May 16, 2006
VIA EDGAR
Ms. Kathleen Collins
Ms. Kari Jin
Mr. Tom Ferraro
United States Securities and Exchange Commission
Division of Corporation Finance
Room 4561
Washington, DC 20549
Re: Catuity, Inc.
Form 10-KSB for fiscal year ended December 31, 2005
Filed March 31, 2006
Form 8-K/A Filed December 16, 2005
Dear Ms. Collins:
On behalf of Catuity Inc. (the "Company"), this letter sets forth the
Company's responses to the comments of the Staff of the Division of Corporation
Finance (the "Staff") contained in your letter dated April 28, 2006 to Mr.
Alfred H. Racine, President and CEO of the Company. For reference, each Staff
comment is reprinted below, followed by the corresponding response of the
Company.
Form 10-KSB for the Fiscal Year Ended December 31, 2005
Management's Discussion and Analysis (MD&A)
Liquidity and Capital Resources, page 13
COMMENT 1. Tell us how you considered providing disclosure regarding any known
operational commitments and expansions (e.g. leases, contracts,
salaries etc.) for the next twelve months and how you will fund
these commitments.
RESPONSE: In addition to disclosing its commitments and contingencies in
footnote 4 of the financial statements in its Form 10-KSB, Catuity
evaluated its commitments for disclosure in the liquidity and
capital resources section of its MD&A, and concluded that the
nature and amounts of its commitments were not material. The
majority of Catuity's contractual commitments consist of office
leases in the US and Australia and two co-location facility
agreements. After discussing the matter with the Staff, Catuity
agrees that adding a commitments table, in the form shown below, in
future filings in the Liquidity and Capital Resources section of
its MD&A will more fully disclose its commitments. As of December
31, 2005, the
Ms. Kathleen Collins
May 16, 2006
Page 2
Company had the following known contractual obligations and
operational commitments.
Amounts Due By Period
Total ----------------------------------
Contractual Obligations Amount 2006 2007 2008 2009
- ----------------------- -------- ------- -------- ------ ----
Operating Leases $293,929 $72,219 $219,436 $2,274 $0
Capital Leases 44,971 11,783 33,188 0 0
-------- ------- -------- ------ --
Total $338,900 $84,002 $252,624 $2,274 $0
Catuity expects to fund the above commitments and any future
expansion related activities out of its cash balances and any
capital raises that it may complete in order to increase its
working capital.
Consolidated Statement of Operations, page 23
COMMENT 2. We note your separate disclosure of "general and
administrative-stock based compensation" expense. Tell us if this
stock-based compensation expense is only related to general and
administrative activities. Stock-based compensation must be
allocated to the appropriate expense category to which it relates.
For example, stock compensation relating to employees whose
salaries are otherwise reflected as cost of revenue must be
reflected as cost of revenue and stock-based compensation issued to
general and administrative personnel must be reflected as such. The
amount may be shown parenthetically within the category or as a
separate line item within the category.
RESPONSE: In the 10-KSB, Catuity included Stock Based Compensation as General
and Administrative expense since a majority of its cost is related
to personnel whose other compensation is included in general and
administrative expense. Based on discussion with the Staff, in
future filings Catuity will allocate all stock-based compensation
to the expense category that includes the compensation of the
employee. Catuity intends to disclose material amounts of stock
based compensation on separate lines related to the expense
categories to which it relates, while non-material expense amounts
will be included in the appropriate expense category without
separate identification. For the twelve month period ended December
31, 2005, stock-based compensation amounts related to each expense
category were as follows:
Ms. Kathleen Collins
May 16, 2006
Page 3
Expense Category Amount
---------------- --------
Cost of processing and service revenue $ 19,770
Cost of license revenue --
Cost of project related revenue --
Research and development 23,571
Sales and marketing 35,305
General and administrative 77,048
--------
Total stock-based compensation $155,694
Catuity does not believe reclassifying these amounts would
materially change the December 31, 2005 financial statements.
