FortuNet 10-Q 2008
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended September 30, 2008
For the transition period from:___________ to ___________
(Exact name of Registrant as specified in its charter)
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.
[ ] Yes [ ] No
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,” ” large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
[ ] Yes [ ] No
As of September 30, 2008, there were 11,363,279 shares of the Registrant’s common stock, $0.001 par value, issued and outstanding.
QUARTER ENDED SEPTEMBER 30, 2008
TABLE OF CONTENTS
PART I FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS>
CONDENSED CONSOLIDATED BALANCE SHEETS
See notes to condensed consolidated financial statements.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
See notes to condensed consolidated financial statements.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to condensed consolidated financial statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nature of business:
FortuNet, Inc. (“FortuNet”) and its wholly-owned subsidiary, Millennium Games (“Millennium”) (collectively the “Company”) was incorporated in 1989 in Nevada. FortuNet is engaged primarily in the business of designing, manufacturing, field maintenance and leasing electronic gaming and entertainment systems throughout North America.
The Company derives 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.
Interim Basis of Presentation:
The accounting policies followed in the preparation of the financial information herein are the same as those summarized in the Company’s 2007 Annual Report on Form 10-K. The condensed consolidated balance sheet at December 31, 2007, was derived from audited consolidated financial statements at that date. The interim condensed consolidated financial information is unaudited and should be read in conjunction with the Company’s 2007 Annual Report on Form 10-K. In the opinion of management, all adjustments, consisting of normal and recurring adjustments that are necessary to fairly present the financial condition of the Company as of September 30, 2008, and the results of its operations and its cash flows for the nine months ended September 30, 2008 and 2007, have been included. Interim results of operations are not necessarily indicative of the results of operations for the full year due to seasonality and other factors.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements (“SFAS 157”), which is intended to increase consistency and comparability in fair value measurements by defining fair value, establishing a framework for measuring fair value and expanding disclosures about fair value measurements. SFAS 157 was originally effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. In November 2007, the FASB placed a one year deferral for the implementation of SFAS 157 for nonfinancial assets and liabilities; however, SFAS 157 is effective for fiscal years beginning after November 15, 2007 for financial assets and liabilities. We adopted all requirements of SFAS 157 on January 1, 2008, except as they relate to nonfinancial assets and liabilities, which will be adopted on January 1, 2009, as allowed under SFAS 157. See Note 4 for further information on the impact of this standard to financial assets and liabilities. We have not yet determined the impact, if any, on our consolidated condensed financial statements for nonfinancial assets and liabilities.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159 permits entities to choose to measure eligible financial assets and liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We adopted SFAS 159 on January 1, 2008, and there was no impact on our consolidated condensed financial statements as we did not choose to measure any eligible financial assets or liabilities at fair value.
Inventories, consisting primarily of parts and components to be used for assembly and installation of products to be leased or 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 (“WIP”) components for installs that are being produced for a future period. The following schedule details inventory between parts and assemblies and work in process:
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Continued
On January 1, 2008, we adopted the methods of fair value as described in SFAS 157 to value our financial assets and liabilities. SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The statement establishes consistency and comparability by providing a fair value hierarchy that prioritizes the inputs to valuation techniques into three broad levels, which are described below:
SFAS 157 requires the use of observable market inputs (quoted market prices) when measuring fair value and requires a Level 1 quoted price be used to measure fair value whenever possible.
Financial assets and liabilities included in our financial statements and measured at fair value as of September 30, 2008 are classified based on the valuation technique level in the table below:
Auction Rate Securities
The Company considers its marketable securities to be “available-for-sale,” as defined by Statement of Financial Accounting Standards No.115, “Accounting for Certain Investments in Debt and Equity Securities,” and, accordingly, unrealized holding gains and losses are excluded from operations and reported as a net amount in a separate component of stockholders’ equity. The following table summarizes the amortized cost basis, the aggregate fair value and gross unrealized holding gains and losses at September 30, 2008 and December 31, 2007, respectively.
The Company computes the cost of its investments on a specific identification basis. Such cost includes the direct costs to acquire the securities, adjusted for the amortization of any discount or premium
The Company continues to reduce the principal amount of Auction Rate Securities (“ARS”) in its portfolio. The ARS investment as of December 31, 2007 was $25.1 million and at September 30, 2008 was $12.9 million. The Company was able to liquidate $15.5million in the nine months ended September 30, 2008 and additional $1.5 million was liquidated subsequent to September 30, 2008. The Company’s portfolio was not affected by auction process deterioration in 2007, although .some of the ARS the Company holds experienced auction failures during 2008. As a result, when the Company attempted to liquidate them through auction, it was
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Continued
unable to do so. In the event of an auction failure, the interest rate on the security is reset according to the contractual terms in the underlying indenture. As of September 30, 2008, the Company has received all scheduled interest payments associated with these securities.
The funds associated with failed ARS auctions will not be accessible until a successful auction occurs, the issuer calls or restructures the underlying security, the underlying security matures and is paid or a buyer outside the auction process emerges. The Company believes that the failed auctions experienced to date are not a result of the deterioration of the underlying credit quality of these securities, although valuation of them is subject to uncertainties that are difficult to predict, such as changes to credit ratings of the securities and/or the underlying assets supporting them, default rates applicable to the underlying assets, underlying collateral value, discount rates, counterparty risk and ongoing strength and quality of market credit and liquidity. The Company believes that any unrealized gain or loss associated with these securities will be temporary and will be recorded in accumulated other comprehensive income (loss) in its financial statements.
