FortuNet 10-K 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2006
For the transition period from:___________ to ___________
Commission file number: 000-51703
(Exact name of Registrant as specified in its charter)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
o Yes xNo
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
o Yes xNo
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
x Yes oNo
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o Accelerated filer o Non-accelerated filer x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
o Yes xNo
As of June 30, 2006, the aggregate market value of the registrant’s common stock held by non-affiilates was approximately $47,385,000 (based on a closing sale price of $16.20 per share as reported by the Nasdaq Global Market). Shares of common stock beneficially held by executive officers and directors and by each person who beneficially owns 5% or more of the outstanding common stock have been excluded since such persons may be deemed affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.
There were 11,351,612 shares of the registrant’s common stock issued and outstanding as of March 15, 2007.
Documents Incorporated by Reference
Portions of the registrant’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on May 3, 2007 are incorporated by reference in Part III of this Form 10-K to the extent stated herein. Except as expressly incorporated by reference, the registrant’s Proxy Statement shall not be deemed to be a part of this Form 10-K.
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2006
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. All statements included in this Annual Report, other than statements that are purely historical, are forward-looking statements. Words such as “anticipate,” “contemplate,” “expect,” “intend,” “plan,” “believe,” “seek,” “estimate,” “will,” “will continue to be,” or the negative of foregoing and similar expressions regarding beliefs, plans expectations or intentions regarding the future also identify forward-looking statements. Forward-looking statements in this Annual Report include, without limitation, our statements that:
(A) in Item 1, (1) if we obtain the necessary approvals, we will begin marketing our wireless gaming platform to Nevada gaming establishments, most likely commencing with casinos with bingo halls where our mobile gaming platforms are already in use for playing bingo games; (2) we believe the addition of traditional casino games to our mobile platform will increase these casino operators’ revenues; (3) we expect to subsequently expand our marketing to additional Nevada gaming establishments that may be attracted to our mobile gaming platform by the potential of new gaming revenues generated in the auxiliary gaming and peripheral public areas of gaming establishments where playing of traditional casino games, such as poker, keno and slots, was previously not available; (4) we expect to subsequently expand marketing efforts for our wireless gaming platform beyond Nevada; (5) we intend to market our mobile casino gaming platforms under the WIN-WIN brand name; (6) we anticipate deploying our WIN-WIN platforms in Nevada casinos as soon as possible upon obtaining the required product approvals from the Nevada gaming authorities; (7) our wireless player terminals may stimulate players to play longer and will, in essence, expand the casino floor to auxiliary gaming and peripheral public areas while simultaneously reducing energy and labor costs; (8) we believe that our current facility is adequate for manufacturing sufficient volume of mobile gaming products to satisfy the initially anticipated demand; (9) we believe that wide acceptance of our mobile bingo gaming platform in Nevada will allow us to succeed in the emerging Nevada mobile gaming market for playing traditional casino games; (10) we believe the combination of the positive experiences of our casino customers and their patrons with our ability to maintain the security and integrity of our mobile gaming platform will be an essential marketing advantage for us as the Nevada mobile gaming market develops; (11) we are planning to deliver traditional casino games on our mobile gaming platform to our existing customer base, Nevada bingo halls, where we already have a presence and a substantial player affinity; (12) we believe that bingo players will embrace the opportunity to play traditional casino games on the same wireless player terminals on which they already play bingo; (13) we are planning to gradually introduce a variety of new games along with the existing traditional casino games; (14) we plan to expand our sales by deploying our wireless gaming systems in both the auxiliary gaming and peripheral public areas of gaming establishments; (15) we are planning to aggressively market our mobile gaming platform not only as a new revenue generating solution for auxiliary gaming and peripheral public areas of gaming establishments but also as a new marketing tool aimed to attract bingo players to gaming establishments that have not historically offered bingo; (16) assuming that other gaming jurisdictions enact laws, regulations and regulatory licensing requirements like those enacted in Nevada, that we comply with such regulatory requirements and that we are successful in the emerging Nevada mobile gaming market, we expect that we will be successful in penetrating gaming jurisdictions outside of Nevada; (17) we plan to increase our sales efforts outside of Nevada and to aggressively market our mobile gaming products worldwide; (18) we anticipate that casino markets will continue to be highly regulated, have stringent product requirements and high system integrity and security requirements as the Nevada mobile gaming market develops; (19) in the emerging mobile gaming market, we expect to encounter competition from new entrants who seek to meet these market requirements; (20) we expect to continue to emphasize the research and development aspect of our business; (21) as the mobile gaming market develops in Nevada, we anticipate selling or leasing our mobile gaming platform products to a broader group of casino operators in Nevada and in other jurisdictions if mobile gaming is approved in these jurisdictions and the operation of our mobile gaming devices is specifically approved in these jurisdictions, and (22) we intend to seek the necessary licenses, approvals and findings of suitability for our products and our personnel in other jurisdictions where there is an opportunity to market our products;
(B) in Item 1A, (23) our future success depends to a significant degree on the skills, experience and efforts of our key personnel; (24) our future success depends upon our ability to attract, train and retain key marketing personnel and key managers as we further develop our products and as we enter new markets and expand in existing markets; (25) we expect competition to increase and intensify as the market for mobile gaming devices develops; (26) we expect fierce competition from multiple large competitors dominating their respective markets in our expansion efforts, such as Aristocrat Leisure, Ltd., International Game Technology, Alliance Gaming Corporation, WMS Gaming Inc. and Shuffle Master, Inc., that may enter the market for mobile gaming devices; (27) initially, we intend to offer our customers equipment lease agreements under which we will lease our wireless gaming terminals and the associated equipment; (28) we expect to enter into agreements with customers that operate casinos and bingo halls in more than one location; (29) we anticipate that our agreements with multi-location customers will provide that the customer will be responsible for providing, at its expense, a dedicated high-speed computer network connection between our server-based gaming systems in the various locations operated by the customer to a remote central gaming server supporting such systems; (30) we expect to spend substantial amounts on research and development; (31) we expect, as needed, to continue to make a significant investment in product development; (32) to manage any future growth effectively, we will have to expand our management team, integrate new personnel and augment our marketing and production capabilities; (33) to rapidly produce large volumes of wireless gaming terminals, we will have to formulate and implement design, production planning, manufacturing and quality assurance plans that are unlike those we have used in the past; (34) when legally permitted, we intend to provide mobile gaming platforms to enable players to play traditional casino games using our wireless player terminals in Nevada; and (35) we expect a substantial portion of our future growth to result from the general expansion of the gaming industry;
(C) in Item 3, (36) we believe that the final resolution of any of the threatened or pending litigation described above, individually or in the aggregate, is not likely to have a material adverse effect on our business, cash flow, results of operations or financial position;
ITEM 1. BUSINESS
We are a manufacturer of multi-game and multi-player server-based gaming platforms. Our gaming platforms include networks of both wireless and stationary player terminals, cashier-based POS terminals, self-service POS kiosks and game file servers that conduct and control bingo games. Our gaming platforms have been adapted to conduct traditional casino games, such as keno, poker and slots, in addition to bingo.
We believe that our field-proven mobile gaming platform is in compliance with the regulations promulgated under Nevada’s new mobile gaming law, AB 471, or the Nevada Mobile Gaming Law, as adopted by the Nevada Gaming Commission on March 23, 2006. We submitted our wireless gaming platform for review by the Nevada gaming authorities in 2006.
If we obtain the necessary approvals, we will begin marketing our wireless gaming platform to Nevada gaming establishments, most likely commencing with casinos with bingo halls where our mobile gaming platforms are already in use for playing bingo games. We believe the addition of traditional casino games to our mobile platform will increase these casino operators’ revenues. We expect to subsequently expand our marketing to additional Nevada gaming establishments that may be attracted to our mobile gaming platform by the potential of new gaming revenues generated in the auxiliary gaming and peripheral public areas of gaming establishments where playing of traditional casino games, such as poker, keno and slots, was previously not available. We expect to subsequently expand marketing efforts for our wireless gaming platform beyond Nevada.
We currently own and lease to our customers an inventory of third- and fourth-generation wireless and stationary player terminals, marketed under the BingoStar® brand name, that are deployed in casinos and bingo halls in 27 jurisdictions in North America, including Nevada casinos operated by several major casino operators. We derive essentially all of our revenue from leasing our gaming platform to our customers. Our contracts are typically based on a fixed fee per use per bingo session, a fixed weekly fee per player terminal or a percentage of the revenue generated by each player terminal.
We were incorporated in Nevada in 1989. In 1993, we were licensed as a gaming equipment manufacturer and distributor by the Nevada Gaming Commission. In 1994, we received Nevada regulatory approval for our server-based, concurrent multi-gaming, video gaming network, Mega Fortune®. In 2003, we were granted an Operator of Inter-Casino Linked Systems, or OILS, license by the Nevada Gaming Commission. The OILS license permits us to operate progressive jackpot linked casino games offered simultaneously at a number of participating casinos. In September of 2006, we were granted an Operator of Mobile Gaming Systems license by the Nevada Gaming Commission.
In January 2004, we became the 100% owner of Millennium Games, Inc., or Millennium, which enabled us to consolidate our worldwide distribution rights and to significantly reduce our overall distribution and operational costs. Millennium serves as a distribution channel for our bingo products in Native American, or tribal, jurisdictions as well as other jurisdictions outside of Nevada.
The FortuNet Gaming Platform
Our core technology is embodied in the FortuNet® gaming platform that we currently lease to casinos and bingo halls throughout North America. Our gaming platform serves as the core foundation on which all of our mobile gaming platforms are based, including our BingoStar electronic bingo gaming platform and our WIN-WIN mobile casino gaming platform. The FortuNet gaming platform includes the following major structural elements:
BingoStar Electronic Gaming Platform
Our BingoStar platform of integrated, multi-game, multi-player wireless and stationary player terminals allows patrons to play over 4,000 bingo cards with the option of concurrently playing entertainment games, such as solitaire. Our BingoStar platform enables many variations of bingo, including fast-paced 30-number bingo, 90-number British-style bingo, bonanza bingo, pari-mutuel bingo, progressive-jackpot bingo, Class-II slot-style bingo and multi-site linked bingo. BingoStar enables automatic and semi-automatic daubing of players’ electronic bingo cards that facilitates playing of numerous bingo cards in each bingo game, yielding higher revenues for bingo hall operators.
We have developed several proprietary sets of electronic bingo cards for generic and custom applications, such as bonanza bingo games and double-action bingo games. No card in our sets duplicates any card in any commercial set of paper bingo cards known to us. In addition, our wireless and stationary player terminals are capable of storing in electronic format complete facsimiles of third-party commercial sets of paper bingo cards. As a result, our player terminals can monitor both paper and electronic bingo cards.
BingoStar also allows the playing of do-it-yourself bingo cards, akin to a lottery ticket, on the player’s terminal by registering all electronic and paper do-it-yourself cards. The central game file server verifies all do-it-yourself cards and automatically rejects all void and unregistered cards, which results in a high degree of security and integrity for do-it-yourself bingo games. BingoStar will automatically disable a wireless player terminal if a POS cashier voids a player’s bingo cards. This feature prevents an unscrupulous cashier from pocketing the proceeds of the voided bingo cards.
Accounting and Inventory Management System (AIMS)
Our gaming platform includes a comprehensive accounting and inventory management software package marketed under the brand name AIMS. Our AIMS software is a distributed software package running on our central game file servers and POS terminals. The AIMS software package runs in a mixed Windows-XP and Linux environment and is an assembly of numerous functional modules, each addressing the specific management needs of casinos and bingo halls. For example, AIMS includes a comprehensive player tracking module that analyzes and reports players’ spending and automatically issues electronic coupons that provide players with incentives to play multiple bingo sessions. AIMS also automatically tracks in real time the inventory of bingo packs as they are sold through POS terminals or directly on the gaming floor. In addition, AIMS automatically computes all payouts owed to bingo players and accrues progressive prizes, including the reserve accounts for the prizes. Because AIMS includes data exporting and importing modules that are fully compatible and integrated with commercial casino management packages running on casino mainframes, AIMS delivers full transparency into the operational results of our gaming platform to casino management.
WIN-WIN Mobile Gaming Platform
We intend to market our mobile casino gaming platforms under the WIN-WIN brand name. These platforms are comprised of our central game file servers, gaming software, wireless player terminals and POS terminals and POS kiosks operated through our wireless communication technology, as described below. We anticipate deploying our WIN-WIN platforms in Nevada casinos as soon as possible upon obtaining the required product approvals from the Nevada gaming authorities.
Redundant Central Game File Servers
The central game file server of our gaming platform is where bingo and traditional casino games are actually conducted. Game outcomes are then displayed on our wireless and stationary player terminals. Our redundant central game file servers are internally developed, PC-compatible computers equipped with non-modifiable and verifiable memory circuitry that we believe complies with Nevada’s gaming device standards. Our central game file servers run on the reliable Linux operating system and facilitate the concurrent playing of multiple types of bingo games along with traditional casino games. In addition, our central game file servers generate all random factors that determine the outcomes of the games played. The central game file servers also generate unique, disposable encryption and authentication keys that are downloaded into the wireless player terminals and redundantly preserve game and financial transaction histories.
Flexible Gaming Software Package with Download Capabilities
Our internally developed modular gaming software allows us to rapidly customize our gaming packages to meet the regulatory requirements of specific jurisdictions. The architecture of our software is designed to provide multi-game, multi-player functionality and facilitates rapid modifications of existing games as well as the ability to download a variety of traditional casino games to the wireless player terminals. The package is written in the efficient C programming language and is executed in the reliable Linux environment.
Wireless Player Terminals
Our wireless player terminal is a key component of the FortuNet gaming platform. It reflects many years of research and development in the areas of wireless technology, communication security, software and hardware architecture, and ergonomic user interface design. While available in a variety of models and formats including smaller, monochrome units, the current models of our wireless player terminals are fourth generation products that incorporate either an 8.40 inch color liquid crystal display and measure 9.75 inches long by 2.00 inches wide and are 8.13 inches tall or 10.4 inch color liquid crystal display and measure 9.5 inches long by 0.6 inches wide and are 8.25 inches tall. The wireless player terminals are equipped with fast-recharge battery circuitry and sustain continuous operation for at least 12 hours.
Our color wireless player terminals are capable of playing not only bingo but also traditional casino games. If required approvals are obtained, our wireless player terminals will allow players to play traditional casino games anywhere within permitted public areas of the casino. By providing a means to play in a comfortable environment, our wireless player terminals may stimulate players to play longer and will, in essence, expand the casino floor to auxiliary gaming and peripheral public areas while simultaneously reducing energy and labor costs.
We believe that our mobile gaming platform meets the standards established by the Nevada Gaming Commission for mobile gaming devices, as well as many of the standards for conventional slot machines. In particular, our internal testing indicates that our wireless player terminal can withstand a 23,000 volt electrostatic discharge, the standard that is required of slot machines. It is also equipped with tamper-evident features and alarms that render the unit inoperable following a tampering event.
Stationary Player Terminals
Our stationary player terminals are secure PC-compatible computers equipped with high-resolution, 15 inch flat liquid crystal color touch screens and are available in different formats, such as slant-top, upright, coin-operated and cashless ultra-thin video terminals. These high end terminals allow players to watch and listen to close-circuit television programs in adjustable picture-in-picture windows while playing bingo or traditional casino games. Our stationary player terminals are housed in custom-made metal, slot-machine-like cabinets. Our stationary player terminals run essentially the same software as our wireless player terminals.