COMMENT 3. We note the separate classification of amortization of intangible
assets. Tell us how you considered recording amortization of
intangible assets in Cost of Revenues.
RESPONSE: In the 10-KSB, Catuity presented amortization expense as a separate
line item. We deemed separate line item presentation to be an
appropriate presentation and in accordance with paragraph 42 of
Statement 142. We believe this presentation is also acceptable
under Staff Accounting Bulletin Topic 11-B. Further, the amount of
amortization expense related to assets used directly in revenue
generating activities is not material, as shown below. Therefore,
we concluded that it was not necessary to parenthetically disclose
that the reported amount of cost of sales excludes amortization as
suggested by SAB 11-B.
Catuity's intangible assets relate to its acquisition of Loyalty
Magic on September 1, 2005 and, at December 31, 2005, consisted of
the following:
Asset Classification Value Method 2005 Expense
-------------------- ---------- -------- ------------
Trademarks $ 566,700 SL $ 6,296
Software 644,800 CF based 49,887
Customer Contracts 285,100 CF based 30,991
Customer Relationships 278,400 CF based 23,823
Non-compete agreements 158,300 SL 10,552
---------- --------
Totals $1,933,300 $121,549
SL represents straight line
CF based represents over the period of expected cash flows
Ms. Kathleen Collins
May 16, 2006
Page 4
Software is the only asset listed above that is used directly in
generating processing and service revenue. The cost of customer
contracts and customer relationships are related to selling
activities while trademarks and non-compete agreements relate to
general and administrative activities. In future filings Catuity
will assign and disclose amortization of intangibles expense to
each individual expense category to which the cost applies. Catuity
does not believe the reclassification of these amounts is material
to the December 31, 2005 financial statements.
Note 2: Summary of Accounting Policies
Revenue Recognition, page 26
COMMENT 4. On page 11, you indicate that the Company sells hosted, Application
Services Provider (ASP) based systems to retailers. You also
indicate that revenues from application processing and hosting
services are recognized as revenue in the month that the services
are performed. Provide us the general nature and terms of hosting
arrangements, the dollar amount of hosting revenues and whether the
customer has the contractual right to take the possession of the
software. Tell us how you considered EITF 00-3 in accounting for
these arrangements.
RESPONSE: Catuity derives processing and services revenue from software
hosting fees and from services provided to customers who use our
software on an Application Services Provider (ASP) basis. Catuity's
agreements with customers do not provide for the customer to take
possession of our software. The Company recognizes revenue for
monthly hosting fees in the month the hosting service is provided.
Revenue for recurring services provided to customers in support of
their loyalty and/or gift card programs is recognized in the month
the service is rendered. For the fiscal year ended December 31,
2005, Catuity's hosting revenue was $511,000. The Company has
reviewed EITF 00-3 and believes it is properly accounting for
revenue. EITF 00-3 concludes that a software element covered by SOP
97-2 is only present in a hosting arrangement if the customer has
the contractual right to take possession of the software at any
time during the hosting period without significant penalty and it
is feasible for the customer to either run the software on its own
hardware or contract with another party unrelated to the vendor to
host the software. This is not the case for Catuity. We will revise
our accounting policy on revenue recognition in future filings to
clarify our accounting treatment for hosting revenues.
Ms. Kathleen Collins
May 16, 2006
Page 5
Note 6: Acquisition, page 32
COMMENT 5. We note that based on common share issuance price in a private
placement, the stock issued in the Loyalty Magic Pty. Ltd.
acquisition was determined to have a value of approximately $7.50
per share. We further note, however, that the Company's common
stock was trading at approximately $18.00 per share at the time of
such acquisition. Pursuant to paragraph 22 of SFAS 141, the quoted
market price of an equity security issued to effect a business
combination generally should be used to estimate the fair value of
an acquired entity. Paragraph 5 of SFAS 107 also indicates that the
fair value of a financial instrument is the amount at which the
instrument could be exchanged, requiring the use of a quoted market
price if available. Furthermore, pursuant to paragraph 58 of SFAS
107, the Board expressed their belief that quoted prices, even from
thin markets, provide useful information because investors and
creditors rely on those prices to make decisions. Tell us how you
considered this guidance in valuing the shares issued in the
Loyalty Magic Pty. Ltd. acquisition.