The Company believes that based on its current cash and cash equivalents balance of $18.6 million, expected operating cash flows, and the liquidation of $15.5 million of ARS during the nine months ended September 30, 2008, that the lack of liquidity associated with our ARS will not adversely affect our ability to conduct business in the immediate future, and the Company believes it has the ability to hold the yet unliquidated ARS throughout the currently estimated recovery period. The remaining $12.9 million balance of ARS held by the Company will likely not have a material negative impact on the Company’s liquidity, earnings, cash flows, financial flexibility or ability to fund its obligations.
The Company continues to monitor the market for auction rate securities and consider its impact (if any) on the fair market value of its investments. Susbquently to September 30, 2008, the Company had entered in redemption agreements with certain investment firms that originally sold the ARS’s to the Company, and a redemption is expected to occur in the near future for certain of the ARS. If the current market conditions continue, in which some auctions for ARS fail, or the anticipated recovery in market values does not occur, the Company may be required to record unrealized losses or impairment charges in 2008. As auctions have closed successfully, the Company has converted its investments in ARS to money market funds. The Company believes it will have the ability to hold any auction rate securities for which auctions fail until the market recovers. It does not anticipate having to sell these securities in order to operate its business.
In accordance with the provisions of SFAS No. 128, Earnings Per Share, basic net income is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is calculated by dividing the amount of income available to common shareholders by the number of diluted weighted average shares of common stock outstanding during each period. Potentially dilutive securities include common shares purchasable upon exercise of stock options and any non-vested stock.
The following tables sets forth the computations for basic and dilutive earnings per common share:
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Continued
On January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payments” (“SFAS No. 123R”), which requires companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. The Company has equity incentive plans that provide for the issuance of stock options, restricted stock and other equity incentives.
On March 11, 2008, the Company issued 12,000 shares of restricted stock to independent members of the board of directors. Subject to the recipients’ continued service on our board of directors, 25% of these shares will vest upon the completion of each fiscal quarter of 2008, and upon the termination of any recipient’s service on our board of directors, all unvested shares will be forfeited back to the Company.
Compensation costs related to vested restricted stock for the nine months ended September 30, 2008, was $55,800. These costs are included in general and administrative expenses. A total of $18,600 of unrecognized compensation costs related to nonvested restricted stock is expected to be recognized over future periods.
As of September 30, 2008, the Company has entered into non-cancelable purchase commitments for certain inventory components used in its normal operations. The purchase commitments covered by these agreements are valid for less than one year and, in the aggregate, amount to approximately $782,000.
Research and development costs are primarily for costs of software and hardware development and continued enhancements for the electronic gaming systems that the Company leases to customers. Research and development costs relating principally to the design and development of products generating revenues 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 total amount of research and development was $983,933 and $1,026,709 during the nine months ended September 30, 2008 and 2007, respectively. A portion of overall research and development costs totaling $308,211 and $624,367 were capitalized during the nine months ended September 30, 2008 and 2007, respectively in accordance with SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed. A significant portion of the capitalized research and development costs is attributable to the development of our mobile gaming platform being reviewed by Nevada gaming authorities since 2006. If in the process of review we encounter an insurmountable obstacle or if the current economic uncertainty resolves into a certainty or even a high likelihood of the potential market for mobile gaming systems not being viable in the foreseeable future, we may have to expense certain costs of the capitalized research and development. .
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Continued
We recorded our income tax provision at an effective rate of 23.4% for the nine months ended September 30, 2008. This effective tax rate takes into account, among other items, the tax exempt interest received in the amount of $625,781 creating a reduction from the statutory tax rate of approximately 13.1%.
As a result of the adoption of FIN 48, as amended by FIN 48-1, at the beginning of fiscal 2007, we reclassified $102,000 to income tax payable (which would not significantly impact our effective tax rate if recognized). This potential liability for unrecognized tax benefits relates to state income taxes from prior years. At the end of 2007, $102,000 was our potential liability for unrecognized tax benefits, which included penalties and interest. During the nine months ended September 30, 2008, $75,000 of the liability was applied as a benefit to income tax expense as relating to the lapse of the potential tax liability to certain taxing jurisdictions. Our policy is to classify penalties and interest related to income tax uncertainties as income tax expense.
Cautionary Note Regarding Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. All statements included in this Quarterly 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 Quarterly Report include, without limitation, our statements that:
(1) our plan to continue to reduce the principal of ARS in our portfolio (2) our belief that the failed auctions that we experienced during the first nine months of 2008 are not a result of the deterioration of the underlying credit quality of the auction rate securities, although valuation of them is subject to uncertainties that are difficult to predict; (3) our belief that any unrealized gain or loss associated with the auction rate securities will be temporary and will be recorded in accumulated other comprehensive income (loss) in our financial statements; (4) we will continue to monitor the market for our auction rate securities and consider its impact (if any) on the fair market value of our investments; (5) our belief that we will have the ability to hold any auction rate securities for which auctions fail until the market recovers; (6) our belief that based on our cash and cash equivalents balances in the first nine months of 2008, the current lack of liquidity in the credit market and capital markets will not have a material impact on our liquidity, cash flows, financial flexibility, or our ability to fund our operations; (7) we expect, as needed, to continue to make a significant investment in product development; (8) our plan to continue to reduce the principal amount of ARS in our portfolio; (9) our plan to continue to focus on research and development and pursue product development opportunities; (10) our intention to continue to introduce new products for the gaming market; (11) our belief that our research and development efforts have made our mobile gaming platform compliant with the wireless gaming regulations promulgated by the Nevada Gaming Commission to date; (12) we expect to spend substantial amounts on research and development; (13) our anticipation to begin selling our gaming platforms for use in conducting traditional casino games, instead of entering into lease contracts, as we do now in the case of bingo games, or pursuant to purchase options contained in lease agreements; (14) our expectation that current legal claims and proceedings pending against