Cashier-operated POS terminals and self-service POS kiosks
Players make all money deposits and receive payouts and refunds at our secure PC-compatible cashier-operated POS terminals or at our self-service POS kiosks. The functions of both POS configurations are nearly identical, as both POS configurations issue bar-coded transaction receipts to the player, register the player’s identification from the player’s card, and register those transactions with the central game file servers. The only difference is that in the case of the cashier-operated terminals, it is the cashier who accepts payments and hands out refunds and prizes, whereas, a kiosk acts much like a bank automated teller machine.
Both POS configurations have optional features, such as the ability to accept credit cards where permitted by law. The kiosk is configurable to dispense bills, coins or redeemable bar-coded vouchers and is also configurable to include a charger rack housing wireless player terminals. In jurisdictions other than Nevada, the kiosk also optionally houses the central file server that operates games on the wireless player terminals dispensed from the kiosk. With optional wheels, a mobile kiosk can be transported to different multi-use facilities, such as theaters. The kiosk incorporates a player-operated touch screen that doubles as an advertising channel when the kiosk is not in use. The kiosk’s internal systems are securely locked and alarmed and are accessible only to authorized personnel who must identify themselves with a magnetic stripe user card and a password entered on the kiosk touch screen.
Because self-service kiosks do not require cashiers, they can yield operators significant savings in labor costs. In addition, kiosks shorten the waiting lines, especially in bingo halls, and free more time for the patrons to play casino games.
Internally Developed, Secure and Reliable Wireless Communication Technology
Our mobile casino gaming platform uses our internally developed, fast-response, secure, bi-directional spread-spectrum and narrow-band RF communication hardware and software for wireless communications. Our communication hardware and software offer reliable and secure data delivery to and from our wireless player terminals, even in the noisy environments characteristic of modern casinos that are saturated with cellular telephones and security radio telephones. We use disposable downloadable encryption and authentication keys to prevent hacking of our RF channels.
Our wireless player terminals are also equipped with a close-proximity, secure, infrared communication channel to download our authentication keys. At the cashier-operated POS terminals and the self-service POS kiosks, we download the wireless player terminal with a file containing many disposable encryption and authentication keys. Each key is used only once to encrypt and authenticate a single gaming transaction performed over the RF channel. For example, each poker hand dealt by the file server to the player terminal is encoded separately with a unique key.
Our mobile gaming platform can detect and automatically terminate operations on the wireless player terminals when they are taken beyond permitted areas by automatically destroying the encryption and authentication keys. Our wireless player terminals are also equipped with player identification circuitry to, among other things, prevent under-age gaming.
Manufacturing and Assembly
We develop and own all technical documentation and intellectual property rights to manufacturing tools, such as plastic molding forms and printed circuit board layout masks used to manufacture our wireless player terminals.
Once a product is designed and thoroughly tested at our facility, we subcontract the volume production of parts and subassemblies to outside vendors. We subcontract subassembly manufacturing jobs to a number of reputable second-source suppliers. As a result, if demand for our products increases significantly, we can increase our manufacturing capabilities by placing additional orders with multiple manufacturers.
In addition to subcontracting the manufacturing of our custom subassemblies, we also purchase standard off-the-shelf components, such as video monitors, power supplies and batteries in volume. In order to achieve economies of scale, we carefully research the component markets for the best prices available and often adjust our designs to incorporate cost-efficient components that we can purchase in large volumes.
Upon receipt of ordered parts and subassemblies, we assemble the finished products at our facility in Las Vegas. We believe that our current facility is adequate for manufacturing sufficient volume of mobile gaming products to satisfy the initially anticipated demand. Currently, we operate only one work shift. However, we can add up to two extra work shifts at our current facility.
We are an established and profitable company with field-proven products that are popular in gaming establishments throughout the United States, including major gaming establishments in Nevada. Our technological advantages include a flexible multi-game, multi-player gaming platform incorporating a secure authenticated wireless communication technology that we believe will be important for success in the emerging mobile gaming market. We believe that our four Nevada non-restricted gaming licenses, including our recently granted Operator of Mobile Gaming Systems license, which are essentially prerequisites for manufacturing, distributing and operating gaming devices in Nevada, give us a time advantage over the potential new entrants into the emerging mobile gaming market in Nevada.
Field-proven, player accepted gaming platform with a majority share of the Nevada mobile bingo gaming market.
Our wireless bingo products are field-proven and well accepted by players nationwide who have played our products for almost a decade. We supply a majority of the mobile bingo gaming equipment in Nevada. We believe that wide acceptance of our mobile bingo gaming platform in Nevada will allow us to succeed in the emerging Nevada mobile gaming market for playing traditional casino games.
Flexible, downloadable gaming platform.
Our gaming platform is expected to provide casino operators with the flexibility to quickly add traditional casino games to our platform, when approved. By simply changing the software on the game file server, operators can quickly enable new games on the wireless player terminals as well as adjust the pay-outs on games. Our multi-game, multi-player gaming platform offers the ability to play bingo and many popular traditional casino games such as keno, poker and slots on a single player terminal. In addition, the platform includes optional small-footprint, self-service POS kiosks that are expected to facilitate gaming in underperforming auxiliary gaming casino areas.
Secure, authenticated wireless communication technology.
Our gaming platform incorporates internally developed wireless security and authentication hardware and software for communication between our servers and wireless player terminals, which we believe is beneficial in meeting the requirements of the Nevada mobile gaming regulations as adopted. While serving our customer base, we accumulated real-world experience with the challenges of secure data delivery to and from our wireless player terminals, even in the noisy RF environments characteristic of modern casinos. In addition, our wireless communication technology incorporates perimeter control and player authentication features that automatically shut down any wireless player terminal taken beyond permitted public areas and allow for periodic or on-demand verification of the identity of the player. We believe the combination of the positive experiences of our casino customers and their patrons with our ability to maintain the security and integrity of our mobile gaming platform will be an essential marketing advantage for us as the Nevada mobile gaming market develops.
Four existing non-restricted Nevada gaming licenses that allow us to manufacture, distribute and operate gaming devices including mobile gaming devices.
Having a non-restricted Nevada distributor gaming license is a prerequisite for distributing gaming products in the state of Nevada. In addition to having such a license, we also have non-restricted Nevada gaming license to manufacture gaming devices. These existing licenses allow us to serve Nevada’s existing mobile bingo gaming market and the emerging mobile casino market. The Nevada Gaming Commission has also granted us an Operator of Inter-Casino Linked Systems, or OILS, license, which permits us to operate multi-site games that link several casinos into a wide area progressive jackpot. In September of 2006, we were also granted an Operator of Mobile Gaming Systems license by the Nevada Gaming Commission. Entrants that hope to serve the mobile gaming market enabled by the Nevada Mobile Gaming Law must have, or obtain, non-restricted gaming licenses to serve the Nevada market. Obtaining such licenses is costly, lengthy process that entails rigorous levels of corporate due diligence and in-depth scrutiny of officers and, in some cases, directors of the companies applying for such licenses.
Our business objective is to capitalize upon our competitive advantages in the emerging mobile gaming market in casino public areas. Our primary business strategies are to:
Initially, deliver traditional casino games on our mobile gaming platform to our existing Nevada casino bingo customer base.
We are planning to deliver traditional casino games on our mobile gaming platform to our existing customer base, Nevada bingo halls, where we already have a presence and a substantial player affinity. We believe that bingo players will embrace the opportunity to play traditional casino games on the same wireless player terminals on which they already play bingo. Since our gaming platform is flexible, and includes the ability to quickly change games, we are planning to gradually introduce a variety of new games along with the existing traditional casino games.
Market bingo and traditional casino games on our mobile gaming platform for use in auxiliary gaming areas and subsequently market our mobile gaming platform for use in peripheral public areas of Nevada casinos.
We plan to expand our sales by deploying our wireless gaming systems in both the auxiliary gaming and peripheral public areas of gaming establishments. Currently, casino operators derive limited gaming revenues from these areas. We believe casino operators would be interested in generating additional revenue from these auxiliary gaming and peripheral public areas and will be receptive to our mobile gaming platform. Accordingly, we are currently marketing our mobile gaming platform to gaming establishments by promoting our products as an efficient means for offering casino games and bingo in these underutilized spaces.
Currently, very few casinos offer bingo to their patrons because of the high real estate and operational costs associated with having dedicated bingo halls. Our mobile gaming technology enables casinos to offer players a virtual bingo hall without the high cost of maintaining a dedicated bingo hall. Accordingly, we are planning to aggressively market our mobile gaming platform not only as a new revenue generating solution for auxiliary gaming and peripheral public areas of gaming establishments but also as a new marketing tool aimed to attract bingo players to gaming establishments that have not historically offered bingo.
Expand marketing efforts beyond Nevada.
We believe there are significant business opportunities for mobile gaming products not only in Nevada but also in many other domestic and foreign gaming jurisdictions. Currently, Nevada is the first and the only jurisdiction to enact legislation authorizing mobile gaming for traditional casino games. However, many gaming jurisdictions tend to follow Nevada’s lead concerning gaming laws and regulations. Assuming that other gaming jurisdictions enact laws, regulations and regulatory licensing requirements like those enacted in Nevada, that we comply with such regulatory requirements and that we are successful in the emerging Nevada mobile gaming market, we expect that we will be successful in penetrating gaming jurisdictions outside of Nevada. Accordingly, we plan to increase our sales efforts outside of Nevada and to aggressively market our mobile gaming products worldwide.
We experience intense competition from a number of established suppliers of gaming equipment to the bingo market and the casino market. Many of our competitors have longer operating histories, long-standing relationships with gaming establishments and suppliers, greater name recognition and greater financial, technical and marketing resources than we do. As a result, our competitors may have substantial competitive advantages over us. Additionally, the casino market is characterized by a cautious attitude toward the reliability and security of emerging wireless gaming platforms, creating additional marketing challenges for us. We may not be able to exploit new or emerging technologies, adapt to changes in customer requirements more quickly than our competitors or devote the necessary resources to the marketing of our products and services. See “Item 1A. Risk Factors.”
Currently, our primary competitors in our existing electronic bingo market are VKGS, LLC, or Video King, formerly a division of BK Entertainment Corp. and GameTech International, Inc., or GameTech. We believe that we are focused on the high performance segment of the electronic bingo market, while many of our competitors serve the mass market segment where bingo player terminals are less expensive and have fewer features and technological capabilities.
In addition to Video King and GameTech, a number of other companies compete in the electronic bingo market including the recently merged Planet Bingo, LLC and Melange Computer Services, Inc., Blue Dog, Inc., Electronic Gaming Solutions, Inc. and California Concepts, Inc. Many of our bingo market competitors offer stationary and portable bingo player terminals. We are not aware of any competitors with an installed base of bi-directional wireless player terminals and only a few of them currently deliver any wireless technology. Our competitors’ existing one-way RF communication technology may limit their ability to offer more advanced versions of bingo or traditional casino games, such as keno, slots and poker on a wireless player terminal.
Emerging Mobile Gaming Market
The casino markets are highly regulated, have stringent product requirements and high system integrity and security requirements. We anticipate that these factors will continue to pertain as the Nevada mobile gaming market develops. In the emerging mobile gaming market, we expect to encounter competition from new entrants who seek to meet these market requirements.
Cantor Fitzgerald LP, a large financial services company that already offers wireless sports betting in the United Kingdom, is expected to seek Nevada’s approval for its technology. At least two other gaming technology companies, Chimera Technology Corp. and Diamond I, Inc. have announced their strong interest in the emerging mobile gaming market. Although we expect these and other companies to be attracted to the potentially lucrative Nevada mobile gaming market, we believe it will be difficult for such companies to fully meet the market’s requirements. For instance, obtaining Nevada gaming licenses can be difficult, costly and time consuming. Also it can be difficult to gain market recognition in the very demanding Nevada gaming market. Lastly, some of these companies have indicated that they plan to use off-the-shelf personal digital assistants as their wireless gaming terminals. We question whether such products can achieve regulatory and market acceptance.
In addition, large gaming equipment manufacturers in the Nevada slot machine market, including Aristocrat Leisure, Ltd., Alliance Gaming Corporation and WMS Gaming Inc., may also attempt to enter the emerging mobile gaming market. At least three well established gaming equipment manufacturers, International Game Technology, or IGT, Shuffle Master, Inc., and Progressive Gaming International Corporation have expressed interest in entering the emerging mobile gaming market. These companies are much larger than we are and are well entrenched in the existing gaming market. The United States gaming equipment market has historically been dominated by IGT, currently the largest gaming equipment manufacturer in the world. However, we are not aware of any mobile gaming devices being field tested by these companies with a possible exception of Progressive Gaming International Corporation, which is currently field testing wireless sports wagering terminals that may be viewed by some as mobile gaming terminals, even though such sports wagering terminals are not considered to be gaming devices under the existing Nevada statutes and regulations.
Finally, traditional casino operators may attempt to enter the emerging mobile gaming markets themselves. Most of these companies are much larger than we are and have greater resources than we do.
Research and Development
Since our inception in 1989, we have continuously developed innovative gaming and entertainment products for our customers. We have internally developed all critical aspects of our gaming platform and have outsourced only the volume manufacturing of parts and subassemblies. We design all of our software, including all of our source code and all of our user interfaces and graphic art for our player terminals. We also design all of our hardware, including both electronic and mechanical components, all printed circuit board diagrams and layouts, and all 3D and 2D mechanical drawings for all our plastic and metal parts. We expect to continue to emphasize the research and development aspect of our business. Research and development costs for the year ending December 31, 2006 were $648,463.
Currently, our customers are bingo hall operators in the commercial casino, tribal casino and charitable bingo markets. As the mobile gaming market develops in Nevada, we anticipate selling or leasing our mobile gaming platform products to a broader group of casino operators in Nevada and in other jurisdiction if mobile gaming is approved in these jurisdictions and the operation of our mobile gaming devices is specifically approved in these jurisdictions.
We have a broadly diversified and geographically dispersed customer base. Sales to charitable organizations in Texas represented approximately 33% of our revenues during 2006. Sales to entities affiliated with the Gila River Indian Community represented approximately 4% of our revenues during 2006.
Sales, Marketing and Distribution
Except where we are contractually or statutorily prohibited from doing so, we market our products to customers through direct and indirect channels. Our direct channel consists of our own marketing efforts as well as marketing through Millennium, our wholly-owned subsidiary.
We also distribute our products to our customers through our indirect channel consisting of a network of authorized distributors, operating in the United States, Canada, the United Kingdom and Australia. Our distributor agreements typically have one-year initial terms with successive one-year automatic renewals. Our distributors provide valuable services to our customers, including immediate on-site customer support. During 2006, sales through our single-largest distributor, K&B Sales Incorporated, doing business as Good Time Bingo, represented approximately 33% of our revenues. During 2006, sales through Atlantic Bingo Supply, Inc., another of our distributors, represented approximately 11% of our revenues.
The profit margins from the distributor facilitated accounts are lower than the profit margins typical for our direct accounts because the latter do not involve any commissions paid to distributors. We are focused on strengthening our direct account sales and marketing capability, which we believe will result in a rising proportion of higher margin direct house accounts.
We generate a significant amount of our revenue from domestic customers. During 2004, 2005 and 2006, our domestic revenues were 98%, 98% and 98%, respectively. During 2004, 2005 and 2006, our international revenues were 2%, 2% and 2%, respectively.
