SHFL entertainment Inc. 10-K 2007
Documents found in this filing:
Washington, D.C. 20549
Amendment No. 2
For the fiscal year ended October 31, 2006
Commission File No. (0-20820)
SHUFFLE MASTER, INC.
(Exact name of registrant as specified in our charter)
(Registrants telephone number, including area code)
Securities registered pursuant to Section 12 (g) of the Act:
Common Stock, par value $.01 per share
Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act. Yes o No x
If this report is annual or transition, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934. Yes o No x
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 x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2). Yes o No x
As of January 12, 2007, 35,024,433 shares of Common Stock of the registrant were outstanding. The aggregate market value of Common Stock beneficially owned by non-affiliates on that date was $910,285,014 based upon the last reported sale price of the Common Stock on that date by The NASDAQ National Market.
DOCUMENTS INCORPORATED BY REFERENCE
Parts II and III of this Annual Report on Form 10-K incorporate by reference information from the Registrants Proxy Statement for its Annual Meeting of Shareholders to be held on March 14, 2007 (Fiscal 2006 Proxy Statement) to be filed with the SEC within 120 days of the end of the fiscal year covered by this report.
This Amendment No. 2 on Form 10-K/A (Amendment No. 2) is being filed to effect a restatement of the previously issued consolidated financial statements of Shuffle Master, Inc. (either the Company, we or our), as of October 31, 2006 and for the year ended October 31, 2006 and the unaudited selected quarterly financial information for the three months ended October 31, 2006 included in our Form 10-K/A filed with the Securities and Exchange Commission (the SEC) on January 17, 2007 (the Original Filing). The Company is restating its previously issued consolidated financial statements to correct an error which resulted from the inadvertent failure to eliminate inter-company profit on inventory that we purchased from our wholly-owned subsidiary Casinos Austria Research & Development GmbH & Co KG (CARD), resulting in a $1,616 overstatement of inventory as of October 31, 2006, a $1,616 understatement of cost of sales and service and a $1,211 overstatement of our net income from continuing operations for the three-month and twelve-month periods ended October 31, 2006. In conjunction therewith, the Company has made certain other miscellaneous adjustments. For further discussion regarding the restatement, see Note 2 to the consolidated financial statements, Restatement of Consolidated Financial Statements, included in Item 8 of this Amendment No. 2.
All information in this Amendment No. 2 is as of January 17, 2007 and does not reflect any subsequent information or events other than the restatement discussed in Note 2 to the consolidated financial statements. For the convenience of the reader, this Amendment No. 2 sets forth the originally filed Form 10-K/A in its entirety, and amended solely as the result of, and to reflect the restatement.
This Amendment No. 2 amends and restates Item 1 of Part I and Items 6,7,8, and 9A of Part II of the Original Filing to reflect the effects of the restatement. In addition, in accordance with Rule 12b-15 promulgated under the Securities and Exchange Act of 1934, as amended, this Amendment No. 2 also includes updated certifications from our Chief Executive Officer and Chief Financial Officer as Exhibits 31.1, 31.2 and 32.1 and 32.2.
We are a gaming supply company that specializes in providing our casino customers Utility Products, including automatic card shufflers, Table iD components, and roulette chip sorters, to improve our casino customers profitability, productivity and security, and Entertainment Products, including live proprietary table games, electronic multi-player table game platforms, traditional video slot machines for select markets, live table game tournaments and wireless gaming solutions to expand our casino customers gaming entertainment content. As of October 31, 2006, we had an installed unit base of approximately 22,000 shufflers, approximately 4,000 table games and approximately 21,000 electronic wagering seats. Installed unit base is the sum of the product units or seats under lease or license agreements and inception-to-date sold units or seats. We believe that installed units is an important gauge of segment performance because it measures historical market placements of leased and sold units or seats and it provides insights into potential markets for service and next generation products. Some sold units or seats may no longer be in use by our casino customers or may have been replaced by other models. Accordingly, we are unable to determine precisely the number of units or seats currently in use.
We are a Minnesota corporation formed in 1983. We conducted our initial public offering and became a Nasdaq-listed public company in 1992. Our corporate offices are located at 1106 Palms Airport Drive, Las Vegas, Nevada 89119 and our telephone number is 702-897-7150.
We maintain an Internet website at www.shufflemaster.com and we make available on the website, free of charge, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after filing such material electronically with the Securities and Exchange Commission. We also provide a variety of other information including all of our press releases. We have included our website address in this filing only as a textual reference. The information contained on our website is not incorporated by reference into this Annual Report on Form 10-K/A.
We group our product offerings into two business segments, summarized as follows:
· Utility Products. Our strategy in the Utility Products segment is the development of products for our casino customers that enhance table game speed, productivity, profitability and security. Currently, Utility Products segment revenue is derived substantially from our automatic card shufflers. We develop and market a full complement of automatic card shufflers for use with the vast majority of card-based table games placed in casinos and other gaming locations, including our own proprietary table games. In addition to selling and servicing, we also lease shufflers, which provides us with recurring revenue. Automatic shufflers increase table game productivity and security, which increases profitability for the casinos and other table game operators. We also offer chip-sorting products that simplify the handling of gaming chips on high volume chip tables such as Roulette. Additionally, we have acquired or are developing products, such as our Automated Bloodhound® and Table iD products, to gather data and to enable casinos to track table game players, such as our. These products are intended to cost-effectively provide casinos and our other customers with data on table game play for security and marketing purposes, which in turn allows them to increase their profitability. To enhance our Table iD product offerings, we entered into a worldwide product integration agreement with International Game Technology (IGT) and Progressive Gaming International Corporation (PGIC) to create a comprehensive, automated table
management solution using complementary capabilities, technologies and resources of the three companies.
· Entertainment Products. Our strategy in the Entertainment Products segment is the development and delivery of proprietary live table game content, electronic content delivery systems, video slot machines for select markets, live table game tournaments and wireless gaming solutions which enhance our casino customers table game operations. Currently, Entertainment Products segment revenue is derived substantially from our live proprietary table game content selection and our multiple electronic content delivery systems. We develop or acquire and market a broad range of proprietary table game entertainment content to casinos and other licensed operators. Products in this segment include our traditional live proprietary poker based, baccarat, pai gow poker and blackjack table games. The majority of these products are licensed to our customers, which provides us with recurring revenue. We also produce and distribute multiple electronic content delivery systems including the Table Master, Vegas Star, and Rapid Table Games multi-terminal electronic table game platforms, and video slot machines for select markets. Products in this segment focus on cost-effectively delivering to casinos and other licensed operators popular table game content on either live table, multi-player video platforms, or wireless platforms. We also offer live table game tournaments developed and managed under our Shuffle Up Productions (Shuffle Up) subsidiary formed in January 2005 to leverage our intellectual property and develop live and broadcast tournament events as well as licensed merchandise based on our extremely popular gaming offerings.
The table below presents our product lines and the percentage of total revenue from continuing operations contributed by each product line in the fiscal years ended October 31:
* Less than 1%
For additional information about our segments, including segment revenue, operating income and assets, see Item 6. Selected Financial Data, Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations and Item 8. Financial Statements and Supplementary Data included elsewhere in this Annual Report.