us, if any, will not have a significant effect on our financial position or results of operations; (15) our expectation to incur similar costs associated with the stock grants to our directors in the remaining quarter of 2008; (16) we anticipate that our leasing revenue will be sufficient to fund our current operating expenses in the short term; (17) our belief that the lack of liquidity associated with our ARS will not adversely affect our business in the immediate future; (18) our belief that our cash flow from operations combined with our available liquid resources will be adequate to meet our expenditures for the next 12 months and foreseeable future; (19) we expect to incur significant additional expenses in connection with the further development of our manufacturing infrastructure including our bingo paper printing presses and electronic assembly lines as well as the procurement of components for the manufacturing of additional stationary and wireless player terminals primarily to stabilize our revenues in the worsening economic market; (20) our anticipation that lease expenses will consume a substantial portion if not all of our recurring lease revenues as well as our accumulated investment funds; (21) our belief that the final resolution of any of pending litigation is not likely to have a material adverse effect on our business, cash flow, results of operations or financial position; (22) we expect competition to increase and intensify as the market for mobile gaming devices develops; (23) we expect fierce competition from multiple large competitors dominating their respective markets in our expansion efforts, such as Aristocrat Leisure, Ltd., International Game Technology, Inc., Alliance Gaming Corporation, WMS Gaming Inc. and Shuffle Master, Inc., that may enter the market for mobile gaming devices; (24) we anticipate that competition in the mobile gaming market will become even more fierce when and if, other licensed operators of mobile gaming systems including, International Game Technology, Inc., Sona Mobile, Inc. and GameTech International, Inc. enter the market; (25) our belief that our revenues in 2008 will be reduced related to the loss of a significant number of locations in the charitable bingo gaming market; (26) our expectation that long term cash will be generated from existing operations and potentially through selling or leasing our products in new markets; (27) we expect, based on 2007 revenues, that our revenues attributable to sales generated through a certain distributor for 2008 will be reduced by approximately $1,500,000; (28) our belief 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; (29) our intention to offer our customers equipment lease agreements under which we will lease our wireless gaming terminals and the associated equipment; (30) we expect to enter into agreements with customers that operate casinos and bingo halls in more than one location; (31) 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; (32) we expect a substantial portion of our future growth to result from the general expansion of the gaming industry; (33) our belief that there will be an increase in demand for our consumable bingo products; (34) our anticipation to temporarily postpone our growth plans in order to concentrate our efforts and resources on adapting to the recent economic downturn; (35) our belief that the Company has the ability to hold the yet unliquidated securities throughout the currently estimated recovery period; and (36) we expect the negative trend in our financial performance to continue at least in the near future.
Our expectations, beliefs, objectives, anticipations, intentions and strategies regarding the future, including, without limitation, those concerning expected operating results, revenues and earnings are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from results contemplated by the forward-looking statements including, but not limited to: unexpected difficulties in penetrating new markets as a result of regulatory, competitive or other barriers; inability to devote additional resources to our marketing efforts; inability to devote additional resources to our research and development initiatives to enhance product development; unexpected changes to zoning laws that effect our ability to continue to manufacture products in our current facility; inability to cut our costs resulting in a loss of our existing customers to our competitors; legality of our electronic bingo players; our inability to create or introduce new products for the conventional bingo market; our failure to gain approval for our gaming platforms to play traditional casino games; unanticipated decreases in our manufacturing capabilities; unfavorable outcome of our ongoing litigation matters; increased costs related to defending our pending litigation matters; loss of existing distributors or our failure to further broaden our distribution channels; inability to accurately predict the impact of a loss of a major portion of revenue from a certain distributor on our revenues for 2008; unanticipated substantial decrease or increase in our research and development expenses; unexpected changes to credit ratings of the auction rate securities; difficulty in evaluating the value of the auction rate securities; unexpected need for additional cash and cash equivalents due to an increase in our capital expenditures; inability to accurately value the underlying assets supporting auction rate securities; changes in default rates applicable to the underlying assets, underlying collateral value, and the strength and quality of the market and liquidity; inability to accurately predict the impact of the recordation of any unrealized gain or loss associated with auction rate securities in our financial statements; unexpected changes in our liquidity, cash flows due to unexpected changes in the credit and capital markets; inability to predict the impact of market changes with respect to our auction rate securities; unanticipated need to liquidate our auction rate securities; an unanticipated need for additional funds for operating expenses, new business opportunities, recession, decrease in consumer spending, or other events; inability to protect and defend our intellectual property rights; the failure of the overall gaming industry to expand at the rate we expect; unexpected need to expand our operations and inability to enter into a new manufacturing lease; unanticipated drop or increase in inventory levels; inability of our leasing revenue to meet our operating expenses in the short and long term; inability to finance additional expenses related to the procurement of equipment and the manufacturing of equipment and component parts in order to expand our production efforts; unanticipated increase in expenditures during the next 12 months; lack of growth in the gaming industry; inability to procure additional customers and enter into new lease agreements; rapid technological changes in the gaming industry that render our technology obsolete; difficulties demonstrating the economic benefits of our products; inability to meet the evolving industry standards of casino and player demands; failure to achieve market acceptance of our products; lack of demand for our consumable bingo products; ; inability to predict the length of the economic decline; inability to predict the timing of expenses related to the development of our manufacturing infrastructure; inability to predict the amount of investment funds that will be consumed in order to develop our manufacturing infrastructure; inability to penetrate new jurisdictions and markets; and inability to improve our financial, accounting and operation systems and controls.
We assume no obligation to update any forward-looking statements. Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. Readers should also review the cautionary statements and discussion of the risks of our business set forth elsewhere herein under the heading “Risk Factors” under Part I, Item 1A and our other filings with the Securities and Exchange Commission (“SEC”), including our Annual Report on Form 10-K for the fiscal year ending December 31, 2007, our Quarterly Reports on Form 10-Q for the quarters ending March 31, 2008 and June 30, 2008, respectively, and our Current Reports on Form 8-K.