We provide comprehensive support services to our customers either directly or through our distributors. We also provide 24/7 hotline support to our customers. Although most of the technical problems are typically resolved over the telephone or by replacing failed equipment with spare parts, in critical cases, our field service personnel have to perform on-site maintenance and technical training. The on-site maintenance is provided by us as an accommodation to our customers and is not required by our contracts. We do not provide any performance, fitness of use or similar warranty or guaranty to our customers.
An important part of customer service is the initial installation and training of customer personnel. From time to time, we also perform customer service at locations directly serviced by our distributors, particularly when a distributor is new or inexperienced. Our personnel, particularly our management team, are composed of experts in the gaming field whose advice is well regarded by our customers. We continually provide our advice to our customers regarding our gaming platforms and compliance with regulatory matters related to our gaming platforms.
Our BingoStar platform can be easily configured by bingo hall personnel for any desired bingo games, patterns, prizes and sessions, without the involvement of ourselves or the local distributor. Our BingoStar platform allows our technicians to reprogram all stationary and wireless player terminals on-site. Where permitted by law and authorized by our customers, we can also remotely reprogram most of the components of our BingoStar platform utilizing secure communication protocols.
With the expiration of one of our patents in August of 2006, we hold two United States patents expiring in 2010, which relates to a lottery-type wagering game, and one United States patent expiring in 2012, which relate to a magnetic bingo board. We do not rely on any licensing revenue related to any of these patents. We have also filed additional patent applications that are currently pending in the United States Patent and Trademark Office.
We are the registered owner of trademarks FortuNet®, Mega Fortune® and BingoStar®, as well as pending trademark applications, including WIN-WIN™ and AIMS™.
In addition, each of our employees has executed an agreement to maintain the confidentiality of our trade secrets and to assign to us any intellectual property that they conceive of in the scope of and during their employment with us.
The gaming industry and the gaming equipment manufacturing industry exist within a stringently controlled regulatory environment and are subject to federal, state, tribal, local and foreign regulation. Companies participating in these industries must hold the required gaming licenses, permits or other approvals in all jurisdictions in which they conduct business. Many jurisdictions also require the licensing or a finding of suitability of officers, directors, major stockholders and key employees, the termination or disassociation with such officer, director, key employee or major stockholder that fails to file an application or to obtain a license or finding of suitability; the submission of detailed financial and operating reports; and the submission of reports of material loans, leases and financings; and the regulatory approval of some commercial transactions, such as the transfer or pledge of equity interests in the company. These regulatory burdens are imposed upon gaming-related suppliers or vendors on an ongoing basis. The regulatory agencies that oversee these jurisdictions not only continually scrutinize license holders, but in some cases also approve the types of products that can be sold by equipment manufacturers and used by operators. The standards for product approval vary from jurisdiction to jurisdiction, although the Nevada standards are generally the most stringent.
Various aspects of our business are subject to gaming regulation. Depending on the nature of the noncompliance, our failure to comply with these regulations may result in the suspension or revocation of any license or registration at issue, as well as the imposition of civil fines and criminal penalties.
Our electronic bingo products, including the wireless and stationary units, are subject to stricter scrutiny than traditional paper bingo products. We believe electronic bingo player units are legal in all tribal jurisdictions, United States Armed Forces bases, 27 states, and in a growing number of foreign jurisdictions.
Electronic bingo in charitable bingo halls is less widely permitted than paper bingo, largely because many states’ laws and regulations were written before electronic bingo technology was available. We believe that electronic bingo is permitted in 27 of the 48 states in the United States in which paper bingo is legal. Favorable changes in this regulatory environment occurred in the recent decade.
Currently, we are licensed as a gaming equipment manufacturer or distributor in several states and tribal jurisdictions. We intend to seek the necessary licenses, approvals and findings of suitability for our products and our personnel in other jurisdictions where there is an opportunity to market our products. We cannot assure you that we will obtain the necessary licenses, approvals or findings of suitability in a timely fashion or at all. If obtained, we cannot assure that the licenses, approvals or findings of suitability will not be revoked, suspended or conditioned or that we will be able to obtain the necessary approvals for our future products as they are developed. If a license, approval or finding of suitability is required by a regulatory authority and we fail to receive the necessary license, approval or finding of suitability, we may be prohibited from distributing our products for use in the applicable jurisdiction or may be required to distribute our products through other licensed entities at a reduced profit.
The Nevada Mobile Gaming Law
On June 6, 2005, Nevada enacted the Nevada Mobile Gaming Law. This law enabled the Nevada Gaming Commission, with the advice and assistance of the Nevada Gaming Control Board, to promulgate regulations governing the operation of mobile gaming and the licensing of operators, manufacturers and distributors of mobile gaming equipment and systems in Nevada. Before adopting the regulations, the Nevada Mobile Gaming Law required the Nevada Gaming Commission to determine that mobile gaming systems could be operated in compliance with all applicable laws, be secure and reliable and provide reasonable assurance that gaming devices would be operated only by players of lawful age and only in approved areas. These determinations were made and the final regulations under the Nevada Mobile Gaming Law were adopted on March 23, 2006.
The Nevada Mobile Gaming Law defines “mobile gaming” as conducting gaming through communication technology and devices that allow a player to transmit information to a computer that assists in placing a bet or wager and corresponding information related to the display of the game and its outcome. “Communications technology” is defined to mean the method and components employed by a gaming establishment to facilitate the transmission and reception of information, including wireless networks, wireless fidelity, wire, cable, radio, microwave, light, optics or computer data networks. Mobile gaming can only be conducted in “public areas” of a gaming establishment that operate at least 100 slot machines and at least one other game. Public areas specifically exclude hotel rooms or living accommodations. The regulations as adopted define “mobile gaming systems,” “operator of a mobile gaming system,” “equipment associated with mobile gaming” and “public areas” for purposes of the law.
The Nevada Mobile Gaming Law mandated that the revenue of operators and manufacturers of mobile gaming systems will be subject to the same licensing fee provisions to which currently licensed gaming establishments are subject with respect to the operation of other games and gaming devices and that mobile gaming devices will be subject to the same fees and taxes as are slot machines. Based upon the regulations as adopted, we believe that our current non-restricted gaming licenses allow us to manufacture and distribute our mobile gaming platforms in Nevada without additional licensing requirements. Our mobile gaming platforms for playing traditional casino games will be required to be approved before they may be deployed in Nevada casinos.
Policy Concerns of Nevada Gaming Laws
The laws, regulations and supervisory practices of most gaming authorities are based upon declarations of public policy. In the case of Nevada, these public policy concerns include, among other things:
Changes in these laws, regulations and procedures could have significant negative effects on our operations, financial condition and results of operations.
Individual Licensing Requirements
The Nevada gaming authorities may investigate any individual who has a material relationship to, or material involvement with, us in order to determine whether the individual is suitable or should be licensed as a business associate of a gaming licensee. Individual licensing is not a prerequisite to become an officer of our company, but the person becoming an officer must apply for individual licensing within 30 days of becoming an officer. Currently, Yuri Itkis, Boris Itkis, Jack Coronel and William R Jacques Jr. are licensed. Licensing is not a prerequisite to become a director of FortuNet and we do not anticipate that any of our independent directors will be required to be licensed as a result of serving as a director. The Nevada gaming authorities may deny any application for any cause they deem reasonable. Granting of an individual license requires a concomitant determination of suitability of the applicant. A finding of suitability and grant of an individual license requires submission of detailed personal and financial information, followed by a thorough investigation. An applicant for licensing or a finding of suitability must pay for all the costs of the investigation. We reimbursed our employees for the cost of seeking and maintaining licenses obtained at our request, including Yuri Itkis, Boris Itkis, Jack B. Coronel and William R. Jacques, Jr. Changes in licensed positions must be reported to the Nevada gaming authorities and, in addition to their authority to deny an application for a finding of suitability or licensing, the Nevada gaming authorities may disapprove a change in a corporate position, such as a change in job title or substantive job responsibilities.
If the Nevada gaming authorities were to find any of our personnel required to be licensed unsuitable for licensing, we would have to sever all relationships with that person. In addition, the Nevada Gaming Commission may require us to terminate the employment of any person who refuses to file appropriate applications or refuses to pay the required investigative fees. Determinations of suitability or of questions pertaining to licensing are not subject to judicial review in Nevada.
Consequences of Violating Gaming Laws
If the Nevada Gaming Commission determines we violated the Nevada Gaming Control Act or any of its regulations, it could limit, condition, suspend or revoke our registrations and gaming licenses. In addition, we and the persons involved could be subject to substantial fines for each separate violation of the Nevada Gaming Control Act, or the regulations of the Nevada Gaming Commission, at the discretion of the Nevada Gaming Commission. Limitation, conditioning or suspension of our gaming licenses or related registrations could, and revocation of any gaming license or registration would, have a material adverse effect on our gaming operations.
Requirements for Beneficial Securities Holders
Unless we are registered as a publicly traded corporation by the Nevada Gaming Commission, no person may become a stockholder of, or receive any percentage of profits from, us without first obtaining the necessary licenses and approvals from the Nevada Gaming Commission. We have also requested and obtained approval from the Nevada Gaming Commission for exemptions available under the Nevada Gaming Control Act that will generally exempt the beneficial holders of our securities from the mandatory licensing requirements. This exemption will apply to current and future beneficial holders of our securities.
Regardless of the number of shares held, any beneficial holder of our voting securities, may be required to file an application, be investigated, and have that person’s suitability as a beneficial holder of voting securities determined if the Nevada Gaming Commission has reason to believe that the ownership would otherwise be inconsistent with the declared policies of the State of Nevada. An exemption from the licensing requirements does not have the effect of exempting a beneficial owner from a suitability determination if the Nevada Gaming Commission requires such determination. If the beneficial owner of our voting securities who must be found suitable is a corporation, partnership, limited partnership, limited liability company or trust, it must submit detailed business and financial information including a list of beneficial owners. The applicant must pay all costs of investigation incurred by the Nevada gaming authorities in conducting any investigation.
The Nevada Gaming Control Act requires any person who acquires five percent or more of any class of the voting securities of a registered company to report the acquisition to the Nevada Gaming Commission. The Nevada Gaming Control Act requires beneficial owners of 10 percent or more of a registered company’s voting securities to apply to the Nevada Gaming Commission for a finding of suitability within 30 days after the Chairman of the Nevada Gaming Control Board mails the written notice requiring the filing. Under certain circumstances, an “institutional investor,” as defined in the Nevada Gaming Control Act, which acquires 10 percent or more, but not more than 15 percent, of the registered company’s voting securities may apply to the Nevada Gaming Commission for a waiver of the finding of suitability if the institutional investor holds the voting securities for investment purposes only. An application to be considered as an institutional investor is a separate application and the applicant is required to pay the applicable investigative fees.
An institutional investor will not be deemed to hold voting securities for investment purposes unless the voting securities were acquired and are held in the ordinary course of its business as an institutional investor and were not acquired and are not held for the purpose of causing, directly or indirectly, the election of a majority of the members of the board of directors of the registered company, a change in the corporate charter, bylaws, management, policies or operations or the registered company or any of its gaming affiliates or any other action that the Nevada Gaming Commission finds to be inconsistent with holding our voting securities for investment purposes only. Activities that are not deemed to be inconsistent with holding voting securities for investment purposes only include:
Our Chief Executive Officer and Chairman, Yuri Itkis, and our Chief Technical Officer, Boris Itkis, and our Chief Marketing Officer, Jack Coronel, and our Chief Financial Officer, William R Jacques Jr., who have been found suitable by various gaming authorities. If a gaming authority in any jurisdiction fails to find any of our officers, directors or significant stockholders suitable, we may be prohibited from leasing, licensing or selling our products in that jurisdiction. We are unaware of any facts or circumstances that would categorically prevent a gaming authority from finding any of our officers, directors or significant stockholders suitable.
Consequences of Being Found Unsuitable
Any person who fails or refuses to apply for a finding of suitability or a license within 30 days after being ordered to do so by the Nevada Gaming Commission or the Chairman of the Nevada Gaming Control Board, or who refuses or fails to pay the investigative costs incurred by the Nevada gaming authorities in connection with the investigation of its application, may be found unsuitable. The same restrictions apply to an owner of record if the owner of record, after request, fails to identify the beneficial owner. Any person found unsuitable and who holds, directly or indirectly, any beneficial ownership of any voting security or debt security of a registered company beyond the period of times as may be prescribed by the Nevada Gaming Commission may be guilty of a criminal offense. We will be subject to disciplinary action if, after we receive notice that a person is unsuitable to hold an equity interest in us or to have any other relationship with us, we:
A finding of suitability is generally determined based upon a myriad of facts and circumstances surrounding the entity or individual in question and many gaming authorities have broad discretion in determining whether a particular entity or individual is suitable. We are unaware of any facts or circumstances that would categorically prevent a gaming authority from finding any of our officers, directors or significant stockholders suitable.
Gaming Laws Relating to Securities Ownership
The Nevada Gaming Commission may, in its discretion, require the holder of any common stock, debt or similar security of a registered company to file applications, be investigated and be found suitable to own the common stock, debt or other security of the registered company if the Nevada Gaming Commission has reason to believe that the ownership would otherwise be inconsistent with the declared policies of the State of Nevada. If the Nevada Gaming Commission determines that a person is unsuitable to own the security, then under the Nevada Gaming Control Act, the registered company may be sanctioned, including the loss of its approvals, if without the prior approval of the Nevada Gaming Commission, it:
We are required to maintain a current stock ledger in Nevada that may be examined by the Nevada gaming authorities at any time. If any securities are held in trust by an agent or by a nominee, the record owner may be required to disclose the identity of the beneficial owner to the Nevada gaming authorities. A failure to make the disclosure may be grounds for finding the record owner unsuitable. We will be required to render maximum assistance in determining the identity of the beneficial owners of our voting securities. The Nevada Gaming Commission has the power to require the stock certificates of any registered company to bear a legend stating that the securities are subject to the Nevada Gaming Control Act, but has not imposed this requirement on us. If the Nevada Gaming Commission were to impose this requirement, we expect that we would seek an exemption from this requirement.
Approval of Changes in Control
As a registered company, we must obtain prior approval of the Nevada Gaming Commission with respect to a change in control through a merger, consolidation, stock or asset acquisitions, management or consulting agreements, or any act or conduct by which anyone obtains control of us.
Entities seeking to acquire control of a registered company must satisfy the Nevada Gaming Control Board and the Nevada Gaming Commission with respect to a variety of stringent standards before assuming control of a registered company. The Nevada Gaming Commission also may require controlling stockholders, officers, directors and other persons who have a material relationship or involvement with the entity proposing to acquire control to be investigated and licensed as part of the approval process relating to the transaction.
Approval of Defensive Tactics
The Nevada legislature has declared that some corporate acquisitions opposed by management, repurchases of voting securities and corporate defense tactics affecting Nevada gaming licensees, and registered companies that are affiliated with those operations, may be harmful to stable and productive corporate gaming. The Nevada Gaming Commission has established a regulatory scheme to reduce the potentially adverse effects of these business practices upon Nevada’s gaming industry and to further Nevada’s policy to:
Because we are a registered company, approvals may be required from the Nevada Gaming Commission before we can make exceptional repurchases of voting securities above their current market price and before a corporate acquisition opposed by management can be consummated. The Nevada Gaming Control Act also requires prior approval of a plan of recapitalization proposed by a registered company’s board of directors in response to a tender offer made directly to its stockholders for the purpose of acquiring control.