We are proud of the products that we have developed and market and are pleased with our success as we continue our growth and expansion. Our product strategies, in no particular order, for the future are:
· To focus our development, manufacturing and marketing on products that increase the profitability, productivity and security of our casino and other customers in their table game operations;
· To develop and market the third generation of our shufflers, including features like optical card recognition, deck validation and integration with the Table iD System, to replace older generation shufflers and to further penetrate domestic and foreign markets for these products;
· To market our next generation chip sorting device, the Easy Chipper® and the Intelligent Chip Tree chip tracking device to simplify the process of handling gaming chips and accurately track chip volume and value for our casino and other customers in their table game operations;
· To enhance our Table iD product offerings and increase our market share through the contribution of our shuffler and intelligent shoe products pursuant to our worldwide product integration agreement with IGT and PGIC. This alliance is designed to create a comprehensive, automated table management solution using complementary capabilities, technologies and resources of the three companies;
· To broaden our Entertainment Products segment by developing or acquiring additional table game content to increase our penetration of casino customers table game operations;
· To market our multiple electronic content delivery systems to provide a cost-effective brand extension of our proprietary table game content to existing casino or new racino customers (race tracks that also offer slot games) and to explore other venues in which the platform could be reasonably modified to fulfill market demands;
· To further leverage our intellectual property and develop live and broadcast tournament events as well as merchandise through Shuffle Up;
· To increase our international sales through specific product development or acquisitions and penetration of new markets;
· To develop or acquire patents, licenses, or other intellectual property both to broaden our product offerings and to vigorously protect our patents and products from infringers;
· To continue our strong commitment to research and development of new product technologies in both our Utility Products and Entertainment Products segments.
Since our founding, we have developed and marketed products that increase the productivity, security and profitability of the table game operations of our casino and other customers. Our automatic card shufflers were the first such product. We expect to soon add additional modules, such as our Automated Bloodhound products, to our Table iD System (described below) now under development, and we have added our chip sorting and tracking devices to this product segment. We believe that our casino and other customers are seeking to increase the operating returns of their table game operations. By introducing a combination of technologies our Utility Products increase the profitability, productivity and security for casino and other customers in their table game operations.
Our Shuffler Products. We currently market a complete range of shufflers, including both batch and continuous shufflers. Single deck shufflers are generally used on proprietary table games such as our own Let It Ride® and Three Card Poker® games. Multi-deck shufflers, which include continuous and
batch versions, are most commonly used in multi-deck blackjack and mini-baccarat table games. Additionally, we offer a single deck/double deck shuffler, the Deck Mate®, for use on live stakes poker tables and single or double deck table games.
Our shufflers significantly reduce the opportunity for card manipulation by dealers, resulting in increased security. By allowing cards to be shuffled continuously or in frequent batches, our shufflers reduce or eliminate card counting and shuffle tracking. Because our shufflers shuffle one or more decks while a game is being played, down-time related to dealer shuffling is also significantly reduced, with the potential for a corresponding increase in playing time and win for the casino.
Our existing shuffler products, in no particular order, are the following:
Our Chip Sorting Machine Products. As part of the CARD acquisition in May 2004, we acquired a next generation chip sorting machine, the Easy Chipper. The Easy Chipper simplifies the handling of gaming chips and accurately tracks chip volume and value, which increases the productivity and security on tables with high chip volume, such as Roulette.
Our Other Utility Products. We have acquired or are developing technology to enable casinos and other customers to track and analyze play on their table games. This technology combines computer software and hardware, Radio Frequency Identification (RFID) and the optical card reading features of our next generation of shufflers.
Our other Utility Products are the following:
Customers and Marketing. We market our Utility Products to legal casinos and other gaming establishments around the world with our direct domestic and international sales force and several domestic and international distributors.
Our products and the locations in which we may sell are subject to the licensing and product approval requirements of various national, state, provincial, or tribal jurisdictional agencies that regulate gaming around the world (see additional discussion under Gaming Regulation). We sell and lease our Utility Products. When we lease our products, we generally negotiate a month-to-month operating lease. When we sell our products, we offer our customers a choice between a sale or a longer-term sales-type lease or other financing arrangements, depending on the needs of each customer.
Historically, we marketed our shufflers in the table game areas of casinos. With the commercialization of the Deck Mate shuffler, we have extended the market for shufflers into casino poker rooms and single deck or double deck blackjack tables. As a result, we now market a full line of shufflers to accommodate virtually all of our customers shuffler needs.
Competition. We compete with other gaming utility products and gaming supply companies for space on the casino customers floor, as well as for our customers capital spending. We compete with VendingData Corporation (VendingData), a U.S. company that markets batch and continuous versions of its multi-deck shuffler, the Random Ejection Shuffler, their single deck shuffler, the Poker One, and their Deck Checker card verification device. Historically, VendingData has attempted to compete with our shuffler products on the basis of price. We compete on this basis as well as on the basis of offering a complete line of shufflers, product reliability, a superior service network, the strength of our intellectual property, and the breadth of our sales, regulatory, and distribution channels. Additionally, other companies may develop and market shufflers and seek to develop and obtain regulatory approvals of additional shuffler products. We cannot provide assurances that a competitive product will not gain substantial placements or cause price erosion of our shufflers in the future.
With respect to our Easy Chipper roulette chip sorting product, several companies also manufacture and sell competitive chipper products. We believe the most successful of these products is the Chipper Champ Plus, sold by TCS John Huxley.
Product Supply. We obtain most of the parts for our Utility Products from outside suppliers, including both off-the-shelf items as well as components manufactured to our specifications. We also manufacture a small number of parts in-house that are used both for product assembly and for servicing existing products. We generally perform final assembly ourselves and then warehouse and ship our products from our facilities in Las Vegas. Warehousing, quality control, final assembly and shipping are conducted primarily at our Las Vegas facility, although small inventories are maintained and repairs are performed by our field service employees. Our one2six and Easy Chipper products are manufactured by a subcontract manufacturer, located in Salzburg, Austria, which also inventories and ships these products. We believe that our sources of supply for components and raw materials are adequate and that alternative sources of materials are available.
Research and Development. We employ a staff of electrical, mechanical and software engineers to support, improve and upgrade our existing shufflers, to develop new shufflers, to develop technology and products related to the Table iD system, and to explore other potential table-related Utility products. We perform the majority of our domestic research and development ourselves. We also use a foreign, third party developer for certain of our international product offerings.
Our Entertainment Products segment includes our proprietary table games and side bets, our multiple electronic table game content delivery systems, and a diverse line of Electronic Gaming Machines (EGMs) developed for select markets.
Our Live Table Games and Side Bets. The products in our Entertainment Products segment include proprietary table game content delivered on different live-dealt and electronic platforms. We are continuously developing new table games and have numerous other games in various stages of development to complement our existing offerings and to extend our penetration of the proprietary table game market. Our existing proprietary table games and side bets, in no particular order, are the following:
Our Electronic Content Delivery Systems. In addition to offering our customers our live proprietary table games, we have also developed or acquired other technology or platforms to deliver our or others proprietary table game content or public domain games. We are developing these platforms to enable the marketing of our table game content into previously unpenetrated international and domestic casino, racino, and other gaming markets. These different platforms are described below:
Our Electronic Gaming Machines. Developed by our Australian subsidiary Stargames, we offer an extensive selection of video slot titles developed for select markets including Australia/New Zealand, Asia and Latin America. Featuring a wide variety of denominations and configurations, our EGM titles include a wide range of bonus round options and can be configured as a network of machines or as stand-alone units. Utilizing SAS 6.01 with support for AFT, all EGM titles are offered in the ergonomic eStar® cabinet and are compatible with a variety of back of house systems.
Customers and Marketing. We market our Entertainment Products to the same customers to whom we market our Utility Products. We first began offering table games in 1993 to increase the demand for our shuffler products and we still routinely install shufflers and proprietary table games together. We design our proprietary table games to have broad appeal to players who enjoy a more casual and social card game or who are new to or intimidated by traditional table games. Our various table games offer casinos and players a wide variety of betting propositions and risk and reward trade-offs.
Because they do not utilize a live dealer, our Table Master and Vegas Star electronic table game platforms also enable us to market our proprietary table game content in jurisdictions that only allow slot games, such as racinos (race tracks that also offer slot games). We also market these platforms to casinos who want more cost-effective table game products or who want to offer lower stakes table games.
We typically market our live table games directly to casinos by licensing the games for a monthly fixed fee. In fiscal 2003, we began selling lifetime licenses to some of our live table games including Let It Ride and Three Card Poker. We also license our table games in international jurisdictions.