We are an established and currently 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 (although not yet approved for sales in Nevada) to conduct traditional casino games, such as keno, poker and slots, in addition to, and concurrently with, bingo. Our gaming platforms enable patrons to play bingo using either our wireless or our stationary player terminals. In addition, our gaming platforms have been adapted (although not yet approved for sales in Nevada) to enable patrons to play traditional casino games using our stationary player terminals.
Having believed that our research and development efforts have made our mobile gaming platform compliant with the wireless gaming regulations promulgated by the Nevada Gaming Commission on March 23, 2006 and Mobile Gaming System Policies published by Nevada Gaming Commission on July 21, 2006, we submitted our mobile gaming platform for review by the Nevada gaming authorities in 2006. Recently, we have received a communication from Nevada Gaming Control Board (“NGCB”) raising new additional questions regarding certain software and hardware aspects of our mobile gaming platform. Although we believe that we have expeditiously developed software and hardware modifications adequately responding to the raised questions, we can provide no assurances that the latest modifications may be acceptable to NGCB. Even assuming that the modifications are acceptable to NGCB, we are concerned that the NGCB analysis of the new modifications may delay significantly the overall process of reviewing of our mobile gaming platform. If our wireless gaming devices are eventually 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 are continuously upgrading our wireless player terminal to serve as a multi-game platform that enables patrons to play traditional casino games in casino public areas in addition to playing bingo. We also recently introduced and started selling new advanced bingo flashboards that utilize long-life color light emitting diodes instead of conventional incandescent lamps. We also recently introduced advanced automatic ball blowers for bingo, keno and lottery applications working in conjunction with our flashboards and player terminals. In addition, we have recently started to manufacture and sell advanced barcoded bingo paper products to supplement our electronic bingo products. We print the barcoded bingo paper products on high-speed variable-data web presses in our recently expanded manufacturing facilities in Las Vegas, NV. Although our continuous development of new products and manufacturing infrastructure is capital extensive, we are committed to continue to introduce new products for the gaming market.
Almost all of our revenues are currently generated 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 is affected by player acceptance of electronic and paper bingo products in our existing customer establishments, our ability to expand operations into new markets and most importantly, our ability to retain our market share in the existing markets. 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 loss of existing customers, we experience an increase in rental revenue due to the addition of customers and a decrease in rental revenue due to the loss of customers. Our rental revenue is also affected from period to period by 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, or pursuant to purchase options contained in lease contracts. 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 determined by the then current price for our products and our unit-volume sales.
We envision that if we develop product sales revenue, we will also see a recurring revenue component generated from software upgrades and/or maintenance of the software components of our sold products.
Our expenses primarily 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 we do so in order to improve the quality and reliability of our products;
(b) general and administrative expenses, including the costs of activities associated with the management of our company and related support, which includes all payroll and benefits other than payroll in connection with research and development activities, travel costs, professional fees, facility lease expenses and bad debt expense reserves;
(c) sales and marketing expenses, consisting primarily of commissions paid to distributors for promoting and supporting our products and related marketing costs;
(d) costs of research and development activities geared to the further development of our gaming platform, including labor costs and costs of hardware and software testing, prototyping and development tools; and
(e) cost of maintaining, upgrading and expanding our manufacturing infrastructure including electronic assembly lines and web printing presses
We envision that the development of our product revenue, especially in the bingo consumables market, will require us to record costs of products sold (rather than leased) that include materials, labor, and direct and indirect manufacturing costs and associated warranty costs, if any.
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 in all territories and the exclusive distribution of our bingo products in Nevada, Texas and Washington, are conducted by FortuNet.
During the nine months ended September30, 2008, we incurred $493,940 in legal expenses incurred in a routine course of business and the Company’s civil lawsuit filed in the United States Federal Court, District of Nevada under the federal Racketeer Influenced Corrupt Organization, or RICO, law against GameTech International Incorporated and its wholly owned subsidiary, GameTech Arizona Corporation.
Deferred taxes are primarily the result of differences in tax and financial amortization lives of other assets and differences in property and equipment depreciation.
Application of Critical Accounting Policies and Estimates
Our condensed 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, player terminal 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 materially from these estimates under different assumptions or conditions.
There has been no material change in the critical accounting policies that affect our more significant judgments and estimates used in the preparation of our consolidated financial statements from the critical accounting policies described in our Annual Report on Form 10-K for fiscal year ended December 31, 2007.
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
Consolidated Income Statement
The following table sets forth our results of operations in dollars and as a percentage of revenue for each of the periods indicated:
Three Months and Nine months ended September 30, 2008 and September 30, 2007
In the third quarter of the current year, our revenues and our profits significantly decreased, while our operating costs significantly increased as detailed below. In view of the quickly deteriorating economic environment and in combination with other negative factors and risks specific to the Company outlined elsewhere in this document, we expect the negative trend in our financial performance to continue at least in the near future.
Sales revenue. Sales revenue was $3,922,447for the three months ended September 30, 2008, as compared to $4,273,737for the three months ended September 30, 2007, a decrease of $351,290, or (8.2%). Sales revenue was $12,019,079 for the nine months ended September 30, 2008, as compared to $12,770,294 for the nine months ended September 30, 2007, a decrease of $751,215, or (5.9%). This decrease was due primarily to the reduction of revenue from charitable bingo halls, partially offset by the deployment of new units in the field.
For the nine months ended September 30, 2008, the net change in our revenue as a result of changes in our customer base was a decrease in revenue of $1,254,268 over the same period in the prior year, and the net change in revenue as a result of changes in operations at our existing customer locations was an increase of revenue of $503,053 over the same period in the prior year.
