February 07, 2007

Dear Shareholders:

We have now completed our fiscal year for 2006.  We thought it would be a good time to review the year and look into 2007. 

We have previously predicted that quarter over quarter growth would continue and it appears that Q4 will likely follow that trend.  On an unaudited basis, credit card transactions for Q4 2006 increased 234% over Q4 2005 with transaction dollar volume reflecting an increase of 143% for the same period.  On a year over year basis, 2006 showed an increase of 328% for transactions over 2005 and the related transaction dollar volume grew by 143% for the same period. Throughout the fiscal year, our 2006 quarterly growth over the same periods of 2005 has increased consistently at triple digit rates. 

During 2006 we issued thirty-six press releases outlining the progress of your company.  If you haven’t had a chance to review them, I would encourage you to do so as it will provide a great review of the exciting highlights of the year.  You can view them at www.paymentdata.com/pressrelease.htm. A few highlights follow:

 We continue to evolve and mature our product offerings to meet the needs of the marketplace.  To perhaps illustrate this point it might be important to review and understand our business model.

Payment Data Systems’ services are provided via three complementary product groups.  The first group is the Acquiring line, or merchant services, that provides credit card and ACH processing for merchants and billers.  The second group is the Issuing business, which is the line that provides for our stored-value debit cards (personal spending and gift cards).  The third component is the Bill Payment Processing line where we offer managed private labeled bill payment portals for banks, credit unions and card processors.  We also operate our bank-independent retail bill payment portal, www.billx.com.  These service components are graphically displayed in the following chart.

 

 This business model provides benefits to us in several ways.  Perhaps the most obvious is that each product group when fully mature could support itself without assistance from the other lines.  However, the combination of the three groups allows us to truly leverage the capabilities of the others; creating a true opportunity for synergy.  For example, if we contract with a biller for credit card processing within the Acquiring line, we have opportunity to cross-sell into the Issuing side for payroll cards and/or personal spending/gift cards for their employees and consumers.  These employees and consumers can then be led into the Bill Payment line as an additional service either as a billx.com customer or into the billers’ private labeled bill payment portal that we have licensed to them and are operating and supporting.

 The business model also provides us a significant competitive advantage, in particular, with those companies that are looking for single vendor solutions across the full spectrum of their payment processing needs.

 Another benefit of our business model is that each contract for any line of business generates recurring revenue and is supported for the most part by multi-year contracts.  Additionally, these diversified revenue streams enable increased visibility and sustainable blended margins.

 As you know, our prepaid card processing platform is essentially the same for a number of variations on the cards such as celebrity, corporate incentives, rebates, payroll, per diem, travel, etc.  And certainly these products are adaptable to virtually any industry or market segment without changes to our technology or a significant outlay of capital investment. You can expect that more celebrity and non-celebrity card announcements will be made in 2007. 

 More specifically, we do believe that we are well positioned to take advantage of the market opportunity, supported by research firms, that exists today and into the future. This research provided by the well-recognized companies of the Pelorus and The Tower Group suggest that the prepaid market will grow from today’s levels of some 22 million cards to more than 540 million cards in circulation by the end of 2008.  Furthermore, Pelorus suggests that the market value will be at over $70 billion by the end of this year and The Tower Group suggests a market of $3 trillion by the end of 2010. 

 We do intend to push forward with our strategies to tap into the estimated 109 million under-banked consumer market of which over 50 million are unbanked.  As part of this strategy, we will continue to work toward delivering products to fully participate in the very large Latino market.  As you know, there is a great deal of money that is moving into Mexico and Latin America.  The value is estimated to be in excess of $60 billion in 2006, of which an estimated $20 billion is going to Mexico alone.  We believe that market is looking for a quality, reliable, trust-worthy solution that competes effectively and efficiently with Western Union.  Our card program clearly meets those requirements by allowing immediate access to cash from any ATM and conversion rates that are better than a bank, exchange office, or those arbitrarily set by the money transfer agencies.  Therefore, the cardholder has access to money sooner, gets only what is needed at that time, and pays less to receive money in the transaction.