Competition. We compete with other gaming and entertainment products and gaming supply companies for space on the casino customers floor, as well as for our customers capital spending. Some of the larger gaming supply companies with whom we compete with in this regard are IGT, Bally Technologies, Inc., WMS Industries, Inc., and Aristocrat Leisure Limited.
The market for live table games is characterized by numerous competitors who develop and license proprietary table games. Some of our competitors widely known proprietary table game titles include PGICs Caribbean Stud® and Texas Holdem Bonus, Galaxy Gamings Lucky Ladies and Masque Publishings Spanish 21®.
Competition in the table game market is typically on the basis of price, brand recognition, and the strength of underlying intellectual property. Smaller developers and vendors are more able to participate in developing and marketing table games, compared to other gaming products, because of the lower cost and complexity associated with the development of these products. We compete on these bases, as well as on the strength of our extensive sales, service and distribution channels. We have been able to increase our placements of table games not only because of the growth of the proprietary table game market, but also by displacing other table game products. In the future, table game competitors could market table games that might displace our products.
There are also numerous other companies that manufacture and/or sell multi-player games, which are similar to our Table Master and Vegas Star products. These companies include, but are not limited to, Elektroncek (also known as Interblock), Aruze Corporation, Novomatic Group Companies, IGT, PokerTek, Inc. and TableMAX Holdings.
Product Supply. We obtain most of the parts for our Entertainment Products from outside suppliers, including table game felts, signs, and accessories, as well as components for our side bet systems. We also manufacture a small number of parts in-house that are used both for product assembly and for servicing existing products. We generally perform final assembly ourselves and then warehouse and ship our products from our facilities in Las Vegas. Warehousing, quality control, final assembly and shipping are conducted primarily at our Las Vegas facility, although small inventories are maintained and repairs are performed by our field service employees. Our Table Master units are manufactured by a subcontract manufacturer who also inventories and ships this product. Our Vegas Star, Rapid Table Games and EGMs are generally assembled and shipped from the Stargames premises in Sydney, Australia. Parts and components for these products are sourced from outside suppliers primarily from Asia. We believe that our sources of supply for components and raw materials are adequate and that alternative sources of materials are available.
Research and Development. Our primary Entertainment Product research and development efforts have involved re-engineering and improving the Table Master, Vegas Star and Rapid Table Game multi-player platforms as well as the EGM platform. This development work involved re-engineering the Table Master cabinet, betting stations and electronics as well as improving video quality and game interface options. Several games are currently available on Table Master including Three Card Poker, Let It Ride Bonus with 3 Card Bonus, Dragon Bonus and Royal Match 21, and we are continually developing software to allow our other proprietary table games to operate on this platform. The Vegas Star product development focused on the development of proprietary game titles including Dragon Bonus, Bet the Set 21 and Casino War along with the redevelopment of other non-proprietary titles such as Roulette and Blackjack. Rapid Table Games have been developing Rapid Baccarat, including the Dragon Bonus side bet, as well as Rapid Craps to add to the current titles of Roulette, Sic Bo and Big Wheel. The EGM product development produced a large range of new titles including a selection of jackpot games for the diverse international market. The cabinet and platform technology for Vegas Star, Rapid Table Games and EGM have undergone a program of continuous improvement to the design and capabilities of the technology.
We believe that our patents, trademarks, licenses, copyrights and trade secrets are significant assets that provide us with a competitive advantage and are critical to our future profitability and growth. We protect our investment in research and development by seeking patent, trademark and copyright
protection for our technologies. We also acquire and license patents and other intellectual property from third parties. Infringement claims, patent invalidity or expiration, license non-renewal, failure to stop infringers, delays in using our intellectual property to develop products or the costs of protecting our intellectual property could adversely affect our future results of operations and our financial position.
Patents. We own numerous United States and international patents and applications related to our existing products and methods, future products that have not yet been introduced, potential product modifications and improvements and to products we do not currently sell. A majority of these technologies are internally developed. Some of our technology is purchased and licensed.
In 2006, we purchased Stargames Limited of Sydney, Australia. Stargames has a broad range of intellectual property that complements our existing portfolio. In particular, the intellectual property relating to multi-player gaming platforms significantly expands the types of proprietary game systems that are now available to our customers.
We purchased a license from PGIC that allows us to install progressive side bet systems on our table games. We also sold our half interest in two RFID chip patents to the co-owner of the patents, IGT. Most of the patents we own have a life of 20 years from the filing date of the patent application and none of our patents covering current products will expire before 2009. A majority of our patents expire on 2011 or well beyond that date. The patents which expire in 2009 are no longer important to our business. We also have numerous patent applications pending for our existing, planned and potential products. No assurance can be given that any such patents will be issued or that the patents we currently hold or have licensed or any new patents that we acquire will be or remain valid or will provide any competitive protection for our products.
Trademarks. We own numerous United States and international trademark registrations and common law trademarks. Some of the more important marks include: Shuffle Master, Incorporated®, the Shuffle Master 4-square logo, Shuffle Master Gaming®, Let It Ride®, Let It Ride Bonus®, Let It Ride The Tournament®, Three Card Poker and design®, Four Card Poker and design®, Crazy 4 Poker®, Fortune Pai Gow Poker®, Royal Match 21®, Casino War®, 61¤2 Card Poker, Bad Beat Texas Hold Em, Bringing More to the Table, Casino On Demand, Free Roll, Big Raise Hold Em®, Ultimate Texas Hold Em, 6 Card Poker®, Dakota Stud®, Dragon Bonus®, Jack Magic®, Single 21 and design®, Blackjack Press, Table Master, ACE®, King®, Deck Mate®, MD1, MD2®, iDeal, Bloodhound®, iShoe, and mCasino. We also license trademarks from others. We have not only aggressively sought protection of our current trademarks, but have also sought protection for a number of names we plan to use in the future.
Intellectual Property Licenses. We obtain licenses to intellectual property from third parties. These licenses are subject to various conditions and restrictions and typically involve us paying royalties on a fixed or unit basis. As mentioned above, we acquired a paid-up license in the PGIC Progressive Side Bet patents this year. While we do not believe that any of these current license agreements are in jeopardy of being terminated, we can make no assurance that all of these license agreements will remain in effect or that such licenses can be extended under terms favorable to us.
In addition, when we license our products to our customers, we also license the right to use our intellectual property to casino customers. We typically earn license royalties on a periodic basis or on a paid-up lifetime basis. We do not license our intellectual property to other gaming equipment suppliers, except occasionally as part of a cross-license arrangement.
We granted a multiple game license to Delta Rangers, Inc. for the play of a number of our proprietary games on internet gaming sites outside of the United States.
Other Intellectual Property. In addition to patents, we also protect much of our intellectual property with copyrights, trademark registrations, and as trade secrets. No assurance can be given that we will be successful in maintaining the confidentiality of our proprietary information. Further, costs associated with defending and pursuing infringement claims can be substantial. In the absence of valid patent, copyright, trademark or trade secret protection, we would be vulnerable to competitors who could lawfully copy our products and technology.
Product-Related Agreement. We are party to certain cross-licensing agreements. Under these agreements, we have certain rights to third party intellectual property. There are no royalty obligations with respect to any of these agreements that are material to our results of operations. Further, none of the royalties that we receive from these agreements are material to our results of operations.
Infringement and Litigation. We do not believe that any of our products, methods or technologies infringe the patents and other intellectual property rights of others. However, we have been and are subject to litigation claiming that we have infringed the rights of others. We have also brought actions against others to protect our rights. For a discussion of these cases see Item 3. Legal Proceedings, included elsewhere in this Annual Report.