Fees and Taxes
We pay license fees and taxes computed in various ways depending on the type of gaming or activity involved. These fees and taxes, depending upon their nature, are payable monthly, quarterly or annually and are based upon either a percentage of the gross revenues received or the number of gaming devices operated. Annual fees are also payable to the State of Nevada for renewal of our manufacturers and distributors licenses, OILS license and our Mobile Gaming license. Our cost of fees and taxes for the years ending 2004, 2005 and 2006 were $97,503, $91,410 and $87,515 respectively.
Foreign Gaming Investigations
Any person who is licensed, required to be licensed, registered, required to be registered, or who is under common control with those persons, collectively, “licensees,” and who proposes to become involved in a gaming venture outside of Nevada, is required to deposit with the Nevada Gaming Control Board, and thereafter maintain, a revolving fund in the amount of $10,000 to pay the expenses of investigation by the Nevada Gaming Control Board of the licensee’s or registrant’s participation in foreign gaming. We currently comply with this requirement. The revolving fund is subject to increase or decrease at the discretion of the Nevada Gaming Commission. Licensees and registrants are required to comply with the reporting requirements imposed by the Nevada Gaming Control Act. A licensee or registrant is also subject to disciplinary action by the Nevada Gaming Commission if it:
The Federal Gambling Devices Act of 1962, the “Johnson Act,” makes it unlawful for a person to manufacture, transport, or receive gambling machines, gambling devices or components across interstate lines unless that person has first registered with the United States Attorney General. We have complied with the registration requirements of the Johnson Act. Gambling devices must also be identified and we must keep certain records in accordance with the Johnson Act’s requirements. If we violate the Johnson Act, our equipment may be seized or forfeited and we may be subject to other penalties.
Tribal Gaming Regulation
When contracting with tribal owned or controlled gaming establishments, we become subject to tribal laws and regulations that may differ materially from the non-tribal laws and regulations under which we generally operate. In addition to tribal gaming regulations that may require us to provide disclosures or obtain licenses or permits to conduct our business on tribal lands, we may also become subject to tribal laws that govern our contracts. These tribal governing laws may not provide us with processes, procedures and remedies that enable us to enforce our rights as effectively and advantageously as the processes, procedures and remedies that would be afforded to us under non- tribal laws, or to enforce our rights at all, and may expose us to an increased risk of contract repudiation as compared to that inherent in dealing with non-tribal customers. Many tribal laws permit redress to a tribal adjudicatory body to resolve disputes; however, such redress is largely untested in our experience. We may be precluded from enforcing our rights against a tribal body under the legal doctrine of sovereign immunity.
Gaming on tribal lands, including the terms and conditions under which gaming equipment can be sold or leased to tribal users, is governed by federal law, tribal-state compacts and tribal gaming regulations. The Indian Gaming Regulatory Act of 1988, “IGRA,” provides the framework for federal and state control over all gaming on tribal lands and is administered by the National Indian Gaming Commission and the Secretary of the United States Department of the Interior. IGRA requires that the tribe and the state enter into a written agreement, a tribal-state compact that governs the terms of certain types of gaming activities. We are not aware of any state in which a tribal-state compact seeks to regulate bingo.
The regulations and ordinances adopted by tribal authorities vary but generally impose standards and technical requirements on gaming hardware and software, and may impose registration, licensing and background check requirements on gaming equipment suppliers and their officers, directors and stockholders similar to typical requirements imposed by Nevada gaming authorities.
Traditional Casino Game Regulation
Traditional casino games, such as poker, keno and video slots, are regulated much more stringently than bingo games. The number of jurisdictions in which traditional casino games are currently permitted is relatively small in comparison to the number of jurisdictions in which bingo is permitted. The State of California just entered into compacts with a large number of tribal authorities. The evolution of the regulation of traditional casino games is very difficult to predict, and no assurance can be provided that our planned entrance into the traditional casino game market with mobile gaming platforms will be successful.
As of December 31, 2006, we had employed 47 employees, including 20 employees in the manufacturing and service department, 18 employees in the engineering programming department and 9 employees in the administration and sales department. None of our employees are covered by collective bargaining agreements. We consider our employee relations to be good.
ITEM 1A. RISK FACTORS
Risks Relating to Our Business
Our failure to obtain approvals under the regulations promulgated under the Nevada Mobile Gaming Law will negatively impact our growth strategy.
Notwithstanding our receipt of an Operator of Mobile Gaming Systems license by the Nevada Gaming Commission, the regulations promulgated under the Nevada Mobile Gaming Law require us to obtain specific approval of our mobile gaming devices for use in Nevada casinos. If we are unable to obtain or maintain approval of our mobile gaming platform as required by the regulations, we will be unable to manufacture, distribute and operate wireless player terminals that enable casino players to play casino games in public areas of gaming establishments as permitted by the Nevada Mobile Gaming Law.
Our inability to comply fully, or at all, with the mobile gaming regulations may result in substantial additional development costs and preclude us from executing our growth strategy.
The regulations require that our mobile gaming systems be approved by the Nevada Gaming Lab before we may distribute these systems to Nevada casinos. The Nevada Gaming Lab may impose significant requirements on the functionality or design of mobile gaming systems that may be manufactured, distributed or operated in Nevada. To the extent that our existing mobile gaming platform may not comply with such requirements, we would need to undertake additional research and development activities that may be costly, time consuming or require the procurement of components that are scarce in supply. Despite undertaking additional research and development activities, we may not be able to design or develop a mobile gaming platform that complies with the standards adopted by the Nevada Gaming Lab, in which case we would be unable to manufacture, distribute or operate wireless player terminals that enable casino players to play traditional casino games in the public areas of gaming establishments permitted under the Nevada Mobile Gaming Law, and therefore be unable to fully execute our growth strategy.
Our failure to maintain our current licenses and regulatory approvals or failure to maintain or obtain licenses or approvals for our gaming devices in any jurisdiction will prevent us from operating in that jurisdiction and possibly other jurisdictions, leading to reduced overall revenue.
As a manufacturer, distributor and operator of gaming platforms, we currently hold licenses in a number of jurisdictions, including Nevada. Our officers, including our major stockholder, Yuri Itkis, are required to obtain and maintain licenses, permits and other forms of approval in certain jurisdictions. We are under continuous scrutiny by the applicable regulatory authorities. Our or our officers’ current regulatory approvals may be revoked, suspended or curtailed at any time. Our or our officers’ failure to obtain or maintain regulatory approval in any jurisdiction may prevent us from obtaining or maintaining regulatory approval in other jurisdictions. The failure to maintain a license in a single jurisdiction or a denial of a license by any new jurisdiction may cause a negative “domino effect” in which the loss of a license in one jurisdiction could lead to regulatory investigation and possible loss of a license in other jurisdictions.
Some jurisdictions also require licenses, permits or other forms of approval for specific gaming devices. If other jurisdictions adopt mobile gaming laws similar to the Nevada Mobile Gaming Law, these approval requirements may vary from jurisdiction to jurisdiction. As a general matter, the regulatory approval of devices involving traditional casino games is more difficult to obtain than those for bingo products. Some jurisdictions require the regulatory approval of entities and individuals before the pursuit of regulatory approval of specific gaming devices, but other jurisdictions allow the pursuit of such regulatory approvals concurrently. Although we and the individuals associated with us may obtain regulatory approval in a particular jurisdiction, we may not be able to manufacture, distribute or operate our mobile gaming platforms in that jurisdiction without separate and specific regulatory approval of our mobile gaming platform. Any failure of our gaming platform to meet the requirements for approval or to obtain the approval in any jurisdiction will cause us to not be able to distribute our gaming platforms in the jurisdiction.
If we are unable to retain our senior employees or attract other key personnel our operations may suffer.
Our future success depends to a significant degree on the skills, experience and efforts of our key personnel. We depend heavily on the ability and experience of a small number of senior executives who have substantial experience with our operations and the electronic gaming device industry, including Yuri Itkis, our Chief Executive Officer and Chairman; William Jacques, our Chief Financial Officer and Controller; Jack Coronel, our Chief Marketing Officer and Director of Compliance and Strategic Development; and Boris Itkis, our Chief Technical Officer and Vice President of Engineering. The loss of any of these senior executives or the failure of any of these senior executives to obtain or maintain the requisite regulatory licenses, permits or determination of suitability would have a material adverse effect on our business.
Changes in licensed positions must be reported to the Nevada gaming authorities and, in addition to their authority to deny an application for a finding of suitability or licensing, the Nevada gaming authorities may disapprove a change in a corporate position, such as a change in job title or substantive job responsibilities. Any such disapproval would prevent us from redeploying our senior executive talent in new functional roles even if management desires to do so.
Our future success depends upon our ability to attract, train and retain key marketing personnel and key managers as we further develop our products and as we enter new markets and expand in existing markets. In connection with the audit of our financial statements for 2006, our independent registered public accounting firm identified a significant deficiency in our internal control over financial reporting arising from the current level of staffing in our accounting department; we may not be able to augment our current level of staffing with qualified individuals on a timely basis. Due to licensing requirements of these personnel that may be imposed by gaming authorities, our pool of potential employees may be more limited than in other industries. Competition for individuals with the skills required is intense, and we may not be successful in recruiting such personnel. In addition, we may not be able to retain such individuals as they may leave our company and go to work for our competitors. If we are unable to attract or retain key personnel, our business, financial condition and operating results could be materially adversely affected.
If other gaming jurisdictions do not adopt mobile gaming legislation similar to the Nevada Mobile Gaming Law, or on any terms at all, we will be unable to implement our growth strategy outside of Nevada.
Our ability to execute fully our growth strategy in jurisdictions other than Nevada depends upon other gaming jurisdictions adopting mobile gaming legislation involving traditional casino games. Currently, Nevada is the first and the only state to enact legislation authorizing mobile gaming for traditional casino games. Although we are not aware of any tribal gaming authority that has specifically prohibited mobile casino gaming involving traditional casino games, we are also not aware of any that have approved it, even though many tribal gaming authorities in practice allow mobile bingo gaming. The adoption of gaming legislation can be affected by a variety of political, social and public policy forces and gaming jurisdictions other than Nevada may not adopt mobile gaming legislation involving traditional casino games in the foreseeable future. To the extent that other jurisdictions do adopt mobile gaming legislation involving traditional casino games, we may not be able to comply fully with the legislation without incurring substantial additional development costs, or at all. If we are required to modify our mobile gaming platform to comply with such potential legislation, we may suffer the increased costs of maintaining multiple variants of our mobile gaming platform to comply with the differing legislation of different jurisdictions. If other gaming jurisdictions fail to adopt mobile gaming legislation involving traditional casino games or we are unable to comply with such legislation without substantial additional costs, we may be unable to execute our growth strategy.
Our failure to obtain gaming licenses or other regulatory approvals in other jurisdictions would preclude us from expanding our operations into and generating revenue from these jurisdictions.
The manufacture and distribution of gaming devices are subject to extensive federal, state, local and tribal regulation. Some jurisdictions require licenses, permits and other forms of approval for gaming devices. Most jurisdictions require licenses, permits or other forms of approval of the manufacturers, distributors and operators of gaming devices, including evidence of financial stability, and of the suitability of their officers, directors, major stockholders and key employees. The regulatory agencies conduct in-depth investigations of gaming device manufacturer licensees as well as detailed personal background checks of key employees and major stockholders of the licensees. Obtaining requisite approvals of state and tribal gaming authorities is a time-consuming and costly process. Even after incurring significant time and expense in seeking regulatory approvals, we may not be able to obtain them. Our failure or the failure of our officers, directors, major stockholders or key personnel to obtain regulatory approval in any jurisdiction will prevent us from distributing our products and generating revenue in that jurisdiction.
We operate in a highly competitive industry and expect the market for mobile gaming devices to become increasingly competitive, which may negatively affect our operations and our ability to maintain relationships with gaming establishments.
The market for gaming devices generally is intensely competitive, and we expect competition to increase and intensify as the market for mobile gaming devices develops. We currently compete with other providers of electronic bingo products, such as VKGS, LLC, or Video King, formerly a division of BK Entertainment Corp., GameTech International, Inc., the recently merged Planet Bingo, LLC and Melange Computer Services, Inc., Blue Dog, Inc. Electronic Game Solutions, Inc. and California Concepts, Inc. in the marketing of our BingoStar wireless bingo systems. Although none of our competitors that manufacture mobile bingo devices is currently licensed in Nevada other than GameTech International, Inc., we may face competition from these providers in the market for mobile gaming devices in the future. Given the market penetration, name recognition, marketing resources and familiarity with the gaming device industry generally, traditional casino game device manufacturers could be a significant competitive threat to us. We expect fierce competition from multiple large competitors dominating their respective markets in our expansion efforts, such as Aristocrat Leisure, Ltd., International Game Technology, Alliance Gaming Corporation, WMS Gaming Inc. and Shuffle Master, Inc., that may enter the market for mobile gaming devices. In addition, we may in the future face potential competition from new entrants into the gaming device market, such as Cantor Fitzgerald LP, a large financial services company that already offers wireless sports betting in the United Kingdom, and at least two other gaming technology companies, Chimera Technology Corp. and Diamond I, Inc. Finally, traditional casino operators, most of whom are much larger than us, may attempt to enter the emerging mobile gaming market. Some of our competitors and potential competitors have significant advantages over us, including greater name recognition, longer operating histories, pre-existing relationships with current or potential customers, proprietary technology, significantly greater financial, marketing and other resources and more readily available access to capital that could allow them to respond more quickly to new or changing opportunities.
Other providers of electronic bingo products have in the past reduced, and may in the future continue to reduce, the prices of their products to gaming establishments in order to win those gaming establishments as customers and to gain market share. To the extent that competitive pressures force us to reduce our prices or provide other incentives to establish or maintain relationships with gaming establishments, our business and operating results could be adversely affected.
Our failure to retain and extend our existing contracts with customers and to win new customers would negatively impact our operations.
All of our lease contracts relate to our electronic bingo products. In 2006 we derived 99.7% of our revenues and cash flow from our portfolio of contracts to lease electronic bingo products to gaming establishments, such as casinos, and bingo halls. Our contracts are typically for a term ranging from one to three years in duration and several are on a month-to-month basis. Not all of our contracts preclude our customers from using bingo devices of our competitors. Upon the expiration of one of our contracts, a gaming establishment may award a contract through a competitive procurement process, in which we may be unsuccessful in winning the new contract or forced to reduce the price that we charge the gaming establishment in order to renew our contract. In addition, some of our contracts permit gaming establishments to terminate the contract at any time for our failure to perform and for other specified reasons. The termination of or failure to renew or extend one or more of our contracts, or the renewal or extension of one or more of our contracts on materially altered terms could, depending upon the circumstances, have a material adverse effect on our business, financial condition, results and prospects.
We derive a substantial portion of our revenue from direct sales to our customers, or house accounts, which we service ourselves, without any involvement of outside distributors. Although such accounts typically involve higher profit margins, the competition for these accounts is very keen. We typically negotiate one to three year, automatically renewable leases for our bingo units with our direct customers. The house account contracts tend to be challenging to maintain and enforce, especially those with tribal gaming operators, and therefore, we may not be able to retain lucrative house accounts indefinitely. A loss of any such account may have a severe negative impact on our revenue.
A material reduction in the yield on our investment of the proceeds of our initial public offering and our retained earnings could materially and adversely affect our net income and earnings per share.