 The biggest challenge we see in being successful in the market is to overcome today’s behavior among these consumers.  We need to move them away from money orders and wire transfers into the use of plastic.  We believe that by working with the companies that have strong ties and brand recognition in the Latino community, these barriers can be overcome through education and the inherent trust the consumers have in those companies.  It is worth noting that we are already working with two market leaders that have these profiles.  Additionally, we believe word-of-mouth by the consumers about the reliability and security of our product will also be come a strong marketing tool for us.

 In July we went live with the Carmen Electra Prepaid MasterCardÒ and the Carmen Electra Gift MasterCardÒ.  In late October we had our official launch of the card program with a red carpet event in Los Angeles.  Over 30 television programs were in attendance at the press conference to hear Carmen Electra and PDS discuss the unique value proposition of the card programs.  We experienced a lot of media exposure and continue to enjoy national coverage.  In the February 5th 2007 edition of the In Touch weekly magazine, Carmen Electra was shown in the magazine using her card shopping in Los Angeles.  During this year we expect to receive a lot of attention when we will auction a date with Carmen Electra.  We will also send one of our quarterly sweepstakes winners on the same dinner date.  The gift card program will just start to generate the bulk of its revenue in February when we will earn the first month of card spoilage from funds left by cardholders on cards issued in July 2006.  We have built a nice portfolio of active cards in the Carmen Program and expect to continue to add to the cardholder base this year.  Finally, the success of the Carmen program has other celebrities and athletes calling PDS proposing business relationships with us.  We expect to capitalize on selected opportunities this year and we believe that as we capitalize on the new opportunities we continue to grow the visibility of our company and our products.

 We continue to maintain a low expense structure and a steady count of eight employees.  If we decide to add personnel, based on business needs, they will most likely be in the area of customer service or clerical positions.  As you know, these positions do not have, on a comparative basis, high salary requirements.

 In April 2006, we were awarded Patent # 7,021,530 for the company’s technology and method for managing and processing bill payment via a stored-value debit card, check card, signature debit card, PIN based card or automatic teller machine (ATM) card from a variety of access points.  This patent has already provided us business opportunities that might not have otherwise been there for us.  We do plan to become more assertive with organizations that appear to be infringing on the patent.  However, I would not look for any significant activity on that until much later this year at the earliest.

 Our strategic initiatives that began in 2005 and were carried forward into 2006 will continue into 2007 as well. 

As it relates to other strategic initiatives, one of our goals is to complete in early 2007 our PCI Level One certification as a Third Party Processor.  This certification validates our ability to properly process and store credit card transactions within published compliance standards.  It is important to PDS because it signifies a level of competence and security that is required for us to earn the business of larger companies and perform processing for banks. Once completed, our firm will be recognized among the premier payment processing companies in the United States. 

We plan to create a Billx Prepaid MasterCard for both adults and teens and integrate both card programs into the Billx bill payment processing system.  This new offering will allow us to operate much like a bank for unbanked consumers.  It will also have a strong value proposition for the banked community by allowing a new level of financial flexibility.  Through the use of the Billx platform, consumers will be able to load and unload in real-time their Billx Prepaid MasterCard’s for both their personal use and their children’s use.  We believe this offering will be the first of its kind in the industry and provide us a competitive advantage.  Furthermore, it is an excellent use of our intellectual property covered under our bill payment patent.  Finally, since the program will be integrated into the Billx platform, it allows us to offer the same program to our new and existing private label bill payment companies and could generate new revenues for both our issuing and bill payment processing business lines.

In closing, we believe that 2007 will be a year of capturing the benefits from the plans and building that we have been doing since our rebirth some three and half years ago.  Clearly we will continue to strengthen our transaction growth and delivery of prepaid debit and gift cards, traditional merchant services, and all forms of payment processing.  Additionally, I believe you will see that Payment Data Systems will continue to deliver innovative products and services to the marketplace thus bringing some significant revenue-producing opportunities to our company.

We also believe that we are well positioned, provided our strategic initiatives and forecasts are realized, to cross into the area of profitability during the 2007 fiscal year.

We are very enthusiastic about our future and the possibilities that are in the pipeline of prospective customers and products and in particular the strategic vision that is providing guidance for our direction and growth.  I hope that you agree with our outlook and find it as exciting and positive as we do. 

 

Sincerely,

Michael R. Long
Chairman and CEO

Email: michael.long@paymentdata.com
Phone: 210.249.4040