Overview. We are subject to a wide range of complex gaming laws and regulations in over 200 jurisdictions, both foreign and domestic, in which we are licensed or have applications pending. Jurisdictions require us to be licensed, our key personnel to be found suitable, qualified or licensed, and our products to be reviewed and approved before placement. Additionally, gaming laws and regulations of most jurisdictions provide that beneficial owners of 5% or more of our common stock are subject to reporting procedures and may be subject to licensure that includes suitability investigations and submission of personal and financial information as required. Furthermore, most jurisdictions have ongoing reporting requirements for certain transactions and are concerned with our accounting practices, internal controls, business relationships, and the fair operation of our products. Gaming regulatory requirements vary from jurisdiction to jurisdiction and licensing, approval, and processes related to findings of suitability, qualifications or licensure of the Company, our products, key personnel, and certain shareholders can be lengthy and expensive.
General Regulatory Licensing and Approvals. We intend to maintain our existing licenses and to seek the necessary licenses, approvals, qualifications and findings of suitability for us, our products and our management personnel in new jurisdictions where we anticipate sales opportunities. We have never been denied a license, permit or approval necessary to do business in any jurisdiction, nor had a license suspended or revoked. However, there can be no assurance that new licenses, approvals, qualifications or findings of suitability will be obtained or that our existing licenses will not be revoked, suspended or conditioned. If a license, approval, qualification or finding of suitability is required by a regulatory authority and we fail to seek or do not receive the necessary license, qualification or finding of suitability, then we may be prohibited from distributing our products for use in the respective jurisdiction or may be required to provide our products through other licensed entities at a reduced profit to us. There can also be no assurance that we will be able to obtain the necessary approvals for our products as they are developed. In addition, changes in legislation or in judicial or regulatory interpretations could occur which could adversely affect us.
We are licensed as a manufacturer and distributor of gaming devices, an operator of inter-casino linked systems and a slot route operator in Nevada. We are a gaming-related casino service industry licensee in New Jersey and hold supplier, manufacturer and distributor licenses in numerous other jurisdictions throughout North America and elsewhere. Due to variations in jurisdictional regulatory transaction reporting, as well as manufacturer, distributor, and product licensing requirements, only the specifics of Nevada gaming law requirements are provided below as being representative of gaming regulations to which we are subject in other jurisdictions.
Nevada Regulatory Matters. We are subject to the Nevada Gaming Control Act (the Nevada Act) and to the licensing and regulatory control of the Nevada State Gaming Control Board (the Nevada Board), the Nevada Gaming Commission (the Nevada Commission), and various local, city and county regulatory agencies (collectively, the Nevada Gaming Authorities).
The laws, regulations and supervisory procedures of the Nevada Gaming Authorities are based upon declarations of public policy which are concerned with, among other things: (i) the character of persons having any direct or indirect involvement with gaming to prevent unsavory or unsuitable persons from having a direct or indirect involvement with gaming at any time or in any capacity; (ii) application of appropriate accounting practices and procedures; (iii) maintenance of effective control over the financial practices and financial stability of licensees, including procedures for internal controls and the safeguarding of assets and revenues; (iv) record-keeping and reporting to the Nevada Gaming Authorities; (v) fair operation of games; and (vi) the raising of revenues through taxation and licensing fees.
We are registered with the Nevada Commission as a publicly traded corporation and are licensed as a manufacturer and distributor of gaming devices, an operator of inter-casino linked systems and a slot route operator. Such licenses are not transferable and require periodic payment of fees. The Nevada Gaming Authorities may limit, condition, suspend or revoke a license, registration, approval or finding of suitability for any cause deemed reasonable by such licensing agency. If it were determined that we violated gaming laws, then the approvals and licenses we hold could be limited, conditioned, suspended or revoked, and we, and the individuals involved, could be subject to substantial fines for each separate violation of the gaming laws at the discretion of the Nevada Commission. Each type of gaming device, slot game, slot game operating system, table game or associated equipment manufactured, distributed, leased, licensed or sold in Nevada must first be approved by the Nevada Board and, in some cases, the Nevada Commission. We must regularly submit detailed financial and operating reports to the Nevada Board. Certain loans, leases, sales of securities and similar financing transactions must also be reported to or approved by the Nevada Commission.
Certain officers, directors and key employees are required to be found suitable by the Nevada Commission and employees associated with gaming must obtain work permits which are subject to immediate suspension under certain circumstances. An application for suitability may be denied for any cause deemed reasonable by the Nevada Commission. Changes in specified key positions must be reported to the Nevada Commission. In addition to its authority to deny an application for a license, the Nevada Commission has jurisdiction to disapprove a change in position by an officer, director or key employee. The Nevada Commission has the power to require licensed gaming companies to suspend or dismiss officers, directors or other key employees and to sever relationships with other persons who refuse to file appropriate applications or whom the authorities find unsuitable to act in such capacities.
The Nevada Commission may also require anyone having a material relationship or involvement with us to be found suitable or licensed, in which case those persons are required to pay the costs and fees of the Nevada Board in connection with the investigation. We customarily reimburse such costs and fees. Any person who acquires more than 5% of our voting securities must report the acquisition to the Nevada Commission. Any person who becomes a beneficial owner of more than 10% of our voting securities is required to apply for a finding of suitability. Under certain circumstances, an Institutional Investor, as such term is defined in the regulations of the Nevada Commission, which acquires more than 10% but not more than 15% of our voting securities, may apply to the Nevada Commission for a waiver of such finding of suitability requirements, provided the Institutional Investor holds the voting securities for investment purposes only. The Nevada Commission has amended its regulations pertaining to Institutional Investors to temporarily allow an Institutional Investor to beneficially own more than 15%, but not more than 19%, if the ownership percentage results from a stock repurchase program. These Institutional Investors may not acquire any additional shares and must reduce their holdings within one year from constructive notice of exceeding 15%, or must file a
suitability application. An Institutional Investor will be deemed to hold voting securities for investment purposes only if the voting securities were acquired and are held in the ordinary course of business as an Institutional Investor and not for the purpose of causing, directly or indirectly, the election of a majority of our board of directors, any change in our corporate charter, bylaws, management, policies or operations, or any of our gaming affiliates, or any other action which the Nevada Commission finds to be inconsistent with holding our voting securities for investment purposes only.
Any person who fails or refuses to apply for a finding of suitability or a license within 30 days after being ordered to do so by the Nevada Commission may be found unsuitable based solely on such failure or refusal. The same restrictions apply to a record owner if the record owner, when requested, fails to identify the beneficial owner. Any security holder found unsuitable and who holds, directly or indirectly, any beneficial ownership of the common stock beyond such period of time as may be prescribed by the Nevada Commission may be guilty of a gross misdemeanor. We are subject to disciplinary action if, after we receive notice that a person is unsuitable to be a security holder or to have any other relationship with us, we: (i) pay that person any dividend or interest upon our voting securities; (ii) allow that person to exercise, directly or indirectly, any voting right conferred through securities held by that person; or (iii) give remuneration in any form to that person. If a security holder is found unsuitable, then we may be found unsuitable if we fail to pursue all lawful efforts to require such unsuitable person to relinquish his or her voting securities for cash at fair market value.
The Nevada Commission may also, in its discretion, require any other holders of our equity securities or any holders of our debt securities to file applications, be investigated and be found suitable to own our debt or equity securities. The applicant security holder is required to pay all costs of such investigation. If the Nevada Commission determines that a person is unsuitable to own such security, then pursuant to the regulations of the Nevada Commission, we may be sanctioned, including the loss of our approvals, if, without the prior approval of the Nevada Commission, we: (i) pay to the unsuitable person any dividends, interest or any distribution whatsoever; (ii) recognize any voting right by such unsuitable person in connection with such securities; (iii) pay the unsuitable person remuneration in any form; or (iv) make any payment to the unsuitable person by way of principal, redemption, conversion, exchange, liquidation or similar transaction.
We are required to maintain a current stock ledger in Nevada which may be examined by the Nevada Commission at any time, and to file with the Nevada Commission, at least annually, a list of our shareholders. The Nevada Commission has the power to require our stock certificates to bear a legend indicating that the securities are subject to the Nevada Act and the regulations of the Nevada Commission. However, to date, the Nevada Commission has not imposed such a requirement on us.