Because we have not yet begun full-scale production of mobile gaming devices under the Nevada Mobile Gaming Law, we have invested the bulk of the proceeds of our initial public offering and retained earnings. Our net income and earnings per share for the year ended December 31, 2006 depended substantially on the yield that we achieved on these investments. Approximately 28% of our income before tax during 2006 resulted from these investments. Although we have invested these proceeds in relatively conservative investments, there can be no assurance that we will continue to enjoy the same yields on these investments as we did during 2006. Moreover, there can be no assurance that these investments will continue to generate a positive yield. Assuming no other changes in our sources of revenues, any decrease in the yield on these investments, and any loss on these investments, would directly reduce our revenues.
Losing any of our small number of independent distributors upon whom we depend for a significant portion of our revenue would negatively impact our operations.
We are dependent upon a small number of independent distributors to market and sell our products to casinos and bingo halls. For the fiscal year ended December 31, 2006, approximately 58.6% of our revenues were derived through nine distributors. During the same period, we derived approximately 32.7% of our revenue from our single largest distributor. Due to our payment of commissions to distributors, our customer contracts derived from distributors generate lower profit margins than our contracts derived from direct sales, or house accounts. Because we do not directly control our distributors or their customer intake practices, contracts with customers derived from distributors may be susceptible to higher default rates and lower profit margins than our house accounts.
Some of our distributors are not contractually prohibited from marketing or selling products of our competitors. Our contracts with our distributors typically cover one to three year terms and are automatically renewed for one year unless terminated upon the expiration of the then current term. Upon the expiration of a contract term, we may not be able to renew any of these contracts on terms that are favorable to us, or at all. Our competitors may provide incentives to our distributors to market and sell their products in addition to or in lieu of ours. The loss of any of our distributors may result in a material reduction in our revenue, resulting in a material adverse effect on our business, financial condition and results of operations.
Difficulties with the limited number of manufacturers and suppliers upon whom we rely for components of our products would negatively impact our production capacity, customer relationships and operations.
We purchase most of the parts, components and subassemblies necessary for the manufacture of our products from outside sources. We assemble these parts, components and subassemblies into finished products in our manufacturing facility. While most of the parts, components and subassemblies are produced by more than one manufacturer and can be purchased through more than one supplier, we currently rely upon approximately 12 vendors from whom we purchase substantially all of our components. We currently obtain the touch screens for our wireless gaming terminals from a single supplier. While changing suppliers for this component is not impossible, doing so would require significant time and effort on the part of our engineering and management teams and may cause us to miss revenue generating opportunities until we are able to obtain touch screen monitors from a new supplier. In addition, the supplies of the central processing units, memory and peripheral drives for our mobile gaming platforms are often uncertain and subject to significant backlogs from time to time due to spikes in general demand for such products. We compete with other companies for the production capacity of third party manufacturers and suppliers of these and other components. Certain of these competing companies have substantially greater financial and other resources than we have and thus we may be at a competitive disadvantage in seeking to procure production capacity.
To procure certain parts, components and subassemblies, we sometimes commit to supply contracts in which we commit to purchase large quantities over extended periods of time. By doing so, we are exposed to a number of risks. If the market prices of these components drop below the prices at which we are committed to purchase them, our purchase commitments may preclude us from taking advantage of reductions in market prices. If the components are surpassed by superior technology that becomes available after we make our purchase commitments, our purchase commitments may preclude us from taking advantage of technological advancements. If a change in the design or specifications of our products results in a substitution or elimination of a component, we may be forced to write off a substantial quantity of obsolete inventory of components or to sell such components in the open market at a loss.
Our inability to contract with third-party manufacturers and suppliers to provide a sufficient supply of our components on acceptable terms and on a timely basis could negatively impact our relationships with customers and materially and adversely harm our business. For those components that we procure under supply contracts, if any of such supply contracts were to be terminated or breached, we may not be able to procure an alternate supply on terms as favorable to us in time, or at all. We may suffer lengthy delays in our manufacturing process while we seek to procure an alternate supply. A delay in our ability to manufacture products may adversely affect our goodwill with customers, expose us to liability to customers and result in the loss of business opportunities. Any alternate supply of parts, components or subassemblies may be more expensive to us or may require us to undertake additional engineering activities to integrate the alternate supply into our products or manufacturing process.
Certain parts, components and subassemblies for our products are manufactured outside of the United States, which exposes us to the risks of foreign currency fluctuations, political and economic instability and limited protection of intellectual property.
If our wireless gaming terminals do not achieve and maintain widespread acceptance by gaming establishments and casino game players as a means to play traditional casino games, our business operations will not grow as anticipated.
Our current business depends on the preferences of gaming establishment players that play bingo games, and our growth strategy depends on the preferences of gaming establishment players that play traditional casino games, such as poker, keno and slots. The tastes and preferences of players of bingo and traditional casino games are known to change over time. If the bingo games or traditional casino games that we enable gaming establishment players to play using our wireless gaming terminals do not appeal to players to the degree anticipated, our mobile gaming platforms will not be fully utilized and our business will suffer.
The success of our growth strategy will depend to a large extent on broad market acceptance of our wireless gaming terminals among casinos and their players who play traditional casino games. The only market acceptance that our wireless gaming terminals currently enjoy is as a means to play bingo games electronically. Even if we are successful in deploying mobile gaming platforms that enable casino players to play traditional casino games, gaming establishments and their players may still not use our wireless gaming terminals for a number of reasons, including preference for live dealers, preference to play casino games in a traditional environment using traditional equipment, mistrust of technology and perceived lack of reliability. We believe that the acceptance of our wireless gaming terminals by gaming establishments and their players will depend on our ability to demonstrate the economic and other benefits of our products to gaming establishments, casino players becoming comfortable with using our wireless gaming terminals, the attractiveness of the casino games that players can play using our wireless gaming terminals, ease of use, and the reliability of the hardware and software that comprise our mobile gaming platforms.
Initially, we intend to offer our customers equipment lease agreements under which we will lease our wireless gaming terminals and the associated equipment. However, if and when market acceptance of our wireless gaming platforms has been established, we may be required to sell wireless gaming platforms to customers rather than lease them because of the prevailing practices of casino operators to purchase rather than lease equipment. However, if our wireless gaming terminals fail to quickly achieve market acceptance as a means to play traditional casino games, our customers may not renew their leases or may not purchase our mobile gaming platforms, which would have a material adverse effect on our business, financial condition and results of operation.
Any change in our business model from the lease of wireless gaming terminals to the sale of gaming terminals may result in an eventual reduction of our revenues.
We currently derive substantially all of our revenues by leasing our wireless gaming terminals and associated equipment to our gaming establishment customers. If and when market acceptance of our wireless gaming terminals is established, our gaming establishment customers may prefer to purchase our wireless gaming terminals rather than lease them. If we sell our wireless gaming terminals in the future, we must price them in a manner that reflects the ongoing lease revenues that leasing them generates. If we are unable to sell our wireless gaming terminals for a sales price in excess of the lease revenues that we would otherwise receive, our revenues may eventually decline.
Our failure to comply with tribal regulation and tribal laws would preclude us from operating in tribal jurisdictions and deriving revenue therefrom.
We are required to obtain licenses and approvals from tribal authorities in order to operate in tribal jurisdictions. When seeking approvals from or licensing with tribal-owned or tribal-controlled gaming establishments, we become subject to tribal laws and regulations. These laws and regulations may differ materially from the non-tribal laws and regulations under which we generally operate. A change in tribal laws and regulations or our inability to obtain required licenses of our gaming platforms or licenses to operate on tribal lands could have a material adverse effect on our business, financial condition and operating results.
We may not be able to enforce our contractual rights against tribal governments or agencies, which may negatively impact our operations.
In addition to tribal gaming regulations that may require us to provide disclosures or obtain licenses or permits to conduct our business on tribal lands, we may also become subject to tribal laws that govern our contracts. These tribal governing laws may not provide us with processes, procedures and remedies that enable us to enforce our rights as effectively and advantageously as the processes, procedures and remedies that would be afforded to us under non-tribal laws, or to enforce our rights at all. Many tribal laws permit redress to a tribal adjudicatory body to resolve disputes; however, such redress is largely untested in our experience and tribal judiciaries are not always independent. We may be precluded from enforcing our rights against a tribal body under the legal doctrine of sovereign immunity. Our inability to enforce our contract rights under tribal law could negatively impact our operations.
Disrupted operation of our server-based gaming systems caused by the network infrastructure of the casinos in which they are installed would cause dissatisfaction among customers and gaming establishments and may harm our operating results.
We expect to enter into agreements with customers that operate casinos and bingo halls in more than one location. In such cases, we anticipate that our agreements with such customers will provide that the customer will be responsible for providing, at its expense, a dedicated high-speed computer network connection between our server-based gaming systems in the various locations operated by the customer to a remote central gaming server supporting such systems. Failures or disruptions of a customer’s dedicated high-speed connection that result in the stoppage of play or in reduced performance of our server-based gaming system could disrupt players’ gaming experience, adversely affect the casinos’ or bingo halls’ satisfaction with our gaming devices, delay market acceptance of our mobile gaming platforms and harm our reputation, business, operating results and financial condition. In addition, our customers have to reserve, for our exclusive use, certain radio frequency, or RF, channels of adequate capacity to accommodate reliable and expedient wireless communication between our wireless player terminals and central game file servers.
We expect to spend substantial amounts on research and development, but these efforts may fail or lead to operational problems that could negatively impact our operations.
In order to compete effectively in an era of technological changes, we must continuously enhance our existing products and develop, introduce and market new products and services. As a result, we expect, as needed, to continue to make a significant investment in product development. Our development of products is dependent on factors such as assessing market trends and demands and obtaining requisite governmental approvals. Although we are pursuing and will continue to pursue product development opportunities, we may fail to develop any new products or services or enhancements to existing products. Even if new products or services are developed, these products or services may not prove to be commercially viable, or we may not be able to obtain the various gaming licenses and approvals necessary to manufacture and distribute these products or provide these services to our customers. We may experience operational problems with such products after commercial introduction that could delay or defeat the ability of such products to generate revenue or operating profits. Future operational problems could increase our costs, delay our plans or adversely affect our reputation or our sales of other products, which, in turn, could materially adversely affect our success. We cannot predict which of the many possible future products will meet evolving industry standards and casino or player demands.
Changes in technology may make our inventory obsolete and cause significant losses.
Future technological advances in the gaming equipment market may result in the availability of new products or increase the efficiency of existing products. We may not be able to adapt to such technological changes. If a technology becomes available that is more cost-effective or creates a superior product, we may be unable to access such technology or its use may involve substantial capital expenditures that we may be unable to finance. Existing, proposed or as yet undeveloped technologies may render our technology less viable, less profitable or obsolete. We may not have available the financial and other resources to compete effectively against companies possessing such technologies. If we were to fail to develop our product and service offerings to take advantage of technological developments, we may fall behind our competitors and our business, financial condition, results and prospects could suffer. If technological advances render our current inventory of products obsolete, we may suffer significant revenue losses and write-downs of our assets.
Defects in, and fraudulent manipulation of, our gaming platforms could reduce our revenue, increase our costs, burden our engineering and marketing resources, involve us in litigation and adversely affect our gaming licenses.
The real and perceived integrity and security of mobile gaming is critical to its ability to attract players. We strive to set exacting standards of system security for the systems that we provide to gaming establishments, and our reputation in this regard is an important factor in our business dealings with our customers and regulators, such as the Nevada Gaming Commission and other governmental agencies. For this reason, an actual or alleged system security defect or failure attributable to us could have a material adverse effect upon our business, financial condition, results and prospects, including our ability to retain existing contracts or obtain new contracts.
Our success will depend on our ability to avoid, detect and correct software and hardware defects and prevent fraudulent manipulation of our mobile gaming platforms. Although our mobile gaming platforms are subject to rigorous internal testing and will be subject to additional testing by regulators in certain gaming jurisdictions, we may not be able to build and maintain products that are free from defects or manipulations and that satisfy these tests. Although we have taken rigorous steps to prevent defects and manipulations, our gaming platforms could suffer from such defects and manipulation after they are put into operation.
Although we do not believe it is likely, it is possible that an individual could breach the security systems of a casino or bingo hall, gain access to the central game file server on which our server-based mobile gaming platform operates and fraudulently manipulate its operations. The occurrence of such fraudulent manipulation or of defects or malfunctions could result in financial losses for our customers and, in turn, termination of leases, cancellation of orders, product returns and diversion of our resources. Even if our customers do not suffer financial losses, casinos and bingo halls may replace our gaming platforms if they do not perform according to expectations. Any of these occurrences could also result in the loss of or delay in market acceptance of our server-based gaming platform and loss of licenses, leases and sales.
In addition, the occurrence of defects in, or fraudulent manipulation of, our gaming platforms may give rise to claims for lost revenue and related litigation by our gaming establishment customers and may subject us to investigation or other disciplinary action by regulatory authorities that could include suspension or revocation of our regulatory approvals.
Improper conduct of our employees could harm our reputation and adversely affect our business operations.
The real and perceived integrity and security of mobile gaming is critical to its ability to attract players. We strive to set exacting standards of personal integrity for our employees and reliable security for the gaming platforms that we provide to our customers, and our reputation in this regard is an important factor in our business dealings with Nevada Gaming Commission and other governmental agencies. For this reason, any allegation or a finding of improper conduct on our part, or on the part of one or more of our employees, or an actual or alleged security defect with our gaming platform or failure attributable to us, could have a material adverse effect upon our business, financial condition, results and prospects, including our ability to retain existing contracts or obtain new or renewal contracts, or the loss of gaming licenses or other regulatory approvals.
Our failure to properly manage growth would adversely affect our business operations.
In order to implement our business strategy, we must effectively manage rapid growth in our manufacturing, sales and customer support operations. This rapid growth will strain our existing management, financial and other resources. To manage any future growth effectively, we will have to expand our management team, integrate new personnel and augment our marketing and production capabilities. To rapidly produce large volumes of wireless gaming terminals, we will have to formulate and implement design, production planning, manufacturing and quality assurance plans that are unlike those we have used in the past. These plans may strain our manufacturing and industrial engineering capabilities and resources. Rapid growth would also require us to improve our financial, accounting and operational systems and controls. Expansion into new geographic areas would further strain our limited operational and marketing resources. If we are unable to effectively manage our growth, we may fail to execute our business strategy and our operations and financial results may be adversely affected.
Possible future acquisitions could prove difficult to integrate, disrupt our business, dilute stockholder value and strain our resources.
As part of our business strategy, we may seek to acquire businesses, services and technologies that we believe could complement or expand our business, augment our market coverage, enhance our technical capabilities, provide us with valuable customer contacts or otherwise offer growth opportunities. If we fail to achieve the anticipated benefits of any acquisitions we may complete, our business, operating results, financial condition and prospects may be impaired. Acquisitions and investments involve numerous risks, including:
Acquisitions also frequently result in recording of goodwill and other intangible assets, which are subject to potential impairments in the future that could harm our operating results. In addition, if we finance acquisitions by issuing convertible debt or equity securities, our existing stockholders may be diluted. Such dilution could adversely affect the market price of our stock. It is also possible that at some point in the future we may decide to enter new markets, thus subjecting ourselves to new risks associated with those markets.
Our patents and proprietary rights may not be enforceable, may not be cost effective to enforce or may not provide significant competitive advantage, which could negatively impact our operations.