Cost of revenue. Cost of revenue was $533,345 for the three months ended September 30, 2008, compared to $587,391 for the three months ended September 30, 2007, a decrease of $54,046, or (9.2%). Cost of revenue was $1,798,621 for the nine months ended September 30, 2008, compared to $1,766,398 for the nine months ended September 30, 2007, an increase of $32,223, or 1.8%. The latter increase in the cost of revenue is primarily the result of increased depreciation expense for the nine months ended September 30, 2008. Depreciation increased as the number of units deployed increased over the past 12 months. The increase in depreciation for the three months ended September 30, 2008 was offset by the decrease in repair and upgrade expenses in the three months ended September 30, 2008, because much of the repair and upgrades took place in the first half of 2008.
General and Administrative. General and administrative expenses were $1,442,317 or 36.8% of revenue, for the three months ended September 30, 2008 compared to $1,074,328, or 25.1% of revenue, for the three months ended September 30, 2007, an increase of $367,989 or 34.3%. General and administrative expenses were $3,883,540 or 32.3% of revenue for the nine months ended September 30, 2008 compared to $3,344,880, or 26.2% of revenue for the nine months ended September 30, 2007, an increase of $538,660, or 16.1%. This increase in general and administrative expenses was attributable primarily to a substantial increase in labor costs during the respective periods, partially offset by the reduction in professional expenses.
In the three and nine months ended September 30, 2008, the cost associated with the stock grants to our directors was $18,600 and $55,800, respectively. We expect to have similar costs associated with the stock grants to our directors in the remaining quarter of 2008.
Sales and marketing. Sales and marketing expenses were $1,075,490, or 27.4% of revenue for the three months ended September 30, 2008 compared to $1,206,978, or 28.2% of revenue for the three months ended September 30, 2007, a decrease of $131,488, or (10.9%). Sales and marketing expenses were $3,290,226, or 27.4% of revenue for the nine months ended September 30, 2008, compared to $3,937,602, or 30.8% of revenue, for the nine months ended September 30, 2007, a decrease of $647,376, or (16.4%). This decrease was attributable primarily to the reduction of commissions paid to the distributors.
Research and development. Research and development expenses were $209,247, or 5.3% of revenue, for the three months ended September 30, 2008, compared to $117,522, or 2.7% of revenue, for the three months ended September 30, 2007, an increase of $91,725, or 78.0%. Research and development expenses were $675,722, or 5.6% of revenue, for the nine months ended September 30, 2008, compared to $402,342, or 3.2% of revenue, for the nine months ended September 30, 2007, an increase of $273,380, or 67.9%. The overall increase in research and development costs was the result of a reduction in capitalized labor costs related to the ongoing development of our Mobile Gaming Platform. Specifically, in the nine months ended September 30, 2008, $308,211 was capitalized as compared to $624,367 capitalized in the nine months ended September 30, 2007.
Other income and investment income. Interest income from investments for the nine months ended September 30, 2008 was $779,177 or 6.5% of revenue, compared to $768,953 or 6.0% of revenue, for the nine months ended September 30, 2007, an increase of $10,224, or 1.3%. The increase in interest income is the result of higher principal balances of investments from interest earned in prior periods. In the quarter ended September 30, 2008 investment income decreased by $72,070 or 26.3% compared to the quarter ended September 30, 2007, the decrease was the result of liquidation of $15,525,000 of auction rate securities during 2008, which funds were placed in money market accounts yielding lower interest rates than we previously earned with the ARS.
Provision for income taxes. An income tax provision of $254,031 with an effective tax rate of 29.3% was recorded for the three months ended September 30, 2008, compared to $436,422 with an effective tax rate of 27.8% for the three months ended September 30, 2007, a decrease of $182,391, or (41.8%). An income tax provision of $740,903 with an effective tax rate of 23.4% was recorded for the nine months ended September 30, 2008 compared to $1,231,661 income tax provision with an effective tax rate of 27.0% for the nine months ended September 30, 2007, a decrease of $490,758, or (39.8%). The decrease in the tax provision is the result of the decrease in the taxable income for the three and nine months ended September 30, 2008 respectively, as well the positive effect of the consideration of the bonus depreciation for equipment purchases made in 2008, in accordance with the Economic Stimulus Package enacted in February of 2008.
Liquidity and Capital Resources
As of September 30, 2008, our principal sources of liquidity were cash and cash equivalents $18.6 million and accounts receivable (net of allowance for doubtful accounts) of $1.3 million. We anticipate that our leasing revenue, which is our principal source of revenue today, will be sufficient to fund our current operating expenses in the short term.
We expect to incur significant additional expenses in connection with the further development of our manufacturing infrastructure including our bingo paper printing presses and electronic assembly lines as well as the procurement of components for the manufacturing of additional stationary and wireless player terminals primarily to stabilize our revenues in the worsening economic environment. We anticipate that these expenses will consume a substantial portion, if not all, of our recurring lease revenues as well as our accumulated investment funds. Although the specific extent and the timing of such expenses is not yet determined, significant expenditures of our investment funds will negatively affect the interest we earn on the these funds.
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 leases.
We believe that our cash flow from operations combined with our available investment funds 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. Currently, there is no plan to raise additional capital, however, if necessary we may seek other 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 in the new economic environment if unforeseen events occur, resulting in the need to raise additional funds.
Summary of Consolidated Statements of Cash Flow
For the nine months ended September 30, 2008, net cash of $3,341,003 provided by operating activities was primarily due to net income of $2,421,467 depreciation and amortization of $1,453,728, stock issued for services of $148,248 and change in operating assets and liabilities of ($773,794). For the nine months ended September 30, 2007, net cash of $4,874,724 provided by operating activities was primarily due to net income of $3,334,105, depreciation and amortization of $1,402,735, stock issued for services of $152,495 and change in operating assets and liabilities of $(5,718). The decrease in net cash provided by operating activities during the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 was primarily due to the decrease in operating income for the nine months ending September 30, 2008, compared to the nine months ended September 30, 2007.