We may not make certain public offerings of our securities without the prior approval of the Nevada Commission. Such approval, if given, does not constitute a finding, recommendation or approval by the Nevada Commission or the Nevada Board as to the accuracy or adequacy of the prospectus or the investment merits of the securities offered. Any representation to the contrary is unlawful.
On December 22, 2005, the Nevada Commission granted us prior approval to make public offerings for a period of two years, subject to certain conditions (the Shelf Approval). However, the Shelf Approval may be rescinded for good cause without prior notice upon the issuance of an interlocutory stop order by the Chairman of the Nevada Board. The Shelf Approval does not constitute a finding, recommendation or approval by the Nevada Commission or the Nevada Board as to the accuracy or adequacy of the prospectus or the investment merits of the securities offered. Any representation to the contrary is unlawful.
Changes in control of us through merger, consolidation, acquisition of assets, management or consulting agreements or any form of takeover cannot occur without prior investigation by the Nevada Board and approval by the Nevada Commission. Entities seeking to acquire control of us must satisfy the Nevada Board and the Nevada Commission concerning a variety of stringent standards prior to assuming control of us. The Nevada Commission may also require controlling shareholders, officers,
directors and other persons having a material relationship or involvement with the entity proposing to acquire control, to be investigated and licensed as part of the approval process of the transaction.
Approvals are required from the Nevada Commission before we can make exceptional repurchases of voting securities above the current market price and before a corporate acquisition opposed by management can be consummated. Nevadas gaming regulations also require prior approval by the Nevada Commission if we adopt a plan of recapitalization proposed by our Board of Directors in opposition to a tender offer made directly to our shareholders for the purpose of acquiring control of us.
We have formally adopted a compliance plan and appointed a compliance committee in accordance with Nevada Commission requirements. Our compliance committee meets quarterly and is responsible for implementing and monitoring our compliance with regulatory matters. This committee also reviews information and reports regarding the suitability of potential key employees or other parties who may be involved in material transactions or relationships with us.
Federal Registration. As a manufacturer and distributor of gaming devices, including Table Master products and slot machines, we are registered pursuant to and have complied with the Federal Gambling Devices Act of 1962 (the Federal Act). In order to manufacture, sell, deliver or operate our gaming devices, including our Table Master product, we must renew our federal registration annually and comply with its various record-keeping and equipment identification requirements. The Federal Act makes it unlawful for a person or business entity to manufacture, deliver, receive, operate, lease or sell gaming devices in interstate or foreign commerce unless that person or entity has first registered with the Attorney General of the United States. Violation of the Federal Act may result in seizure and forfeiture of the equipment, as well as other penalties.
Native American Gaming Regulation. Gaming on Native American lands is governed by the Federal Indian Gaming Regulatory Act of 1988 (IGRA) and specific tribal ordinances and regulations. Class III gaming, as defined under IGRA, also requires a Tribal-State Compact, which is a written agreement between a specific tribe and the respective state. This compact authorizes the type of Class III gaming activity and the standards, procedures and controls under which the Class III gaming activity must be conducted. The National Indian Gaming Commission (NIGC) has oversight authority over gaming on Native American lands and generally monitors tribal gaming including the establishment and enforcement of required minimum internal control standards. Each Tribe is sovereign and must have a tribal gaming commission or office established to regulate tribal gaming activity to ensure compliance with IGRA, NIGC, and its Tribal-State Compact. We have complied with each of the numerous vendor licensing and specific product approval and shipping notification requirements imposed by Tribal-State Compacts and enforced by tribal and/or state gaming agencies under IGRA in the Native American lands in which we do business.
Other Jurisdictions. We have obtained or are in the process of obtaining all licenses/permits required by jurisdictions having legalized gaming. In general, such requirements are similar to Nevada in that there are company approvals as well as individual and product approvals.
Product Approvals. Each of our products is subject to extensive testing and review by multiple state, jurisdictional or third party laboratories. The detail and extent of the review generally depends upon the classification of the product by the respective gaming authority as a new game, game variation, associated equipment, gaming equipment or gaming device. The time required for product testing can be extensive and is subject to a wide range of formal and informal standards that can lead to great uncertainty as to the length of the regulatory approval process. Additionally, product testing is subject to changing standards, as a result of which, we may be required to upgrade or revise our products. We believe the laboratories responsible for testing are handling a great number of product submissions and are under the pressure of limited funding and resources. Such limitations could cause our product approvals to be delayed for unknown periods of time. A description of regulatory status and issues related to each of our product segments follows:
Utility ProductsWe have obtained approvals for our shuffler products, excluding developmental models, in all gaming markets in North America where casino and poker gaming is legalized. We have also received or filed (directly or through our international distributors) for approval of our shuffler products and related software in additional international jurisdictions where required. Our shufflers and related software are typically classified and approved as associated equipment or as gaming equipment, depending on the particular jurisdiction and their regulations. Associated equipment is equipment that is not classified as a gaming device or gaming equipment but, which due to its integral relationship to the conduct of licensed gaming, regulatory authorities have discretion to require manufacturers and distributors to meet licensing or suitability requirements prior to or concurrent with the use of such equipment in the respective jurisdiction. Although the classifications of shufflers vary among jurisdictions, most, if not all, jurisdictions require specific hardware and software approvals and certain licenses or permits to be held by companies, their key personnel, and service technicians in connection with the manufacture, distribution, service, and repair of such equipment.
Entertainment ProductsOur Let It Ride and Three Card Poker table games are approved in all major casino gaming markets in North America and numerous other international gaming jurisdictions. Four Card Poker, Ultimate Texas Holdem, Fortune Pai Gow Poker, and Royal Match 21 are approved in most jurisdictions in North America, with additional approvals expected throughout fiscal 2007. We intend to submit Black Jack Press, Streak Shooter, and progressive versions Three Card Poker and Fortune Pai Gow Poker to regulatory laboratories for approvals in the first two quarters of fiscal 2007. Similar approvals will be required for any future table games and related equipment.
Our Table Master multi-player video table game unit with blackjack was first submitted for regulatory testing in the third quarter of fiscal 2004 and is currently approved in multiple jurisdictions. Additionally, our Table Master unit with Three Card Poker and Let It Ride Bonus was approved in certain jurisdictions in fiscal 2005. We will continue to submit Table Master with other proprietary games to various regulatory laboratories for testing during fiscal 2007.
Our Vegas Star multi-player video table game unit with Roulette was first submitted for regulatory testing in the fourth quarter of fiscal 2003 and is currently approved in key Australian jurisdictions, tribal North American jurisdictions and Macau. Additional games have included Sic Bo, Dragon Bonus, Blackjack, Bet the Set 21 and a Wide Area Progressive Blackjack. Vegas Star is currently submitted for approval for Gaming Laboratories International, Inc. markets across North America and has a variety of new games under development for all markets.
Customer Service. As part of our strategy to maintain and expand our market position, we have made a commitment to maintain a high level of service to our customers. We have numerous field service centers in the United States and internationally, including our most recently opened service center in Macau. Within our service areas, we provide regular preventative maintenance service and on-demand repair service for our leased equipment, provide service training to our customers, and provide back-up units to our lessees. For casinos that purchase our products, we offer service contracts providing service benefits similar to those of leased units or parts-only warranty contracts.
Research and Development Costs. Because we believe that one of our strengths is identifying new product opportunities and developing new products, we expect to continue to spend a significant portion of our annual revenues on research and development, including the acquisition of intellectual property from third parties. Our total research and development expenses for continuing operations were $12,910, $7,784, and $6,185 in fiscal 2006, 2005, and 2004, respectively.