RESPONSE: On September 1, 2005 Catuity Inc. completed the acquisition of all
of the outstanding shares of Loyalty Magic Pty. Ltd. (Loyalty Magic
or LM), headquartered in Melbourne Australia. Loyalty Magic is now
a wholly-owned subsidiary of Catuity. The Shareholders of Loyalty
Magic received $2,700,000 (A$3,600,000) in cash and 335,000 shares
of Catuity common stock in consideration for Loyalty Magic.
Also on September 1, 2005, the Company completed an offering of its
common stock for cash. The Company issued 700,000 shares of its
common stock to existing and new Australian shareholders who opted
to subscribe for shares, accredited Australian institutional
buyers, and certain U.S. accredited institutional investors who
purchased shares that were not subscribed for by Australian buyers.
The shares were sold for A$10.00 per share in Australia and $7.50
per share in the U.S. (A$10.00 per share at a .7500 foreign
currency exchange rate). The proceeds from the offering were used,
in part, to fund the cash portion of the purchase price paid for
Loyalty Magic. In addition, on September 19, 2005 the Company
issued 270,000 shares in another offering. The terms and $7.50 per
share price were the same as in the September 1, 2005 offering.
The acquisition of Loyalty Magic is reflected in the consolidated
balance sheet of the Company as of December 31, 2005 and has been
accounted for in accordance with Statement of Financial Accounting
Standards ("SFAS") No. 141, Business Combinations. In accordance
with SFAS 141 paragraph 22 and EITF 99-12, securities issued in a
business combination generally should be valued based on quoted
market price at the date an agreement is signed and announced. The
Ms. Kathleen Collins
May 16, 2006
Page 6
Company signed the LM purchase agreement and announced it on Form
8-K on March 17, 2005 with approximately 372,000 shares of common
stock to be issued to shareholders of Loyalty Magic. Catuity's
stock was trading at an average price of $4.93 per share during the
few days before, after and including March 17, 2005. The $4.93 per
share was the price used in the proxy and related pro forma
financial statements filed by the Company in May 2005.
Catuity's daily closing stock price and daily trading volumes in
the first 20 days of June 2005 were in the range of $3.92 - $4.31
and 0 - 25,000 shares per day respectively. In the last 10 days of
June its daily closing price was between $10.10- $16.50 per share
with trading volumes between 297,000 - 8,690,000 shares per day.
Catuity's stock price volatility continued over the next thirty
five days with daily closing prices in a range from $9.50 to
$17.80. Due to the volatility of Catuity's stock prices and delayed
closing on the LM acquisition, on August 5, 2005, the Company and
LM Shareholders agreed to adjust the numbers of shares to be issued
to LM shareholders in connection with the acquisition to 335,000
shares. Catuity's stock price was trading at an average price of
about $12 per share during the few days before, after and including
August 5, 2005. According to EITF 99-12 paragraph 5, a new
measurement date is established when the number of shares on the
securities to be issued are substantively changed subsequent to
date of acquisition. The market price on the new measurement date
shall be used to value the issued securities.