Our success depends to a significant degree upon protecting our intellectual property rights. We have three United States patents relating to our products and corresponding patents in certain foreign countries. Of the three patents, two expires in 2010 and one expire in 2012. The patents that we own now or in the future may not provide us with significant competitive advantages or may be impaired by challenges to the validity or enforceability of such patents. For example, in the past the validity of one of our patents has been repeatedly challenged. Others may independently develop similar or more advanced technologies or products or design around aspects of our technology that may be patented.
It is possible that third parties may copy or otherwise obtain and use our information and proprietary technology without our authorization or otherwise infringe on our intellectual property rights. We may have to rely on litigation to enforce our intellectual property rights and contractual rights. For example, we are pursuing a patent infringement action against Planet Bingo, LLC and Melange Computer Services, Inc. to discontinue what we believe to be their infringement of our rights arising under of our patents. Both defendants have counterclaimed that our patents are invalid and Planet Bingo, LLC has alleged that our operations infringe one of its patents. See “Item 3. Legal Proceedings” for a more detailed discussion of this litigation. If these counterclaims are successful, our patents may be invalidated or limited in scope or we may be forced to modify or discontinue our operations or pay substantial damages. If litigation that we initiate is unsuccessful, including the litigation described above, we may not be able to protect the value of our intellectual property and our business could be adversely affected.
We have patent applications that are currently pending before the United States Patent and Trademark Office. These patent applications may not result in any patents being issued. If these patent applications do not become issued patents, our competitors would not be prevented from using these inventions described in the applications.
In addition, we may face claims of infringement that could interfere with our ability to use technology or other intellectual property rights that are material to our business operations. If a claim of infringement against us is successful, we may be required to pay royalties to use technology or other intellectual property rights that we had been using or we may be required to enter into a license agreement and pay license fees, or we may be required to stop using the technology or other intellectual property rights that we had been using. We may be unable to obtain necessary licenses from third parties at a reasonable cost or within a reasonable time. Any litigation of this type, whether successful or unsuccessful, could result in substantial costs to us and diversions of our resources.
In addition, we may not be able to deter current and former employees, consultants, and other parties from breaching confidentiality agreements with us and misappropriating proprietary information from us. If we are unable to adequately protect our intellectual property, it could have a material adverse effect on the value of our intellectual property, our reputation, our business and our operating results.
We may not be able to obtain additional financing if required, which could harm our operations and ability to generate revenue.
Our ability to manufacture our gaming platforms on a large scale may require us to obtain additional financing necessary for the manufacture of such hardware components and expansion of our inventory. The net proceeds that we have received from the sale of the shares of common stock in our initial public offering together with revenue that we generate from operations may not be sufficient to execute our growth strategy.
If we are unable to generate sufficient revenue or if our working capital and manufacturing capacity is not capable of keeping up with demand, we will need to seek additional equity or debt financing to provide the capital required to maintain or expand our production capabilities. We may not be able to obtain needed additional equity or debt financing on terms that are favorable to us, or at all. If we are able to obtain such financing, existing stockholders may suffer dilution and the equity or debt securities issued to raise such financing may have rights, preferences and privileges senior to those of existing stockholders. If we require, but are unable to obtain, sufficient additional financing in the future we may be unable to implement our business plan, respond to changing business or economic conditions, withstand adverse operating results and compete effectively. More importantly, if we are unable to raise further financing when and if required, our continued operations may have to be scaled down or even ceased and our ability to generate revenues would be materially impaired.
Our inability to lease suitable facilities may harm, delay or prevent our operations.
The long term lease for our Las Vegas, Nevada facility, which is our only facility, expires in December 2010. This facility provides us with a convenient central location from which to service our customers. We may not be able to extend the lease on its current terms or, if required, locate new adequate manufacturing facilities on commercially reasonable terms or at all.
Risks Relating to Our Industry
A decline in the popularity of gaming could reduce the demand for our products.
We provide mobile gaming platforms to gaming establishments to enable players to play bingo in several jurisdictions, including Nevada, and traditional casino games on cruise lines. When legally permitted, we intend to provide mobile gaming platforms to enable players to play traditional casino games using our wireless player terminals in Nevada. As a result, our business depends on consumer demand for the games that we enable. Gaming is a discretionary leisure activity, and participation in discretionary leisure activities has in the past, and may in the future, decline during economic downturns because consumers have less disposable income. Therefore, during periods of economic contraction, our revenue may decrease while some of our costs remain fixed, resulting in decreased earnings. Gaming activity may also decline based on changes in consumer confidence related to general economic conditions or outlook, fears of war, future acts of terrorism, or other factors. A reduction in tourism could also result in a decline in gaming activity. Finally, a legislature or regulatory authority may prohibit all or some gaming activities all together in its jurisdiction. A decline in gaming activity as a result of these or any other factors would have a material adverse effect on our business and operating results.
Changes in consumer preferences could also harm our business. Gaming competes with other leisure activities as a form of consumer entertainment, and may lose popularity as new leisure activities arise or as other leisure activities become more popular. In addition, gaming in traditional gaming establishments competes with Internet-based gaming for gaming players, and we do not serve the Internet gaming market. The popularity and acceptance of gaming is also influenced by the prevailing social mores, and changes in social mores could result in reduced acceptance of gaming as a leisure activity. To the extent that the popularity of gaming in traditional gaming establishments declines as a result of either of these factors, the demand for our gaming platforms may decline and our business may be adversely affected.
Expansion of the gaming industry faces opposition that could limit our access to some markets and impair our growth.
We expect a substantial portion of our future growth to result from the general expansion of the gaming industry. The expansion of gaming activities in new markets can be very controversial and may depend heavily on the support of national, local and tribal governments. Changes in government leadership, failure to obtain requisite voter support in referenda, failure of legislators to enact enabling legislation and limitations on the volume of gaming activity that is permitted in particular jurisdictions may prevent us from expanding our operations into new markets. A failure by the gaming industry to expand at the rate that we expect could have a material adverse effect on our business, growth rates, financial condition and operating results.
Gaming opponents continue to persist in efforts to curtail the expansion of legalized gaming. Unfavorable public referendums, anti-gaming legislation or unfavorable legislation affecting or directed at manufacturers or operators of gaming products may materially and adversely impair our business and growth prospects. Gaming opponents may be successful in preventing the legalization of mobile gaming in jurisdictions where mobile gaming may be presently prohibited or in limiting the expansion of mobile gaming where it is currently permitted, in either case to the detriment of our business, financial condition, results and prospects.
Future acts of terrorism, as well as other factors affecting discretionary consumer spending and air travel, may impact our industry and may harm our operating results.
Future terrorist attacks similar to those of September 11, 2001, may have a significant impact on the travel and tourism industries upon which the gaming industry, and we in turn, depend. In general, our Nevada-based gaming establishment customers are adversely affected by disruptions in air travel, regardless of cause. Although, our gaming establishment customers in markets outside of Nevada, which are not as dependent on air travel, may not experience as much business disruption, the potential for future terrorist attacks, the national and international responses to terrorist attacks and other acts of war or hostility have created many economic and political uncertainties that could adversely affect our business and results of operations. Future acts of terror in the United States or an outbreak of hostilities involving the United States may reduce players’ willingness to travel, with the result that our operations will suffer. The amounts that our customers pay to us are based on usage of our devices. Accordingly, reduced usage results in reduced payments to us. Although the revenue we generate from our gaming devices may decline as a result of reductions in air travel or consumer spending, our contracts do not generally provide our customers with the right to terminate their contracts with us as a result of reductions in air travel or consumer spending.
We operate our business in regions subject to natural disasters and other severe catastrophic events, including hurricanes. We have suffered casualty losses as a result of natural disasters (e.g. Hurricane Katrina), and any disruption to our business resulting from natural disasters will adversely affect our revenue and results of operations.
The strength and profitability of our business depends on player demand for our products at gaming establishments. The impact of natural disasters, the outbreak of infectious diseases and other factors affecting discretionary consumer spending could negatively affect gaming activity and consequently, the demand for and use of our products at affected gaming establishments. Disruptions of gaming establishment operations, as a result of natural disasters and other catastrophic events beyond our control, would also reduce the number of gaming establishments that offer our products.
We operate our business primarily through gaming platforms, including wireless and stationary player terminals, cashier-based POS terminals and self-service POS kiosks, used by players at gaming establishments and bingo halls. Accordingly, a substantial portion of our physical assets are in locations beyond our direct control, including areas of Louisiana that sustained major damage as a result of Hurricane Katrina. Generally, our business may also be adversely affected by any damage to or loss of equipment that we install at gaming establishments resulting from theft, vandalism, terrorism, flood, fire or any other natural disaster. Our insurance may not be adequate to recover our losses from these events. The amounts that our customers pay to us are based on usage of our devices. Accordingly, reduced usage results in reduced payments to us. Although the revenue we generate from our gaming devices may decline as a result of a natural disaster, our contracts do not generally provide our customers with the right to terminate their contracts with us as a result of a natural disaster.
Beneficial holders of our securities are subject to regulation by the Nevada gaming authorities, which may result in required applications for license, findings of suitability and mandatory redemption of shares.
Because we are a registered company under the Nevada Gaming Control Act, any person who acquires five percent or more of any class of our voting securities is required to report the acquisition to the Nevada Gaming Commission. The Nevada Gaming Control Act requires any person who acquires 10 percent or more of our voting securities to apply to the Nevada Gaming Commission for a finding of suitability within 30 days after the Chairman of the Nevada Gaming Control Board mails a written notice requiring the filing. If such person fails or refuses to apply for a finding of suitability or license within 30 days after being ordered to do so by the Nevada gaming authorities, or if such person refuses or fails to pay the investigative costs incurred by the Nevada gaming authorities in connection with such person’s application, the person may be found unsuitable. The same restrictions apply to the owner of record if the owner of record, after request, fails to identify the beneficial owner. Any person found unsuitable and who holds any voting security may be guilty of a criminal offense. We will be subject to disciplinary action if, after we receive notice that a person is unsuitable to hold an equity interest or to have any other relationship with us, we:
Our Amended and Restated Articles of Incorporation provide that persons who acquire five percent or more of the beneficial ownership of our outstanding capital stock notify us and consent to any background investigation or other requirements imposed by any gaming authority. Our Amended and Restated Articles of Incorporation also provide for mandatory redemption of its shares if the beneficial owner fails to comply with any applicable gaming law requirements.
Certain Nevada statutes have potential anti-takeover effects that could delay or prevent a change in control of our company and depress the price of our common stock.
Nevada statutes regulating business combinations, takeovers and control share acquisitions may hinder or delay a change in control of our company. In addition, under Nevada law, any change of control of our company must also be approved by the Nevada gaming authorities. Other jurisdictions may have similar requirements. These statutes could limit the price that investors might be willing to pay in the future for shares of our common stock and may limit our stockholders’ ability to receive a premium on their shares by discouraging takeovers and tender offer bids, even if such events could be viewed as beneficial by our stockholders.
ITEM 2. PROPERTIES
We conduct our operations at our facility located at 2950 South Highland Drive, Suite C, Las Vegas, Nevada, 89109. This facility is an approximately 22,000 square foot facility utilized for our administrative office, product showroom, research and development and manufacturing functions. The lease for this facility expires in December 2010. Although we believe that our current facility is adequate for manufacturing a sufficient volume of mobile gaming products to satisfy the anticipated demand through the existing lease term, we may be forced to lease additional manufacturing space if demand for our expanded line products should exceed our capability to manufacture the products in our currently leased facility.
ITEM 3. LEGAL PROCEEDINGS
We are pursuing a patent infringement lawsuit against one of our competitors, the recently merged Planet Bingo, LLC and Melange Computer Services, Inc. The lawsuit involves two of our patents. We allege that both patents are being infringed by Plant Bingo, LLC and one of the patents is being infringed by Melange Computer Services, Inc. We filed this action in May 2004 in the United States Federal Court, District of Nevada. We are seeking unspecified monetary damages and injunctive relief. The defendants have counter-claimed that our patents are invalid and one of the defendants, Planet Bingo, LLC, has alleged that our operations infringe on one of its patents. The patent that Planet Bingo, LLC alleges that we have infringed has been invalidated by a Federal District Court in unrelated litigation. This decision is on appeal. If either of the counter-claims is successful, our patents may be invalidated, or limited in scope, or we may be forced to modify or discontinue our operations or pay substantial damages.
In 2006, we commenced a civil action under the federal Racketeer Influenced Corrupt Organization (RICO) law proceeding against our competitor GameTech International, Inc.
In rare instances, we are threatened with or named as a defendant in lawsuits arising in the ordinary course of business, such as personal injury claims and unemployment-related claims and from time to time, also prosecute various collection claims against delinquent customers.
We believe that the final resolution of any of the threatened or pending litigation described above, individually or in the aggregate, is not likely to have a material adverse effect on our business, cash flow, results of operations or financial position.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Since our initial public offering on January 31, 2006, our common stock has traded on the Nasdaq Global Market (formerly the Nasdaq National Market) under the symbol “FNET”. Prior to that time, there was no public market for our stock.
The following table sets forth, for the indicated periods, the high and low closing sale prices of our common stock:
On March 1, 2007, the closing sale price of our common stock on the Nasdaq Global Market was $7.85.
As of December 31, 2006, our stock was held by approximately 10 stockholders of record. Because many of our shares of common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of beneficial stockholders represented by these record holders.
During 2005, which was prior to our initial public offering, we paid dividends to holders of our common stock on a quarterly basis. The dividends paid during 2005 were $2,370,000 in the aggregate. Since becoming a publicly traded entity in 2006 we have paid no dividends and may not pay any dividends on our common stock in the foreseeable future and instead, may retain our future earnings, if any, to finance our business and for general corporate purposes. As long as there are funds legally available to do so, any future determination to pay cash dividends will be at the discretion of our board of directors and will depend upon earnings, financial condition, operating results, capital requirements, any contractual restrictions and other factors that our board of directors deems relevant. The terms of any future debt or credit facility may preclude us from paying dividends on our common stock.
Use of Proceeds
We completed an initial public offering of our common stock during the first quarter of 2006. Our registration statement on Form S-1 under the Securities Act (File No. 333-128391) was declared effective on January 30, 2006. The aggregate net proceeds to us were approximately $23,728,995.
We have invested all of the net proceeds from our initial public offering in short-term interest bearing investment grade securities. We may utilize a significant amount of proceeds from our initial public offering to acquire parts and components for the manufacture of our gaming products. However, we do not intend to commence procuring any significant amount of component parts for manufacture of our gaming products until we are more able to predict the duration of the currently ongoing reviewing process of our mobile gaming systems by the Nevada gaming authorities. We may also utilize a substantial portion, if not most, of the proceeds from this offering to acquire one or more businesses.
The information contained in the following graph shall not be deemed to be “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933, as amended, or the 1934 Securities Exchange Act, as amended, except to the extent that the Company specifically incorporates it by reference in such filing.
The following graph compares the performance of an investment in our common stock from January 31, 2006 (the first trading day following the Company’s initial public offering) through December 31, 2006, with the S&P 500 Index and a selected peer group index (the “Peer Group Index”). The Peer Group Index was selected on an industry basis and consists of International Game Technology and Shuffle Master, Inc.
The graph assumes $100 was invested in each of our common stock, the Peer Group Index and in the S&P 500 Index at the close of market on January 31, 2006 (the first trading day following the Company’s initial public offering) and the end of each month through out 2006. No cash dividends have been declared on our common stock since our initial public offering. The comparisons in this graph are not intended to forecast or be indicative of possible future performance of our common stock.