Significant Customer Sales, Foreign Sales and Foreign Assets. For the years ended October 31, 2006, 2005 and 2004, sales to customers outside the United States accounted for 44%, 23%, and 23%, respectively, of consolidated revenue. At October 31, 2006, one customers balance accounted for 12% of our trade accounts receivable, net. No single customers balance exceeded 10% of our investment in sales-type leases and notes receivable. At October 31, 2006, no individual customer accounted for more than 10% of consolidated revenue. As of October 31, 2006, approximately 72% of our long-lived assets, primarily acquired intangible assets, were outside the United States. Additional information regarding our foreign sales and long-lived assets by geographic region is included in Note 15 to our consolidated financial statements.
Seasonality and Business Fluctuations. Quarterly revenue and net income may vary based on the timing of the opening of new gaming jurisdictions, the opening or closing of casinos or the expansion or contraction of existing casinos, gaming regulatory approval or denial of our product and corporate licenses, the introduction of new products or the seasonality of customer capital budgets.
Employees. As of October 31, 2006, we had approximately 550 employees. We are not subject to any collective bargaining agreement and we believe that our employee relations are good.
Stargames. As discussed in Note 3 to our consolidated financial statements, on February 1, 2006, our wholly owned indirect subsidiary, Shuffle Master Australasia Pty. Ltd., completed its acquisition of Stargames by purchasing 95% of the outstanding Stargames shares for AU$1.55 per share. We began consolidating Stargames operating results as of February 1, 2006. Effective March 8, 2006, we had acquired 100% of the outstanding Stargames shares. The shares purchase was funded by temporary bridge financing and we secured permanent financing in November 2006. For additional information on the financing related to the Stargames acquisition, see Note 8 and Note 17 to our consolidated financial statements.
Stargames is based in Sydney, Australia and develops, manufactures and distributes a wide range of innovative electronic entertainment gaming products to worldwide markets. Its product offerings include Rapid Table Games, Vegas Star multi-terminal gaming machines, and a broad line of traditional video slot machines designed most specifically for the Australian, Asian and Latin American gaming markets. The Rapid series of games, which we previously distributed in the Americas and the Caribbean, combines a live dealer with multi-terminal electronic wagering. Current offerings include Rapid Roulette, Rapid Sic-Bo and Rapid Big Wheel. Vegas Star multi-terminal gaming machines feature animated dealers and a selection of public domain table games. The Vegas Star Nova line utilizes Stargames existing slot cabinet to extend the number of wagering terminals for a Vegas Star game, while minimizing the footprint required on the gaming floor. Stargames has approximately 210 employees including 80 in design and development.
Additional information regarding our acquisition of Stargames is included in Note 3 to our consolidated financial statements.
There are statements herein which are forward-looking statements that are based on managements beliefs, as well as on assumptions made by and information available to management. We consider such statements to be made under the safe harbor created by the federal securities laws to which we are subject, and, other than as required by law, we assume no obligation to update or supplement such statements.
These statements can be identified by the fact that they do not relate strictly to historical or current facts, and are based on managements current beliefs and expectations about future events, as well as on assumptions made by and information available to management. These forward-looking statements include statements that reflect managements beliefs, plans, objectives, goals, expectations, anticipations, and intentions with respect to our financial condition, results of operations, future performance and business, including statements relating to our business strategy and our current and future development plans. When used in this report, words such as anticipate, believe, estimate, expect, intend, project, plan, predict, might, may, could, will, feel and similar expressions or the negative thereof, as they relate to us or our management, identify forward-looking statements.
Forward-looking statements reflect and are subject to inherent known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed or implied. Risk factors that could cause actual results to differ materially from expectations include, but are not limited to, the following:
· changes in the level of consumer or commercial acceptance of our existing products and new products as introduced;
· increased competition from existing and new products for floor space in casinos;
· continued consolidation of gaming operators which could negatively impact our product pricing;
· acceleration and/or deceleration of various product development, promotion and distribution schedules;
· product performance issues;
· higher than expected manufacturing, service, selling, legal, administrative, product development, promotion and/or distribution costs;
· changes in our business systems or in technologies affecting our products or operations;
· reliance on strategic relationships with distributors and technology and manufacturing vendors;
· current and/or future litigation, claims and costs or an adverse judicial finding;
· tax matters including changes in state, federal, or foreign state tax legislation or assessments by taxing authorities;
· acquisitions or divestitures by us or our competitors of various product lines or businesses and, in particular, integration of businesses that we may acquire;
· changes to our intellectual property portfolio, such as the issuance of new patents, new intellectual property licenses, loss of licenses, claims of infringement or invalidity of patents;
· regulatory and jurisdictional issues (e.g., technical requirements and changes, delays in obtaining necessary approvals, or changes in a jurisdictions regulatory scheme or approach, etc.) involving us and our products specifically or the gaming industry in general;
· general and casino industry economic conditions;
· the financial health of our casino and distributor customers, suppliers and distributors, both nationally and internationally;
· our ability to meet debt service obligations, including our senior convertible notes and our senior secured revolving credit facility, which will depend on our future performance and other conditions or events and will be subject to many factors that are beyond our control;
· adverse changes in the creditworthiness of parties with whom we have significant receivables;
· various risks related to our customers operations in countries outside the United States, including currency fluctuation risk, which could increase the volatility of our results from such operations; and
· our ability to successfully and economically integrate the operations of any acquired companies such as Stargames.
Additional information on these and other risk factors that could potentially affect our financial results may be found in other documents filed with the Securities and Exchange Commission, including our quarterly reports on Form 10-Q and current reports on Form 8-K. We urge you to carefully read the following discussion of specific risks and uncertainties that could affect our business. These include, but are not limited to, the following:
Our intellectual property may be infringed, misappropriated or subject to claims of infringement or invalidity.
Our intellectual property rights are protected under a combination of patent, trademark, copyright and trade secret laws, as well as licensing agreements and third-party nondisclosure and assignment agreements. Because of the differences in foreign patent, trademark and other laws concerning proprietary rights, our intellectual property may not receive the same degree of protection in foreign countries as it would in the United States. This risk is increased due to our expansion in Australasia through our acquisition of Stargames. Our failure to obtain or maintain adequate protection of our intellectual property rights for any reason could have a material adverse effect on our business, results of operations and financial condition.
We have numerous patents and trademarks, and utilize patent protection in the United States relating to certain existing and proposed processes and products. We cannot assure you that all of our existing patents are valid or will continue to be valid, or that any pending patent applications will be approved. Our competitors have in the past challenged, are currently challenging, and may in the future challenge the validity or enforceability of our patents. The patents we own could be challenged, invalidated or circumvented by others and may not be of sufficient scope or strength to provide us with any meaningful protection or commercial advantage. We cannot assure you that competitors will not infringe on any of our patents or that we will have adequate resources to enforce our patents.
We also rely on unpatented proprietary technology. It is possible that others will independently develop the same or similar technology or otherwise obtain access to our unpatented technology. To protect our trade secrets and other proprietary information, we require employees, consultants, advisors and collaborators to enter into confidentiality agreements. We cannot assure you that these agreements will provide meaningful protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or disclosure of such trade secrets, know-how or other proprietary information. If we are unable to maintain the proprietary nature of our technologies, it could have a material adverse effect on our business.
We rely on our trademarks, trade names, and brand names to distinguish our products from the products of our competitors, and have registered or applied to register many of these trademarks. We cannot assure you that our trademark applications will be approved. Third parties may oppose our trademark applications, or otherwise challenge our use of the trademarks. In the event that our
trademarks are successfully challenged, we could be forced to rebrand our products, which could result in loss of brand recognition and could require us to devote resources towards advertising and marketing new brands. Further, we cannot assure you that competitors will not infringe our trademarks or that we will have adequate resources to enforce our trademarks.
We also face the risk that we have infringed third parties intellectual property rights. We have many competitors in both the United States and foreign countries, some of which have substantially greater resources and have made substantial investments in competing technologies. Some competitors have applied for and obtained, and may in the future apply for and obtain, patents that may prevent, limit or otherwise interfere with our ability to make and sell our products.