For the nine months ended September 30, 2008, $10,801,044 of net cash was used for investing activities, with $1,423,956 spent on other capital expenditures and $15,525,000 of marketable securities sold and $3,300,000 of marketable securities purchased during the period.
For the nine months ended September 30, 2007, $2,640,457 of net cash was used for investing activities, with $1,240,804 being used to fund the manufacturing of additional equipment for lease to our customers and $1,224,653 used on other capital expenditures and $175,000 used for additional investment in marketable securities.
For the nine months ended September 30, 2008 and 2007, no net cash was provided by financing activities.
Off-Balance Sheet Arrangements
As of September 30, 2008, we have no off-balance sheet arrangements as defined in Item 303(a)(4) of the Securities and Exchange Commission’s Regulation S-K.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
This Quarterly Report does not include information described under Item 3 of Form 10-Q pursuant to the rules of the Securities and Exchange Commission that permit “smaller reporting companies” to omit such information.
ITEM 4T. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
We are required to maintain disclosure controls and procedures that are designed to provide reasonable assurance that information required to be disclosed in our reports under the Securities Exchange Act is recorded, processed, summarized and reported within the time period specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
As required by Rule 13a-15(b) promulgated under the Securities Exchange Act, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the design and operating effectiveness as of September 30, 2008 of our disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act. Based on this evaluation our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of September 30, 2008, at the reasonable assurance level to enable the Company to record, process, summarize and report information required under the Securities and Exchange Commission’s rules in a timely fashion.
Changes in Internal Control Over Financial Reporting
As reported in Item 9A of our Annual Report on Form 10-K dated December 31, 2007, management concluded that its internal control over financial reporting was not effective as of December 31, 2007. Such conclusion resulted from the identification of deficiencies that were determined to be significant deficiencies. Specifically, we did not have appropriate internal controls in the following areas:
Notwithstanding management’s assessment that our internal control over financial reporting was ineffective as of December 31, 2007 and the significant deficiencies described above, we believe that the interim financial statements included in this Quarterly Report on Form 10-Q correctly present in all material respects our financial position, results of operations and cash flows for the interim periods covered therein.
During the nine months ended September 30, 2008 and subsequent thereto, we have undertaken efforts to remediate the significant deficiencies described above. Our remediation measures include the following:
While management believes that progress has been made on the implementation of these initiatives, additional work may need to be done to further remediate the above significant deficiencies during the remainder of 2008.
Except for the remediation initiatives with respect to the significant deficiencies described above, there have been no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2008 that have materially affected, or are reasonably likely to materially effect our internal controls over financial reporting.
PART II OTHER INFORMATION
ITEM 1A. RISK FACTORS>
Set forth below and elsewhere in this Quarterly Report on Form 10-Q, and in other documents we file with the SEC, are risks and uncertainties that could cause actual results to differ materially from the results expressed or implied by the forward-looking statements contained in this Quarterly Report. The risk factors set forth below entitled “Our bingo revenues and potential mobile gaming revenues may be negatively affected or not realized at all due to the general decline in the economic environment,” “If we are unable to comply fully with the mobile gaming regulations, we may incur substantial additional development costs and delays or may be completely precluded from entering into mobile gaming market” , “Our past trend of accumulating investment funds may reverse and may result in a depletion of the funds due to the impending needs to upgrade both our manufacturing infrastructure, and our fleet of rental equipment in the field”” and “We may have to refocus our business strategy from that of growth to a strategy of stability and maintenance of our business in the near term” have been added to this Quarterly Report on Form 10-Q filed with the SEC for the quarter ended June 30, 2008. Additionally, the risk factors set forth below entitled “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,” and “Changes in technology may make our inventory obsolete and cause significant losses” and “Losing any of our small number of independent distributors (such as K&B Sales Incorporated) upon whom we depend for a significant portion of our revenue, or losing the business of a significant number of customers of those distributors, would negatively impact our operations” have been materially changed from the risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2007.
Risks Relating to Our Business
Our bingo revenues and potential mobile gaming revenues may be negatively affected or not realized at all due to the general decline in the economic environment.
The recent deterioration in the general economic environment has materially negatively impacted the gaming market, including the bingo segment and the potential mobile gaming market. Over the course of the last quarter, attendance at gaming establishments and the per player revenues reported at gaming establishments have significantly decreased. The abrupt and sudden worsening of the economic environment has already negatively impacted and is likely to continue to negatively impact our bingo revenues. The economic decline has also diminished our prospects for generating revenues in the potential mobile gaming market because casinos currently have a substantial underutilized gaming floor space for slot machines and gaming tables. The underutilized gaming floor space of casinos may deter casinos from utilizing mobile gaming devices in the auxiliary gaming areas, such as bingo halls, keno parlors, sports and race books and bars. Moreover, additional capital expenditures and/or lease payments required for mobile gaming devices in auxiliary gaming areas may deter casinos from operating such mobile gaming devices because of the lower costs associated with operating already existing games on the main gaming floors of casinos.
If we are unable to comply fully with the mobile gaming regulations, we may incur substantial additional development costs and delays or completely preclude us from entering into mobile gaming market.
Nevada gaming regulations require that our mobile gaming systems be approved by the Nevada Gaming Commission before we may distribute these systems to Nevada casinos. The Nevada Gaming Control Board (“NGCB”) of the Nevada Gaming Commission continues to apply stringent requirements regarding the overall security and integrity of mobile gaming systems. To the extent that our mobile gaming platform currently being reviewed by NGCB may not comply with the latest 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 costly and scarce in supply. Despite undertaking additional research and development activities, we may not be able to design or develop a mobile gaming platform that fully complies with NGCB’s evolving requirements, 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, and therefore be unable to fully execute the growth strategy we pursued so far, and instead, we may have to change our focus in favor of stabilization of our core bingo business.