The table below shows the cumulative total returns in dollars of our common stock, the S&P 500 Index and the Peer Group Index at the end of each calendar month since our initial public offering, assuming $100 was invested in each of our common stock and the Peer Group Index and in the S&P 500 Index at the close of market on January 31, 2006 (the first trading day following our initial public offering), and assumes the reinvestment of dividends on the date of payment without payment of any commissions. No cash dividends have been declared on our common stock since our initial public offering. The comparisons in this table are not intended to forecast or be indicative of possible future performance of our common stock.
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial data should be read in conjunction with out audited consolidated financial statements and related notes and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this Annual Report on Form 10-K. The selected consolidated financial data for the fiscal years ended December 31, 2002, 2003, 2004, 2005 and 2006 have been derived from our audited consolidated financial statements. Our selected consolidated financial data may not be indicative of our future financial condition or results of operations.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
We are an established and profitable manufacturer of multi-game and multi-player server-based gaming platforms. Our gaming platforms include networks of both wireless and stationary player terminals, cashier-based point-of-sale terminals, self-service point-of-sale kiosks and game file servers that conduct and control bingo games. Our gaming platforms have been adapted to conduct traditional casino games, such as keno, poker and slots, in addition to bingo.
We believe that the research and developments efforts that we undertook in 2006 have made our field-proven mobile gaming platform compliant with the wireless gaming regulations promulgated by the Nevada Gaming Commission on March 23, 2006. Accordingly, we have submitted our mobile gaming platform for review by Nevada gaming authorities in 2006. Our gaming platforms currently enable patrons to play bingo using either our wireless or our stationary player terminals. In addition, our gaming platforms currently enable patrons to play traditional casino games using our stationary player terminals. We have also successfully completed the field testing of our wireless player terminals that enable patrons to play traditional casino games on a limited basis on cruise lines. If our wireless gaming devices are approved by the Nevada gaming authorities, Nevada casino patrons will be able to play traditional casino games using our wireless player terminals. However, there can be no assurance that we will obtain such approval in the foreseeable future or at all.
Since our inception, we have been a technology innovator in the gaming equipment industry. We helped to define the core concepts of modern gaming technologies including server-based networks, concurrent multi-gaming, cashless gaming, downloadable gaming and notably, mobile gaming. We continue to focus on research and development and have recently introduced our fourth generation wireless player terminals for our gaming platform that enable patrons to play bingo and has been adapted to conduct traditional casino games in casino public areas. In addition to adapting our wireless gaming platform to comply with the newly promulgated Nevada gaming regulations for mobile gaming devices, we have developed and begun selling super-bright multicolor LED bingo flashboards that not only display the called bingo numbers but also verify bingo cards. We have filed a United States patent application regarding certain aspects of this product.
We currently generate revenue by placing electronic bingo systems in bingo halls under contracts based on (a) a fixed fee per use per session; (b) a fixed weekly fee per terminal; or (c) a percentage of the revenue generated by each terminal. Our revenue growth is affected by player acceptance of electronic bingo as an addition or an alternative to paper bingo in our existing client establishments, our ability to expand operations into new markets and our ability to increase our market share. Our stationary bingo player terminals generate greater revenue per player terminal than our wireless bingo player terminals, but also require a greater initial capital investment. As our customer base changes from period to period through the addition of new customers or the occasional loss of existing customers, we experience an increase in sales revenue due to the addition of customers and a decrease in sales revenue due to the loss of customers. Our sales revenue is also affected from period to period as a result of changes in operations at our existing customer locations that result from numerous factors over which we have little or no control.
We typically install our electronic bingo systems at no charge to our customers and we capitalize all direct costs. We record depreciation of bingo equipment over a five-year estimated useful life using the straight-line method of depreciation.
We anticipate that at some point in time, we may begin selling our gaming platforms for use in conducting traditional casino games, instead of entering into lease contracts as we do now. At that time, our revenue may include product revenue from sales of equipment, in addition to our leasing revenue. At such time, our product revenue will be influenced by the then current price for our products and our unit-volume sales.
We envision that if we develop product revenue sales, we will also see a recurring revenue component for both software upgrades and maintenance of the software components of our sold products.
Our expenses currently consist of:
(a) cost of revenue, depreciation of bingo terminals and other capitalized equipment under lease to customers, maintenance, repair and refurbishment of bingo terminals and related support equipment, and cost of shipping. Installation costs and initial shipment expenses associated with new customer lease contracts are expensed as cost of revenue in the period in which the equipment is deployed. Expenses related to maintenance, repair and refurbishment of our existing equipment that has been deployed at customer locations are expensed as cost of revenue in the period in which the maintenance, repair or refurbishment is performed. These expenses are incurred to, among other things, maintain our existing equipment in working order, provide our customers with updated equipment, fix software bugs, if any, provide new functionality and minimize the number of different installation configurations that we must support. We are not obligated to perform maintenance, repair or refurbishment under the terms of our rental agreements with our customers, but do so in order to improve the quality and reliability of our products;
(b) general and administrative costs, consisting of activities associated with management of our company and related support, which includes all payroll and benefits other than payroll in connection with research and development activities, amortization of our non-competition agreements, travel, professional fees, facility expenses and bad debt expense reserves;
(c) sales and marketing costs, consisting primarily of commissions paid to distributors for promoting and supporting our products and related marketing costs; and
(d) research and development costs associated with the internal research and development activities geared to the further development of our gaming platform, including labor and hardware and software testing, prototyping and development.
We envision that the development of our product revenue may require us to record cost of products sold (rather than leased) revenue that include materials, labor, and direct and indirect manufacturing costs and associated warranty costs.
Millennium, our wholly owned subsidiary, distributes our bingo products in selected territories in the United States. All of our other operations, including the operation and maintenance of our bingo products and the exclusive distribution of our bingo products in Nevada, Texas and Washington, are conducted by FortuNet. Prior to November 2003, Yuri Itkis held approximately 72% of the voting control over Millennium. In November 2003 Millennium purchased its outstanding shares held by stockholders other than Yuri Itkis. In January 2004, we became the 100% owner of Millennium through Yuri Itkis’ contribution to us of the remaining outstanding shares. This enabled us to consolidate our worldwide distribution rights and enabled significant expense reduction in our overall distribution and operational costs.
In 2006, we incurred $952,187 in legal expenses primarily due to (a) ongoing litigation against defendants Planet Bingo, LLC, Melange Computer Services, Inc., and Gametech International, Inc., and (b) our initial public offering. This compares with $320,148 in comparable legal expenses for 2005. We may incur similar or increasing levels of litigation expenses in the future.
Application of Critical Accounting Policies and Estimates
Our consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the reporting date and reported amounts of revenue and expenses during the reporting period. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, bad debts, bingo unit depreciation and litigation. We base our estimates and judgments on historical experience and on various other factors that are 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.
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue is currently recognized for bingo terminals placed in bingo halls under lease contracts based on (a) a fixed weekly fee per terminal available for bingo (even though our contracts are generally on a month to month basis); (b) a fixed fee per usage per bingo session; or (c) a percentage of the revenue generated by each terminal for bingo sessions played. We do not enter into any financing leases or sales type contracts with our customers. Our platform provides reports of daily usage for billing and reporting purposes for the latter two types of contracts. We bill our customers on a weekly and monthly basis for these revenues and recognize the revenue for the period the units are used or prorate for weekly fees. Existing revenue recognition is a key component of our results of operations, and determines the timing of certain expenses, such as commissions, which are reported in the same period when related revenues are recognized. We recognize revenue in accordance with accounting principles generally accepted in the United States when all of the following factors exist: (a) evidence of an arrangement with the customer; (b) installation of our gaming platform; (c) a fixed or determinable fee; and (d) collectibility is reasonably assured. We exercise judgment in assessing the credit worthiness of our customers and therefore in our determination of whether collectibility is reasonably assured. Should changes in conditions cause us to determine these criteria are not met for future transactions, revenue recognized for future reporting periods could be adversely affected.
Allowance for Doubtful Accounts
We estimate the possible losses resulting from non-payment of outstanding accounts receivable. We perform ongoing evaluations of our customers and distributors for credit worthiness, economic trends, changes in our customer payment terms, and historical collection experience when evaluating the adequacy of our allowance for doubtful accounts. In determining these percentages, we review historical write-offs of our receivables, payment trends and other available information. While such estimates have been within our expectations and the provisions established, a change in financial condition of specific customers or in overall trends experienced may result in future adjustments of our estimates of recoverability of our receivables.
The declining balance method of depreciation is used for furniture and fixtures, machinery and equipment and vehicles with a useful life of five to seven years. This method was selected because the productive usefulness of those assets decline at a rate more rapid than straight line. Leasehold improvements are depreciated over the life of the lease. Our rental assets are depreciated over five years using the straight line method. The straight line method is used because we believe this method most accurately matches the costs with the revenues over the useful life of the product. We annually assess whether there is a possible impairment of the assets and equipment and to date have concluded that no impairments exist.
Software Development Cost Policy
We have capitalized software development costs with the achievement of the technological feasibility of our mobile gaming system. We have recorded these costs in accordance with the Statement of Financial Accounting Standards No. 86 “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.”
Internal Control Deficiencies
In connection with the audit of our 2006 financial statements, our Chief Executive Officer & Chief Financial Officer have concluded that there was a significant deficiency in our accounting for income taxes. In preparation of our tax provision for year ending December 31, 2006, we identified certain adjustments to our tax liability account and related income tax provision. All adjustments to correct these matters have been reflected in our consolidated financial statements of the year ending December 31, 2006.
The significant deficiency is the result of insufficient quantity of personnel in the accounting department to perform the necessary checks and balances for daily and year-end procedures, including the accounting for income taxes. Our independent registered public accounting firm has recommended that we hire, and we are currently seeking to hire, an additional employee with the background and skills to perform duties typical of a controller.
We are currently involved in various legal claims and legal proceedings. We have not accrued any liability for estimated losses related to legal contingencies at this time. In management’s opinion, these matters are not expected to have a significant effect on our financial position or results of operations. Periodically, we review the status of each significant matter and assess our potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount can be estimated, we accrue a liability for the estimated loss. Significant judgment is required in both the determination of probability and the determination as to whether an exposure can be reasonably estimated. Because of uncertainties related to these matters, accruals are based only on the best information available at the time. As additional information becomes available, we reassess the potential liability related to our pending claims and litigation and may revise our estimates. Such revisions in the estimates of the potential liabilities could have a material impact on our consolidated results of operations and financial position.
Results of Operations
The following table sets forth our results of operations as a percentage of revenue for each of the periods indicated:
Consolidated Income Statement
Year Ended December 31, 2006 and December 31, 2005
Sales revenue. Sales revenue was $16,460,462 in the year ended December 31, 2006, compared to $14,684,914 in the year ended December 31, 2005, an increase of $1,775,548, or 12.1%. This increase was achieved mainly through the deployment of additional player terminals into the bingo market to existing customers. During 2005 the deployment of hand held units was intentionally curtailed by management in anticipation of the substantial financial resources required for entering the new emerging market for mobile gaming in Nevada. Our initial public offering in January 2006 provided us with sufficient financial resources to manufacture a large number of additional player terminals for lease into the bingo market.
For the year ended December 31, 2006, the net change in our revenue as a result of changes in our customer base was an increase in revenue of $100,123 and the net change in revenue as a result of changes in operations at our existing customer locations was an increase of revenue of $1,704,388.
Other Income. Other income was $898,414 during 2006, approximately 11.5 times the amount of other income of $77,633 in 2005. This increase in other income was almost entirely the result of the yield on our investment of the proceeds of our initial public offering and retained earnings during 2006.
Cost of revenue. The cost of revenue was $2,132,701 during 2006, compared to $2,328,190 for the year ending December 31, 2005, a decrease of $195,489, or 8.4%. The decrease in cost of revenue was mainly attributable to the reduced depreciation cost in 2006 as compared to 2005 as the third generation of products installed in the field in 2001 became fully depreciated. Specifically, the depreciation cost for 2006 was $1,740,858 as compared to $1,906,507 for 2005. Also contributing to the decrease in the cost of revenue in 2006 was the decrease in the installation and maintenance expenses from $356,966 for 2005 to $306,746 for 2006. This decrease was partially attributable to our increased efficiencies and the beneficial use of our distributors’ services in deployment of additional units. As a result of this overall decrease in costs, our gross margin increased from 84.1% in 2005, to 87.0% in 2006. In the future, we anticipate the depreciation of deployed products to increase or decrease in proportion to the increase or decrease of the aggregate cost basis of the equipment utilized in the field during a given year.
General and administrative. The general and administrative expenses were $6,459,210, or 39.2% of revenue, in 2006, compared to $3,552,995, or 24.2% of revenue, in 2005, a increase of $2,906,215, or 81.8%. This cost increase was associated with our transition from a private company to a publicly traded company and was primarily attributable to (a) the consulting services provided by Spiegel Partners LLC with a cost of $611,540, (b) the costs associated with the stock grants to certain of our executives in the amount of $677,881 and (c) the costs associated with our payments to our outside directors in the amount of $97,500.
The increase in general and administrative expenses was also due in part to additional costs associated with being a public company in an aggregate amount of $349,379. These additional costs included the cost of director and officer’s insurance, securities filings and additional audit costs. Also, our litigation and other legal expenses increased from $320,148 during 2005 to $952,187 during 2006 an increase of $632,039 or 197.4%. The balance of the difference in general and administrative expenses between 2006 and 2005 consists primarily of an additional labor cost amounting to $345,870 which also includes the cost of share-based compensation cost resulting from stock options granted during 2006 to some of our employees.
Sales and marketing. The sales and marketing expenses were $5,301,332, or 32.2% of revenue, in 2006, compared to $4,380,529, or 29.8% of revenue, in 2005, an increase of $920,803, or 21.0%. This increase was attributable primarily to the expansion of our distribution channel through our existing distributors network with resulting increased commissions payments to our distributors.
Research and development. The research and development expenses were $648,463, or 3.9% of revenue, in 2006, compared to $927,800, or 6.3% of revenue, in 2005, a decrease of $279,337, or 30.1%. The decrease in research and development expenses was primarily the result of our compliance with the provisions of FASB SFAS No. 86, because we achieved the stage of technological feasibility in the development of our mobile gaming system in the beginning of the second quarter of 2006 and therefore, capitalized $835,378 of our research and development expenses. We anticipate additional capitalization of the cost of developing our gaming platform until the deployment of our mobile gaming system is achieved.
Other income and expense. Other income was $898,414, or 5.5% of 2006 revenue, compared to $77,633, or .05% of 2005 revenue, an increase of $820,781 or 1,057.3%. The increase in other income was primarily due to the interest earned through our investment of funds raised in our initial public offering.
Provision for income taxes. An income tax provision of $776,183 with an effective tax rate of 27.7% was recorded in 2006, compared to $1,306,877 with an effective tax rate of 37.0% in 2005, a decrease of $530,694, or 40.6%. This decrease in the provision for income taxes was primarily due to the decision to invest available assets primarily into tax exempt instruments and also from a decrease in taxable income in 2006.