This amendment to the purchase agreement to change the number of
shares to be issued by Catuity was completed on August 5th, because
this is when Catuity determined, through the work done with its
financial advisor leading the offerings of common stock referred to
above, that $7.50 ($10 AUS) was the price at which the common
shares could be sold in those offerings. The Company and its
financial advisor on the offering had held numerous meetings with
prospective buyers of the shares prior to establishing the $7.50
per share price. Catuity shares were being sold to several
institutional investors and this was the price that each party had
agreed it would pay for Catuity's newly issued shares. The reasons
for the difference between quoted market prices and the $7.50 per
share was the high level of volatility surrounding Catuity's stock
price and the belief that the market price did not represent fair
value. Catuity certainly would have liked to complete the offering
at the NASDAQ trading prices; however, the investors in the
offerings were unwilling to pay a price above $7.50. This was
determined in early August and $7.50 was considered the market
price through the expected closing of the offerings in September
2005. The Company believes, based on the investor feedback referred
to above, and has indicated in several press releases, that the
NASDAQ trading prices were considered irrational by all the
parties. As a result, the offering price was established at $7.50
and did not change from this early August period to the closing on
September 1, 2005 of the initial offering and
Ms. Kathleen Collins
May 16, 2006
Page 7
the closing of the second offering on September 19, 2005. Because
the price to the new investors stayed constant for such a long
period of time and considering the large number of shares that were
sold, the nature of the offerings, and the purpose of the offerings
(in part to fund the acquisition of LM), the Company believes $7.50
was the appropriate market price for the acquisition shares.
Important dates and stock prices in considering the price of shares
used in the transaction are:
Closing NASDAQ
Date Stock Price
---- --------------
March 17, 2005 - Date the Definitive Purchase
Agreement was signed $ 5.21
August 5, 2005 - Date the purchase price in the
definitive purchase agreement was amended $12.32
September 1, 2005 - Acquisition completed $17.88
December 30, 2005 $ 5.97
May 12, 2006 $ 6.44
The Company reviewed and considered paragraphs 22-23 of SFAS 141
and paragraphs 5 and 58 of SFAS 107 in determining the price per
share to be used in the acquisition. Paragraph 22 of SFAS 141
states "Thus, the quoted market price of an equity security issued
to effect a business combination generally should be used to
estimate the fair value of an acquired entity after recognizing
possible effects of price fluctuations, quantities traded, issue
costs, and the like." Paragraph 23 further acknowledges that the
quoted market price may not be the fair value of the securities
issued in a business combination, stating, "If the quoted market
price is not the fair value of the equity securities, either
preferred or common, the consideration received shall be estimated
even though measuring directly the fair values of net assets
received is difficult." Guidance for applying these paragraphs in
practice may be found in, among other places, Accounting Research
Manager (ARM), published by CCH. ARM's Interpretation 141.23-1
elaborates on paragraph 23, stating, "Even an available quoted
market price may not always be a reliable indicator of fair value
of consideration received because the number of shares issued is
relatively large, the market for the security is thin, the stock
price is volatile, or other uncertainties influence the quoted
price" and states that the SEC staff believes that a registrant
"must demonstrate, with objective and verifiable evidence," that a
price other than the quoted market price is appropriate. Catuity
considered this guidance and concluded that objective and
verifiable evidence (discussions with underwriters and transaction
prices in contemporaneous transactions with third parties, both of
which are discussed in
Ms. Kathleen Collins
May 16, 2006
Page 8
ARM Interpretation 141.23-2) supported the conclusion that the fair
value of its common stock was equal to the price for which it sold
securities in the offerings and not the quoted market price.
While Catuity's share price has always been volatile, it was
extremely volatile in the approximately 5 1/2 months between the
signing of the definitive purchase agreement and completion of the
acquisition. During that 5 1/2 month period the trading price of
Catuity shares ranged from a low of $3.75 to a high of $22.58.
The Company considered the large number of shares issued in the
offerings for cash, the sophisticated nature of the investors, the
fact that the consideration in those offerings was cash and the
fact they were completed at the same time as the acquisition (the
proceeds of the first offering were used in part to fund the
purchase price) to provide far more objective and verifiable
evidence of the value of its common stock than the market price. At
the time Catuity acquired Loyalty Magic it had 779,000 shares
outstanding. On September 1, 2005, the date 335,000 shares were
issued to the Loyalty Magic shareholders, the Company also issued
700,000 shares at a price of $7.50 to individual and institutional
investors. On September 19, 2005 the Company issued 270,000 shares
in a private placement on the same terms and $7.50 per share price
used in the September 1, 2005 offering. In total, 970,000 shares
were issued for cash within a 19 day period at $7.50 per share.
This represented 125% of the Company's shares outstanding prior to
the acquisition.