Losing any of our small number of independent distributors (such as K&B Sales Incorporated) upon whom we depend for a significant portion of our revenue, or losing the business of a significant number of customers of those distributors, 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 quarter ended September 30, 2008 approximately 56% of our revenues were derived through seven distributors. During the same period, we derived approximately 38% of our revenue from our single largest distributor, K&B Bingo Sales Incorporated, doing business as Good Time Bingo (“K&B Bingo”). 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 or the loss of business from any customer 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. Towards the end of 2007 and at the beginning of 2008, we lost a significant portion of revenues from charitable bingo hall customer locations that were serviced through one of our distributors, and it is expected, based on 2007 revenues, that our revenues attributable to sales generated through this distributor for 2008 will be reduced by approximately $1,500,000.
K&B Bingo of Dallas, Texas is one of the Company’s largest distributors and generates approximately 38% of our revenue. K&B Bingo is a wholly owned subsidiary of Aces Wired of Dallas, Texas. Aces Wired is currently being investigated by the Texas gaming authorities for alleged violations of Texas Penal Code provisions relating to gambling promotion; keeping a gambling place; possession of a gambling device, equipment or paraphernalia; and engaging in organized criminal activity relating to same. As reported on the Form 8-K filed by Aces Wired with the SEC on October 15, 2008, no criminal charges had been filed as of that date, by authorities against Aces Wired or any of its officers, directors or other employees. However, Aces Wired has been advised that local authorities are seeking to develop charges against Aces Wired and certain of its officers, directors and other employees consistent with the allegations in the search and arrest warrants executed on May 21, 2008. In that regard, on October 9, 2008, the Criminal District Attorney of Bexar County, Texas sent formal notification advising Aces Wired that it was conducting an investigation into violations of state criminal laws by certain of Aces Wire’s officers, directors and other employees (including former directors and employees) involving gambling, fiduciary misapplication of funds, securities fraud, organized crime and money laundering.
The ongoing investigation of Aces Wired by the Texas Attorney General and local authorities may potentially impact the operations of K&B Bingo throughout the state of Texas. While the investigation of Aces Wired has not impacted our ability to generate revenues in Texas through K&B Bingo to date, in the event that K&B Bingo’s activities are suspended in Texas, the loss of revenues generated by K&B Bingo could have a material impact upon our results of operations. Currently the Company does not hold a bingo distributor license in the state of Texas. If our relationship with K&B Bingo terminates or is terminated and we cannot obtain a bingo distributor license in Texas in order to maintain our relationship with existing end users , the loss of end users in Texas would have a material adverse affect upon our business and operations.
Our past trend of accumulating investment funds may reverse and may result in a depletion of the funds due to the impending needs to upgrade both our manufacturing infrastructure and our fleet of rental equipment in the field.
Due to the increasing competitive pressures in our core bingo market, we may no longer be able to postpone a costly upgrade of our existing fleet of rental equipment with the new models that we have developed in the process of pursuing mobile gaming opportunities. For the same reasons, we may no longer be able to postpone a costly upgrade of our manufacturing infrastructure, including very expensive web printing presses. The combined cost of such upgrades may not only prevent us from continuing our trend of accumulating cash resources but may result in a substantial, or even complete, depletion of our investment funds and we redeploy such funds into these upgrades. In such a case, the interest we earn on available investment funds that currently constitutes a substantial portion of our net income may drastically decrease, since such interest is generally proportional to the amount of funds invested.
We may have to refocus our business strategy from that of growth into the mobile gaming market to a strategy of stability and maintenance of our core bingo business in the near term.
We may not be able to implement our growth strategy primarily due to the recent drastic decline in the economic environment and its resultant impact on the gaming market. Our ability to implement our growth strategy is dependent on a number of factors which are outside of our control, including market demand for our gaming products, our ability to obtain licenses, permits and other forms of approval from gaming regulators, participation levels in discretionary leisure activities of consumers, higher fuel and transportation costs and an economic slowdown. Among other things, implementation of our growth strategy may be adversely affected if: we are not able to maintain and attract a sufficient number of customers to meet required levels of profitability that will enable us to continue to pursue our growth strategy, we are unable to adequately penetrate new jurisdictions and markets at reasonable cost thereby limiting the future demand for our products below the level assumed by our growth strategy, or we are forced to significantly alter our business strategy to meet changes in our consumer markets. Therefore in the near term, we anticipate that we will delay our mobile gaming growth plans in order to concentrate our efforts and resources on adapting our core bingo business to the recent economic decline that we expect to continue at least in the near future. Consumable bingo products, such as paper bingo products, may carry a different gross profit margin than electronic bingo products. In order to remain competitive in the bingo market, we believe that we may find it necessary to increase the volume of consumable bingo products that we provide to our customers, which may affect our overall profitability.
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 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. We expect to face competition with several new entrants in the market, including I-bingo, Inc. and eQube, Inc . 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, Inc., Alliance Gaming Corporation, WMS Gaming Inc. and Shuffle Master, Inc., that may enter the market for mobile gaming devices. In addition, we may face a strong competition from Cantor Gaming Ltd. that already offers wireless sports betting in the United Kingdom, holds an Operator of Mobile Gaming Systems license in Nevada and in April of 2008 started field testing of mobile gaming system in Las Vegas, NV The competition in the potentially lucrative Nevada market for mobile gaming systems is anticipated to become even more fierce when other of Nevada’s currently licensed Operators of Mobile Gaming Systems including International Game Technology, Inc., Sona Mobile, Inc. and GameTech International, Inc. enter the market.