Year Ended December 31, 2005 and December 31, 2004
Sales revenue. Sales revenue was $14,684,914 in the year ended December 31, 2005, compared to $14,326,749 in the year ended December 31, 2004, an increase of $358,165, or 2.5%. This increase was achieved despite the loss of customer revenues associated with becoming the 100% owner of Millennium that represented $450,144 during 2005. After becoming the 100% owner of Millennium, we reevaluated the customers of Millennium and subsequently ceased doing business with those customers that did not meet our payment policies and also lost customers that were apparently dissatisfied with the customer service previously provided by Millennium. Moreover, in connection with our relocation to a new and larger facility at the end of September 2005, we were forced to stop our production line in May 2005 and consequently had to suspend our marketing efforts until we restarted the production line in September 2005. The stoppage of our production line affected our ability to deliver products to our customers during the year ended December 31, 2005, which prevented us from significantly increasing our sales revenue for the period.
For the year ended December 31, 2005, the net change in our revenue as a result of changes in our customer base was an increase in revenue of $220,976 and the net change in revenue as a result of changes in operations at our existing customer locations was an increase of revenue of $138,929.
Cost of revenue. Cost of revenue was $2,328,190 during 2005, compared to $2,228,545 during 2004, an increase of $99,645, or 4.5%. The increase in cost of revenue was attributable to the deployment of our fourth generation wireless and stationary player terminals into the market in 2004 that resulted in increased distribution costs as well as depreciation costs during 2005. Specifically, the depreciation cost for 2005 was $1,906,507 as compared to $1,646,091 for 2004. The increase in the depreciation of deployed products was partially offset by a corresponding reduction in the installation and maintenance expenses of $582,454 for 2004 to $356,966 for 2005. This decrease was partially attributable to our increased efficiencies as a result of the integration of our field service operations with former field service operations of Millennium. As a result of this overall increase in costs, our gross margin decreased slightly from 84.5% in 2004, to 84.1% in 2005. In the future we anticipate the depreciation of deployed products to increase or decrease in proportion to the increase or decrease of the aggregate cost basis of the units in the field during a given year.
General and administrative. General and administrative expenses were $3,552,995, or 24.2% of revenue, in 2005, compared to $4,042,257, or 28.2% of revenue, in 2004, a decrease of $489,262, or 12.1%. This decrease in costs was primarily attributable to efficiencies that were achieved through the consolidation of operations and the elimination of duplicative overhead costs that occurred during 2004 as we integrated the operations of Millennium with the operations of FortuNet. We benefited from the lower operational cost during 2005. This decrease was also due in part to no additional bad debt expense reserve related to Millennium customers being accrued in 2005. We had accrued $212,011 of bad debt expense reserve related to Millennium in 2004. We were able to decrease our general and administrative expenses despite a sharp increase in our litigation expenses related to patent infringement suits we brought against certain competitors. Our litigation expenses increased from $179,346 during 2004 to $320,148, or 78.5%, in 2005.
Sales and marketing. Sales and marketing expenses were $4,380,529, or 29.8% of revenue, in 2005, compared to $3,930,135, or 27.4% of revenue, in 2004, an increase of $450,394, or 11.5%. This increase was attributable primarily to the expansion of our distribution channel through the addition of new distributors.
Research and development. Research and development expenses were $927,800, or 6.3% of revenue, 2005, compared to $367,821, or 2.6% of revenue, in 2004, an increase of $559,979, or 152.2%. The drastic increase in research and development expenses was primarily the result of our increased investment in new development hardware and software development tools and labor cost to enable us to accelerate development of upgrades to our hardware and software components of our gaming platform.
Provision for income taxes. An income tax provision of $1,306,877 with an effective tax rate of 37% was recorded in 2005, compared to $1,383,789 with an effective tax rate of 37.1% in 2004, a decrease of $76,912, or 5.6%. This decrease was primarily due to a decrease in taxable income in 2005.
Liquidity and Capital Resources
Since inception, we have financed our operations primarily with revenue generated from the leasing of our bingo products. At December 31, 2006, our principal sources of liquidity were cash and cash equivalents of $26,468,808 and accounts receivable (net of allowance for doubtful accounts) of $1,436,599. We anticipate that our leasing revenue, which is our principal source of revenue today, will be sufficient to fund our operating expenses in the short term. Long term cash is expected to be generated from existing operations and also through selling or leasing of our products in new markets.
We expect to incur significant additional expenses in connection with the procurement of equipment and components and the manufacture of additional stationary and wireless player terminals to take advantage of business opportunities. We anticipate that these expenses will consume a substantial portion, if not all, of our recurring lease revenues. Except to the extent we become obligated under supply contracts that we enter into to procure equipment and components, our fixed payment commitments are limited to our facilities lease.
We believe that our cash flow from operations will be adequate to meet our anticipated future requirements for working capital and capital expenditures for the next 12 months and for the foreseeable future. Although no additional capital raise is currently being contemplated, we may seek, if necessary or otherwise advisable, additional financing through bank borrowings or public or private debt or equity financings. Additional financing, if needed, may not be available to us, or, if available, the financing may not be on terms favorable to us. The terms of any financing that we may obtain in the future could impose additional limitations on our operations and management structure. Our estimates of our anticipated liquidity needs may not be accurate or new business development opportunities or other unforeseen events may occur, resulting in the need to raise additional funds.
Summary of Combined and Consolidated Statements of Cash Flow
For fiscal year ended December 31, 2006, net cash of $5,489,602 provided by operating activities was primarily due to net income of $2,027,660, depreciation and amortization of $2,263,676, the issuing of common stock for certain services of $1,132,140 and the change in operating assets and liabilities of $66,126. For 2005, the net cash of $4,511,364 provided by operating activities was primarily due to net income of $2,225,222, depreciation and amortization of $2,406,047 and the change in operating assets and liabilities of $119,905. The increase in net cash provided by operating activities in 2006 as compared to 2005, was primarily due to the issuing of stock for certain services provided for the Company in connection with becoming a publicly traded entity.
For 2005, the net cash of $4,511,364 provided by operating activities was primarily due to net income of $2,225,222, depreciation and amortization of $2,406,047 and the change in operating assets and liabilities of $119,905. The relatively small decrease in net cash provided by operating activities in 2005 as compared to 2004, was primarily due to the cash flow used to cover the costs associated with our initial public offering in February 2006.
For 2004, the net cash of $3,985,934 provided by operating activities was primarily due to net income of $2,342,171, depreciation and amortization of $2,152,347 and the change in operating assets and liabilities of $508,584. The substantial increase in net cash provided by operating activities in 2004 as compared to 2003 was primarily due to the increased cash flow from leasing activities coupled with the non-cash benefits provided by the depreciation and amortization allowances.
For 2006, $3,410,533 of net cash was used for investing activities, with $3,410,533 being used to fund the manufacture of additional equipment for lease to our customers.
For 2005, $1,766,102 of net cash was used for investing activities, with $1,561,750 being used to fund the manufacture of additional equipment for lease to our customers and the balance spent on other capital expenditures.
In 2004, $3,010,750 of net cash was used for investing activities, with $2,973,601 being used to fund the manufacture of additional equipment for lease to our customers and the balance spent on other capital expenditures.
For the year 2006, $23,878,222 of net cash was raised through financing activities associated with $24,710,625 raised as a result of the sale of our stock in our initial public offering less cost of issuing stock of $981,630 of which $685,722 was used for costs incurred in 2005, with $536,495 used for payments of a long term debt obligation incurred as a result of our acquiring 100% ownership of Millennium.
For the year 2005, $3,613,670 of net cash was used for financing activities, with $557,948 used for payments of a long term debt obligation incurred as a result of our acquiring 100% ownership of Millennium, $685,722 was used in costs associated with our initial public offering which closed in 2006 and $2,340,000 used to pay dividends. On November 7, 2005, prior to our initial public offering, we paid a dividend of $2,250,000 to persons who were our stockholders of record on September 30, 2005.
For the year 2004, $735,382 of net cash was used for financing activities, with $615,382 used for payments of a long term debt obligation incurred as a result of our acquiring 100% ownership of Millennium and $120,000 used to pay dividends.
Off-Balance Sheet Arrangements
As of December 31, 2006, we have no off-balance sheet arrangements as defined in Item 303(a)(4) of the Securities and Exchange Commission’s Regulation S-K.
The following table describes our commitments to settle contractual obligations in cash as of December 31, 2006:
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for us beginning in 2008. We are evaluating whether adoption of this statement will result in a change to our fair value measurements.
In September 2006, the SEC issued SAB 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108 requires analysis of misstatements using both an income statement (rollover) approach and a balance sheet (iron curtain) approach in assessing materiality and provides for a one-time cumulative effect transition adjustment. SAB 108 is effective for our fiscal year 2007 annual financial statements. We do not expect the adoption of this statement to have a material impact on our results of operations, financial position or cash flows.
In June 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109. FIN 48 prescribes the recognition threshold and measurement criteria for determining the tax benefit amounts to recognize in the financial statements. This interpretation is effective for us beginning in 2007. We are evaluating the potential impact of adopting this interpretation on our future results of operations, financial position or cash flows and expect minimal effect on future results of operations.
SFAS 123R (including FSP’s) and SAB 107
In December 2004, the FASB issued SFAS 123R (revised 2004), Share-Based Payment, replacing and superseding both SFAS 123, Accounting for Stock-Based Compensation, and APB 25, Accounting for Stock Issued to Employees. SFAS 123R requires fair value measurement and recognition in the financial statements for all share-based compensation arrangements. SFAS 123R also requires additional accounting and disclosures related to income tax effects and cash flows resulting from share-based compensation arrangements.
In March 2005, the SEC issued SAB 107, Share-Based Payment, providing interpretive guidance on SFAS 123R valuation methods, assumptions used in valuation models, and the interaction of SFAS 123R with existing SEC guidance. The additional SAB 107 requirement for the classification of stock compensation expense to the same financial statement line as cash compensation affected our SG&A expenses and fixed assets with the capitalization of R & D costs. We adopted the provisions of SFAS 123R and SAB 107 in the first quarter of fiscal 2006.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss arising from adverse changes in market rates and prices, including interest rates, foreign currency exchange rates, credit risk, commodity prices and equity prices. Our primary exposure to market risk is due to the fact that certain parts, components, and subassemblies for our products are manufactured outside of the United States, which exposes us to the risk of foreign currency fluctuations, political and economic instability and united protection of intellectual property. We do not believe we are subject to material variable interest risk, credit risk or similar market risks.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Board of Directors
Las Vegas, Nevada
We have audited the consolidated balance sheets of FortuNet, Inc and subsidiary as of December 31, 2005 and 2006, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006. 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 standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financials 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 provided a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of FortuNet, Inc and subsidiaries as of December 31, 2005 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 16, New Accounting Pronouncements, to the consolidated financial statements, the Company adopted Statement 123(R), Shared-Based Payments, as of the first fiscal quarter of fiscal 2006.
/s/ Schechter Dokken Kanter Andrews & Selcer Ltd.
March 20, 2007
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2005 and 2006
Nature of business:
FortuNet, Inc. or the Company was incorporated in 1989 in Nevada. FortuNet is engaged primarily in the business of designing, manufacturing and leasing electronic gaming and entertainment systems throughout North America.
FortuNet and its wholly-owned subsidiary, Millennium Games (Millennium), derive substantially all revenues from the gaming industry in the United States and Canada. Changes in laws and regulations related to gaming in each state or province can affect the Company’s revenues in any given state or province.
Principles of consolidation:
The consolidated financial statements for 2004, 2005 and 2006 include the accounts of FortuNet and its wholly-owned subsidiary. All inter company transactions have been eliminated for all periods presented.
Cash and cash equivalents:
For purposes of the statement of cash flows, the Company considers all liquid investments with an initial maturity of three months or less as well as money market mutual funds to be cash equivalents.
Cash and cash equivalents consist of cash in bank and investments of 90 days or less in municipal bonds and money markets consisting of the following:
Inventories, consisting primarily of parts and components to be used for manufacturing of products to be sold, are valued at the lower of cost or market, as determined by the first-in, first-out basis. Also classified as inventories are Work In Process components for installs that are being produced for a future period. The following schedule details inventory between raw materials and work in process:
Prepaid expenses include various prepaid operating items and deposits for inventory parts to be purchased.
Property and equipment:
Property and equipment are stated at cost. Depreciation is provided using the declining balance method except for rental assets for which the straight line method is used. Estimated lives used for depreciation are as follows:
In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company periodically reviews the carrying amount of property and equipment for events or changes in circumstances that indicate that their carrying value may not be recoverable.
Software development capitalization:
The Company capitalizes internally developed software costs in accordance with SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed. Capitalization of development costs of software products begins once the technological feasibility of the product is established. Capitalization ceases when such software is ready for general release, at which time amortization of the capitalized costs begins. Starting in April 2006 through December 2006 the Mobile Gaming System internal software development costs have been capitalized as technological feasibility of the product has been established. Research and development costs relating principally to the design and development of products are expensed as incurred. Hardware, tools and tooling that have an alternative future use, such as for manufacturing, are capitalized. Hand tools used in research and development, as well as special purpose fixtures are expensed when incurred.
The Company leases its products, using operating leases directly to gaming facilities and through several regional distributors. The agreements generally require lessees to pay rent for player terminals only when they are actually used based upon an automated reporting system whereby each day’s usage by customer is reported to the Company or a self-reporting system where the customer submits sales information to the Company which is used as the basis for determining revenue. The Company recognizes revenue as the devices are used in accordance with each lease agreement. Most leases are on a per-use arrangement with some lease payments being determined as a percentage of revenue that the devices generates for the lessee and some devices are leased at a flat weekly amount. The terms range from one to three years duration with annually renewable leases; and month-to-month rentals. There are no significant leases with terms greater than one year. The Company recognizes revenue as the devices are used based upon the automated reporting system or self-reporting system described above.
Commissions, which are calculated as a percentage of actually collected revenues, are recognized in the same period as related revenues.
Cost of revenue:
The cost of revenue includes depreciation of our capitalized leased equipment and the cost of shipping to and installation of equipment in the field as well as the cost of subsequent repairs and upgrades of installed equipment. Repairs are expensed as incurred upon the return of the malfunctioning and/or damaged equipment from the field subsequent to the re-deployment of equipment back to the field. Upgrades either for the hardware or the software components of our systems that have been deployed at customer locations are expensed in the period in which the upgrades are actually performed. Installation costs allocated with the new lease contracts are expensed in the period in which the equipment is deployed in the field.
We do not provide any product warranties to any of our customers. However, it is in our best interest to maintain our equipment in good working order. We apply our best effort to promptly repair and/or replace equipment in good working order. We apply our best effort to promptly repair and/or replace equipment returned from customers. The cost of the repairs is expensed in the period incurred. Accordingly, no liability has been established by the Company for future costs to repair our products.
Accounts receivable and allowance for doubtful accounts:
The Company’s receivables are recorded when revenue is recognized in accordance with its revenue recognition policy and represent claims against third parties that will be settled in cash. The carrying value of the Company’s receivables, net of allowance for doubtful accounts, represents their estimated net realizable value.
The Company estimates the possible losses resulting from non-payment of outstanding accounts receivable. The Company evaluates the allowance for doubtful accounts using current year account activity, historical trend information and specific account identification. After all attempts to collect a receivable have failed, the receivable is written off against the allowance.
Use of estimates:
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures. The principal estimate is the 5 year life of rental assets. While actual results could differ from those estimates, management believes that the estimates are reasonable.
Net income per share:
In accordance with the provisions of SFAS No. 128, Earnings Per Share, earnings per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. A dual presentation of basic and diluted earnings per share is required in 2006 to give effect for stock to independent directors.
Fair value of financial instruments:
The carrying amount reflect