Significant litigation regarding intellectual property rights exists in our industry. We have in the past made, are currently making, and may in the future make, enforcement claims against third parties, and third parties have in the past made, are currently making, and may in the future make, claims of infringement against us or against our licensees or manufacturers in connection with their use of our technology. For information on Legal Proceedings, see Note 16 to our consolidated financial statements included in Item 8 of this Annual Report on Form 10-K/A for the year ended October 31, 2006. As discussed in Note 16 to our consolidated financial statements for the fiscal year ended October 31, 2006, we are currently in litigation over various intellectual property matters. Any claims, even those which are without merit, could:
· be expensive and time consuming to defend;
· cause one or more of our patents to be ruled or rendered unenforceable or invalid;
· cause us to cease making, licensing or using products that incorporate the challenged intellectual property;
· require us to redesign, reengineer or rebrand our products;
· divert managements attention and resources;
· require us to pay significant amounts in damages;
· require us to enter into royalty or licensing agreements in order to obtain the right to use a necessary product, process or component; or
· limit our ability to bring new products to the market in the future.
Any royalty or licensing agreements, if required, may not be available to us on acceptable terms or at all. A successful challenge to or invalidation of one of our patents or trademarks, or a successful claim of infringement against us or one of our licensees in connection with its use of our technology, could adversely affect our business.
The gaming industry is highly regulated, and we must adhere to various regulations and maintain our licenses to continue our operations.
Our products are subject to extensive regulation under the laws, rules and regulations of the jurisdictions in which they are used. We will also become subject to regulation in any other jurisdiction where our customers operate in the future. These laws, rules and regulations generally concern the responsibility, financial stability and character of the owners, managers, and persons with financial interests in gaming operations, including makers of gaming equipment such as ourselves. Some jurisdictions, however, empower their regulators to investigate participation by licensees in gaming outside their jurisdiction and require access to and periodic reports concerning gaming activities. Violations of laws in one jurisdiction could result in disciplinary action in other jurisdictions. For a summary of gaming regulations that affect our business, see Gaming Regulation in Item 1 of this Annual Report on Form 10-K/A for the year ended October 31, 2006.
In addition, legislative and regulatory changes may affect demand for our products. Such changes could affect us in a variety of ways. Legislation or regulation may introduce limitations on our products or opportunities for the use of our products, and could foster competitive games or technologies at our or our customers expense. For example, current regulations in a number of jurisdictions where our customers operate limit the amount of space allocable to slot machines, and substantial changes in those regulations may adversely affect demand for our products. Our business will also suffer if our products became obsolete due to changes in laws or regulations or the regulatory framework.
Legislative or regulatory changes negatively impacting the gaming industry as a whole or our customers in particular could also decrease their demand for our products. Opposition to gaming could result in restrictions or even prohibitions of gaming operations in any jurisdiction, or could result in increased taxes on gaming revenues. A reduction in growth of the gaming industry or in the number of gaming jurisdictions or delays in the opening of new or expanded casinos could reduce demand for our products. We cannot assure you that changes in current or future laws or regulations or future judicial intervention in any particular jurisdiction would not have a material adverse effect on our existing and proposed foreign and domestic operations.
Litigation may subject us to significant legal expenses and liability.
We are currently engaged in litigation on a variety of matters, including, in particular, several suits regarding our intellectual property rights. For information on our current material litigation and our current assessments, see Note 16 to our consolidated financial statements included in Item 8 of this Annual Report on Form 10-K/A for the year ended October 31, 2006. As discussed in Note 16 to our consolidated financial statements for the fiscal year ended October 31, 2006, we are currently in litigation over various intellectual property matters. Our current assessment of each matter may change based on future unknown or unexpected events. Litigation requires the expenditure of significant time and resources, and is inherently unpredictable. If any litigation were to have an unanticipated adverse result, there could be a material impact on our results of operations or financial position.
Our products currently in development may not achieve commercial success.
We have a number of products in various stages of development. We believe that our future success will depend in large part upon our ability to enhance our existing products and to develop, introduce and market new products and improvements to our existing products. As a result, we expect, as needed, to continue to make significant investments in product development. Our development of products is dependent on factors such as reaching definitive agreements with third parties and obtaining requisite governmental approvals.
Future technological advances in the gaming products industry may result in the availability of new products or increase the efficiency of existing products. We may not be able to access or finance capital expenditures for new technologies that are more cost-effective or create superior products. We cannot assure you that existing, proposed or as yet undeveloped technologies will not render our technology less profitable or less viable, or that we will have available the financial and other resources to compete effectively against companies possessing such technologies.
While we are pursuing and will continue to pursue product development opportunities, there can be no assurance that such products will come to fruition or become successful. Furthermore, while a number of those products are being tested, we cannot provide any definite date by which they will be commercially available. We cannot assure you that these products will prove to be commercially viable, or that we will be able to obtain the various gaming licenses necessary to distribute them 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 have a material adverse effect on our success and our ability to satisfy our obligations with respect to our indebtedness, including the notes and the senior secured revolving credit facility. We cannot predict which of the many possible future products will meet evolving industry standards and consumer demands. We cannot assure you that we will be able to adapt to such technological changes, offer such products on a timely basis or establish or maintain a competitive position.
We compete in a single industry, and our business would suffer if our products become obsolete or demand for them decreases.
We derive substantially all of our revenues from the sale, lease, licensing and other financing arrangements of products for the gaming industry. Our business would suffer if the gaming industry, in general, and table games in particular, suffered a downturn or loss in popularity, if our products became obsolete or if use of our products decreased. Our operating lease agreements with our customers are typically month-to-month leases and provide for termination upon 30 days prior notice by either party. Accordingly, consistent demand for and satisfaction with our products by our customers is critical to our financial condition and future success, and problems, defects or dissatisfaction with our products could cause us to lose customers or revenues from leases with minimal notice. Additionally, our success depends on our ability to keep pace with technological changes and advances in our industry and to adapt and improve our products in response to evolving customer needs and industry trends. If demand for our products weakens due to lack of market acceptance, technological change, competition or other factors, it could have a material adverse effect on our business, financial condition and results of operations and our ability to achieve sufficient cash flow to service our indebtedness, including the senior notes and the senior secured revolving credit facility.
We operate in a very competitive business environment.
There is intense competition in the gaming products industry, and it is characterized by dynamic customer demand and rapid technological advances. The development of new competitive products or the enhancement of existing competitive products in any market in which we operate could have a negative impact on our business in that market.
In general, we compete with other gaming and entertainment products for space on the casino customers floor, as well as for our customers capital spending. Some of the larger gaming supply companies with whom we compete with are IGT, Bally Technologies, Inc., WMS Industries, Inc., and Aristocrat Leisure Limited.
In the Utility Products segment, we compete with VendingData Corporation, a United States company that markets batch and continuous versions of its multi-deck shuffler, the Random Ejection Shuffler and more recently their single deck shuffler, the Poker One. Additionally, other companies may develop and market shufflers and seek to develop and obtain regulatory approvals of additional shuffler products. We cannot provide assurance that a competitive product will not gain substantial placements or cause price erosion of our shufflers in the future. Several companies also manufacture and sell chipper products which are competitive with our recently-introduced Easy Chipper product. We believe the most successful of these products is the Chipper Champ Plus, sold by TCS John Huxley.
In our Entertainment Products segment, the market for live table games is characterized by numerous competitors who develop and license proprietary table games. Some of our competitors widely known proprietary table game titles include PGICs Caribbean Stud® and Texas Holdem Bonus, Galaxy Gamings Lucky Ladies and Masque Publishings Spanish 21®. Competition in the table game market is typically based on price, brand recognition, and the strength of underlying intellectual property. There is more competition from smaller developers and vendors in the table games segment
because of the lower cost and complexity associated with the development of these products. In the future, table game competitors could market table games that might displace our products.