Additionally, 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.
Finally, 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. Electronic and paper bingo competitors may have greater financial, marketing, technical or other resources, and greater ability to respond to pricing pressures than we do. They may also have broader product lines, ability to reduce price through product bundling, greater experience with high-volume manufacturing, greater customer service capabilities, or larger and more established sales organizations and customer bases. To maintain or capture a position in the market, we must develop new and enhanced electronic and paper bingo products and introduce them at competitive prices on a timely basis, while managing our research and development costs. Competition in the bingo market tends to increase when there is an overall decline in the economy. In particular, pricing pressure increases the number of new entrants into the bingo market and could adversely affect our revenues. 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 obtain approvals under the regulations promulgated under the Nevada Mobile Gaming Law will negatively impact our 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 which would have a material adverse affect on our business and operations.
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. Our CFO, Kevin Karo, has applied for, but has not yet received, a finding of suitability as a corporate officer with various gaming authorities. We are under continuous scrutiny by the applicable regulatory authorities. Our officers’ current regulatory approvals may be revoked, suspended or curtailed at any time. 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, these approval requirements may vary from jurisdiction to jurisdiction and the license, permit and approval process may be costly and more difficult to obtain that the licenses we have obtained in Nevada pursuant to the Nevada Mobile Gaming Law. 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 which would have a material adverse affect upon our business and operations.
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 the three months ended September 30, 2008 we derived 99% 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.
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 experience with our operations and the electronic gaming device industry, including Yuri Itkis, our CEO and Chairman of the board of directors; Kevin A. Karo, our CFO; Jack Coronel, our Chief Compliance Officer; and Boris Itkis, our CTO, Vice President of Engineering and member of the Company’s board of directors. 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 may have a material adverse effect on our business and operations.
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. A loss of one of our senior executives due to a finding of disapproval from the Nevada gaming authorities could have a material adverse effect on our business and operations.
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 2007 and 2008, 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; our efforts to augment our staffing with qualified individuals on a timely basis may not remediate this significant deficiency. 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. We rely heavily on a corporate culture of lean staffing. While helpful to our efforts to contain our costs, our lean staffing exposes us to increased risks of internal control deficiencies and increased harm upon employee departures.
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.
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 quarter ended September 30, 2008 depended substantially on the yield that we achieved on these investments. Approximately 25% of our income before tax during the nine months ended September 30, 2008 resulted from these investments.
Our primary investment objective is to preserve principal while maximizing yield without significantly increasing our risk. Our investments consist of non taxable auction rate securities, or ARS. Our investments totaled $12,900,000 at September 30, 2008.
The ARS that we purchase consist of municipal bonds with maturities greater than five years and have credit ratings of at least AAA, and do not include mortgage-backed instruments. The auction process for ARS is intended, in part, to provide a liquid market for these securities. In the event of an auction failure, the interest rate on the security is reset according to the contractual terms in the underlying indenture. The funds associated with failed auctions will not be accessible until a successful auction occurs, the issuer calls or restructures the underlying security, the underlying security matures and is paid or a buyer outside the auction process emerges. The auction process for some of our ARS began to deteriorate during 2007, and during the first quarter of 2008, we began to reduce the principal amount of ARS in our portfolio, which we have continued to do through the third quarter of 2008. Although we did not suffer any auction failures of our ARS during 2007, a few of the ARS we hold experienced auction failures during the first quarter of 2008. As a result, when we attempted to liquidate some of our ARS through auction, we were unable to do so. We believe that the failed auctions that we have experienced during the first quarter of 2008 are not a result of the deterioration of the underlying credit quality of these securities, although valuation of them is subject to uncertainties that are difficult to predict, such as changes to credit ratings of the securities and/or the underlying assets supporting them, default rates applicable to the underlying assets, underlying collateral value, discount rates, counterparty risk and ongoing strength and quality of market credit and liquidity. We believe that any unrealized gain or loss associated with these securities will be temporary and will be recorded in accumulated other comprehensive income (loss) in our financial statements.
The credit and capital markets have continued to deteriorate in 2008. Continuation or acceleration of instability in these markets and/or deterioration in the ratings of our investments may affect our ability to liquidate these securities, and therefore may affect our financial condition, and cash flows. We believe that, based on our cash and cash equivalents balances during the nine months of 2008, the current lack of liquidity in the credit and capital markets will not have a material impact on our liquidity, cash flows, financial flexibility or ability to fund our obligations.
We continue to monitor the market for our ARS and consider its impact (if any) on the fair market value of our investments. If the market conditions of the nine months of 2008 continue through 2008, in which some auctions for ARS fail, or the anticipated recovery in market values does not occur, we may be required to record additional unrealized losses or impairment charges in 2008. As auctions have closed successfully in 2008, we have converted our investments in ARS to money market funds. We believe we will have the ability to hold any ARS for which auctions fail until the market recovers. We do not anticipate having to sell these securities in order to operate our business.
Although we have invested these proceeds in relatively conservative investments, based on the current market conditions, there can be no assurance that we will continue to enjoy the same yields on our investments as we did during the first six months of 2008. 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.
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 there from.
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 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.
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.
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 expire in 2010 and one expires 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. If litigation that we initiate is unsuccessful, 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 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.
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 the Company and divert our resources which may have a material adverse effect on our growth initiatives.
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.
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 unfavorable changes in general economic conditions including recession, economic slowdown, or higher fuel and transportation cost, may reduce the participation in discretionary leisure activities as a result of consumers having 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. Hurricanes Katrina and Ike), 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 and Texas that sustained major damage as a result of Hurricane Katrina and Hurricane Ike. 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
See Exhibit Index.
* Management contracts or compensatory plans or arrangements.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: November 13, 2008