, which we refer to as the April Financing. Pursuant to the April Financing, shares of common stock were issued as follows:

   Number of     Price per    Total Price                        Terms
     Shares        Share
    5,000,000       $ 0.30     $ 1,500,000      90 day note at 12% due August 9, 2006
   10,000,000      $ 0.55     $ 5,500,000      One year note at 12% due May 11, 2007
   10,000,000      $ 0.30     $ 3,000,000      Cash due 30 days, or June 10, 2006
   25,000,000                   $ 10,000,000

These shares and warrants are being held in escrow by Margaux Investment Management Group, S.A., a Company controlled by a board member, Carl Hessel and are deemed not to be issued and outstanding. As of September 28, 2006, we have not received any of the funds pursuant to the April Financing.

Management plans to continue raising additional capital through a variety of fund raising methods during fiscal 2007 and to pursue all available financing alternatives in this regard. Management may also consider a variety of potential partnership or strategic alliances to strengthen its financial position. Although we have been successful in the past in raising capital, no assurance can be given that these sources of financing will continue to be available to us and/or that demand for our equity/debt instruments will be sufficient to meet our capital needs, or that financing will be available on terms favorable to us. The financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should we be unable to continue as a going concern.

If funding is insufficient at any time in the future, we may not be able to take advantage of business opportunities or respond to competitive pressures, or may be required to reduce the scope of our planned product development and marketing efforts, any of which could have a negative impact on our business and operating results. In addition, insufficient funding may have a material adverse effect on our financial condition, which could require us to:

o curtail operations significantly;

o sell significant assets;

o seek arrangements with strategic partners or other parties that may require us to relinquish significant rights to products, technologies or markets; or

o explore other strategic alternatives including a merger or sale;

To the extent that we raise additional capital through the sale of equity or convertible debt securities, the issuance of such securities may result in dilution to existing stockholders. If additional funds are raised through the issuance of debt securities, these securities may have rights, preferences and privileges senior to holders of common stock and the terms of such debt could impose restrictions on our operations. Regardless of whether our cash assets prove to be inadequate to meet our operational needs, we may seek to compensate providers of services by issuance of stock in lieu of cash, which may also result in dilution to existing shareholders.

We have been successful in obtaining cash resources through private placements and the exercise of options. Financing activities provided cash of $7,461,852 during the year ended June 30, 2006 compared to $2,505,900 for the year ended June 30, 2005, an increase of $4,955,952 or approximately 198%.

Certain Indebtedness

Paul Egan and Ciaran Egan have delayed payment of a portion of their salary in order to conserve our cash. At June 30, 2006, $19,730 and $20,444 of accrued salaries were owed to Paul Egan and Ciaran Egan, respectively. At June 30, 2005, $150,753 and $112,800 of accrued salaries were owed to Paul Egan and Ciaran Egan, respectively.

Paul Egan has advanced funds to us for our operations. These amounts include advances of $169,177 and accrued interest of $17,894 at June 30, 2005. These amounts were repaid to Mr. Egan at June 30, 2006.

Ciaran Egan has advanced funds to us for our operations. These amounts included advances of $8,208 and accrued interest of $904 at June 30, 2005. These amounts were repaid to Mr. Egan at June 30, 2006.

Exchange Rates

Our operations are principally conducted in Finland through our subsidiary Rahaxi, which operates in its local currency, the Euro. We also have operations in the Dominican Republic under the name ePayLatina S.A., and Freestar Dominicana, Inc. operating in its local currency, the Dominican Republic Peso. All assets and liabilities are translated at exchange rates in effect at the end of the year. Accounts for consolidated statements of operations are translated at weighted average rates for the year. Gains and losses from translation of foreign currency into U.S. dollars are included in other comprehensive income
(loss). The accumulated foreign currency translation adjustment was ($25,354) for the year ended June 30, 2006.

A significant portion of our revenues and expenses is denominated in currencies other than U.S. dollars; Rahaxi generates its revenue in Euros. Any significant change in exchange rates may have a favorable or negative effect on both our revenues and operational costs. In particular, the value of the U.S. dollar to the Euro impacts our operating results. Our expenses are not necessarily incurred in the currency in which revenue is generated, and, as a result, we are required from time to time to convert currencies to meet our obligations. In addition, a significant portion of our financial statements are prepared in Euro and translated to U.S. dollars for consolidation.

Inflation

The impact of inflation on our costs, and the ability to pass on cost increases to our customers over time is dependent upon market conditions. We are not aware of any inflationary pressures that have had any significant impact on our operations over the past fiscal year, and we do not anticipate that inflationary factors will have a significant impact on future operations.

Off-Balance Sheet Arrangements

We do not maintain off-balance sheet arrangements nor do we participate in non-exchange traded contracts requiring fair value accounting treatment.

Other

We do not provide post-retirement or post-employment benefits requiring charges under Statements of Financial Accounting Standards No. 106 and No. 112.

Critical Accounting Policies

The SEC has issued Financial Reporting Release No. 60, "Cautionary Advice Regarding Disclosure About Critical Accounting Policies" ("FRR 60"), suggesting companies provide additional disclosure and commentary on their most critical accounting policies. In FRR 60, the Commission has defined the most critical accounting policies as the ones that are most important to the portrayal of a company's financial condition and operating results, and require management to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, our most critical accounting policies include: (a) use of estimates in the preparation of financial statements; (b) stock-based compensation arrangements; (c) revenue recognition; and (d) long-lived assets. The methods, estimates and judgments we use in applying these most critical accounting policies have a significant impact on the results we report in our financial statements.

Use of Estimates in the Preparation of Financial Statements

The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate these estimates, including those related to revenue recognition and concentration of credit risk. We base our estimates on historical experience and on various other assumptions that is believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Stock-Based Compensation Arrangements

We intend to issue shares of common stock to various individuals and entities for management, legal, consulting and marketing services. These issuances will be valued at the fair market value of the service provided and the number of . . .