As a result of all of the above, the Company, determined that the
shares should be valued at the price used for the offering that was
completed on the same day as the acquisition. Management determined
that this represented the fair value of the shares at the time the
transaction was finalized, due to the size of the offering, the
number of shares issued and the high volatility of our stock price.
The Company's auditors concurred with this conclusion.
Form 8-K/A Filed December 16, 2005
COMMENT 6. We note that the Company filed an amended Form 8-K to include
audited financial statements for Loyalty Magic. We further note
that such audit was performed in accordance with auditing standards
generally accepted in Australia. Tell us how you considered the
requirements of Instruction 8.A.2 to Item 8 of Form 20-F to include
audited financial statements as required by Article 3-05 of
Regulation S-X that were audited in accordance with US generally
accepted accounting standards. Also, tell us how the auditor
complied with the U.S. independence standards. Further provide a
reconciliation to U.S. GAAP within the notes to the financial
statements.
Ms. Kathleen Collins
May 16, 2006
Page 9
RESPONSE: McInnes, Graham & Gibbs (MGG), chartered accountants in Australia,
performed the audit of Loyalty Magic's balance sheet as of June 30,
2005. At the time of the audit MGG was aware of the need for the
audit to be in accordance with auditing standards generally
accepted in the United States of America and to audit any
differences in the financial statements of Loyalty Magic due to
differences between Australian and U.S. GAAP. Prior to conducting
the audit, the Company and MGG determined that MGG met U.S.
standards for independence.
MGG has reissued their audit opinion letter stating that the audit
was conducted in accordance with U.S. generally accepted accounting
standards. Footnotes 1 and 7 disclose and provide a reconciliation
to U.S. GAAP. A copy of MGG's reissued audit opinion is included as
Attachment A to this letter and it, along with revised LM financial
statements, which include the U.S. GAAP reconciliation referred to
above, will be filed as an amendment to Catuity's Form 8-K/A.
* * *
In connection with responding to your comments, the Company acknowledges that:
- the Company is responsible for the adequacy and accuracy of the
disclosure in the filing;
- Staff comments or changes to disclosure in response to Staff comments
do not foreclose the Commission from taking any action with respect to
the filing; and
- the Company may not assert Staff comments as a defense in any
proceeding initiated by the Commission or any person under the federal
securities laws of the United States.
Please don't hesitate to contact me at 734-779-9000 ext 202 if you
have further comments or questions.
Sincerely,
CATUITY INC.
/s/ John H. Lowry
----------------------------------------
Chief Financial Officer
Ms. Kathleen Collins
May 16, 2006
Page 10
ATTACHMENT A
INDEPENDENT AUDITOR'S REPORT
The Directors
Loyalty Magic Pty Ltd
5th Floor, 140 Bourke Street
MELBOURNE VIC 3000
We have audited the accompanying balance sheet of Loyalty Magic Pty Ltd as of
30th June, 2005 and 30 June, 2004, and the related statements of profit and loss
and cash flows for the years then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with the auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Loyalty Magic Pty Ltd at 30th
June, 2005 and 2004, and the results of its operations and its cash flows for
the years then ended in conformity with accounting principles generally accepted
in the United States of America, except for the following matter which is
referred to at Note 1 to the Financial Statements -
CONFORMITY WITH UNITED STATES OF AMERICA (US) GENERALLY ACCEPTED ACCOUNTING
PRINCIPLES (GAAP)-
In order to comply with the provisions of US GAAP, capitalised Web Development
Costs, $70,017 (2004 - $54,391) and Development Costs of New Platform, $209,173
(2004 - $Nil), (refer to Note 1), should be written off as expenses in the year
in which they are incurred. This adjustment would reduce the company's net
profit for the year by $224,799 (2004 - $54,391) and reduce net assets at 30th
June, 2005 by $279,190 (2004 - $54,391).
McInnes Graham & Gibbs
/s/ Jeffrey E Graham
- -------------------------------------
Jeffrey E Graham
Partner
16th December 2005