With our acquisition of Stargames, we have increased our Entertainment product lines to expand our multi-player table games. This product line has significantly more competition than our traditional Utility and Entertainment product offerings. There are numerous other companies that manufacture and/or sell multi-player table games, which are similar to our Table Master, Vegas Star and Rapid Table Games products. These companies include, but are not limited to, Elektroncek (also known as Interblock), Aruze Corporation, PacificNet Inc., Novomatic Group Companies, IGT, PokerTek, Inc. and TableMAX Holdings. Lastly, our Electronic Gaming Machines also compete for casino floor space with gaming suppliers such as IGT and Aristocrat Leisure Limited.
We are working to develop player tracking and data gathering technologies of Table iD, and we believe that several existing gaming companies are working to develop similar competitive technologies. These companies, or others, may own intellectual property that is superior to ours, has priority over ours or prevents us from marketing Table iD without a license arrangement concerning such intellectual property. We cannot assure you that we will be able to compete effectively in this market, or that our competitors will not develop superior technologies or products.
If we do not retain our key personnel and attract and retain other highly skilled employees, our business may suffer.
If we fail to retain, recruit and motivate the necessary personnel, our business and our ability to obtain new customers, develop new products and provide acceptable levels of customer service could suffer. The success of our business is heavily dependent on the leadership of our key management personnel and on our key employees. Our employment contracts with our corporate officers and certain other key employees are primarily at will employment agreements, under which the employee or we may terminate employment. If any of these persons were to leave our company it could be difficult to replace them, and our business could be harmed. We do not have key-man life insurance.
Our success also depends on our ability to recruit, retain and motivate highly skilled service, sales, marketing and engineering personnel. Competition for these persons in our industry is intense and we may not be able to successfully recruit, train or retain qualified personnel.
A downturn in general economic conditions or in the gaming industry or a reduction in demand for gaming may adversely affect our results of operations.
Our business operations are affected by international, national and local economic conditions. A recession or downturn in the general economy, or in a region constituting a significant source of our customers, or a reduction in demand for gaming, could harm the health of casino operators and our other customers, and consequently result in fewer customers purchasing or leasing our products, which would adversely affect our revenues.
The terrorist attacks of September 11, 2001 and other recent terrorist incidents have had a significant impact on the travel, tourism and gaming industries in which our customers operate. The significant reduction in both business and leisure travel following the September 11th event significantly reduced patronage of or visits to our customers properties, particularly in Las Vegas, with the result that many of our customers operating results declined significantly. These events, 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 or hostilities may again reduce our customers guests willingness to travel, with the result that our customers operations will suffer, which could have an impact on our operating results.
Since we sell our products worldwide, our business is subject to risks associated with doing business internationally. Our sales to customers outside the United States, primarily Canada, Europe and Australasia, accounted for approximately 44% of our consolidated revenue in fiscal 2006. We expect the percentage of our international sales to increase in fiscal 2007 and thereafter due to our acquisition of Stargames in February 2006. Accordingly, our future results could be harmed by a variety of factors, including:
· changes in foreign currency exchange rates;
· exchange controls;
· changes in regulatory requirements;
· changes in a specific countrys or regions political or economic conditions;
· tariffs, other trade protection measures and import or export licensing requirements;
· potentially negative consequences from changes in tax laws or application of such tax laws;
· difficulty in staffing and managing widespread operations;
· changing labor regulations;
· requirements relating to withholding taxes on remittances and other payments by subsidiaries;
· different regimes controlling the protection of our intellectual property;
· restrictions on our ability to own or operate subsidiaries, make investments or acquire new businesses in these jurisdictions; and
· restrictions on our ability to repatriate dividends from our subsidiaries.
Our international operations are affected by global economic and political conditions. Changes in economic or political conditions in any of the countries in which we operate could result in exchange rate movement, new currency or exchange controls or other restrictions being imposed on our operations.
Fluctuations in the value of the U.S. dollar, the Euro or the Australian dollar may adversely affect our results of operations. Because our financial results are reported in dollars, if we generate sales or earnings in other currencies, the translation of those results into dollars can result in a significant increase or decrease in the amount of those sales or earnings.
We also have agreements with casinos in Native American jurisdictions, which may subject us to sovereign immunity risk and could subject us to additional compliance costs.
We could face considerable business and financial risk in implementing acquisitions.
As part of our overall growth strategy, we have in the past acquired, and will continue to seek to acquire, complementary products, assets and businesses. We regularly engage in discussions with respect to and investigate possible acquisitions. Future acquisitions could result in potentially dilutive issuances of equity securities, significant expenditures of cash, the incurrence of debt and contingent
liabilities and an increase in amortization expenses, which could have a material adverse effect upon our business, financial condition and results of operations.
The risks associated with acquisitions could have a material adverse effect upon our business, financial condition and results of operations. We cannot assure that we will be successful in consummating future acquisitions on favorable terms or at all or that any future acquisition will work out as we expect.
Our acquisition of Stargames, and any other future potential acquisitions, may not produce the revenues, earnings or business synergies that we anticipate, and the acquisition of Stargames may not perform as expected for a variety of reasons, including:
· difficulties in the integration of the operations, financial reporting, technologies, products and personnel, including those caused by national, geographic and cultural differences;
· risks of entering markets in which we have no or limited prior experience;
· difficulties in the use, development or sale of intellectual property or future or present products;
· potential loss of employees;
· currency fluctuations or changes in exchange rates in connection with sales to customers in foreign currencies;
· diversion of managements attention away from other business concerns; and
· expenses of any undisclosed or potential legal liabilities.
Both Stargames, an Australian company, and CARD, an Austrian company, substantially increase our exposure to the risks of international operations. Additionally, all of the risks applicable to our business also apply to Stargames and CARD. Any one or a combination of these factors may cause our revenues or earnings to decline.
If our products contain defects, our reputation could be harmed and our results of operations adversely affected.
Some of our products are complex and may contain undetected defects. The occurrence 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. Any of these occurrences could also result in the loss of or delay in market acceptance of our products and loss of sales.
Our business is subject to quarterly fluctuation.
Historically, our operating results have been highest in our fourth fiscal quarter ending October 31 and lowest in our first fiscal quarter ending January 31, primarily due to the seasonality of customer capital budgets. Our quarterly operating results may vary based on the timing of the opening of new gaming jurisdictions, the opening or closing of casinos, the expansion or contraction of existing casinos, approval or denial of our products and corporate licenses under gaming regulations, the introduction of new products, the seasonality of customer capital budgets, the mix of domestic versus international sales and the mix of Sales and Service revenue versus Lease and Royalty revenue. As a result, our operating results and stock price could be volatile, particularly on a quarterly basis.
Our ability to meet debt service obligations is subject to many factors that are beyond our control and may affect future operations.
On November 30, 2006, we entered into a $100,000 senior secured revolving credit facility (the New Credit Agreement) with Deutsche Bank AG Cayman Islands Branch, as a Lender, Deutsche Bank
Trust Company Americas, as Administrative Agent, Deutsche Bank Securities Inc. and Wells Fargo, N.A., as Joint Lead Arrangers and Book Managers and Wells Fargo, N.A. as Syndication Agent. We drew $71,180 on the facility, which was used to repay in its entirety the Old Credit Agreement (as defined below). Any remaining amount available under the revolving credit facility will be used for working capital, capital expenditures and general corporate purposes, including share repurchases. The revolving credit facility under the New Credit Agreement will mature on November 30, 2011. Our ability to meet debt service obligations, including our convertible notes and the New Credit Agreement, will depend on our future performance and other conditions or events and will be subject to many factors that are beyond our control. Our debt service obligations may:
· increase our vulnerability to general adverse economic and industry conditions;
· limit our flexibility in planning for, or reacting to, changes in our business and industry;
· place us at a competitive disadvantage compared to other less leveraged competitors; and
· limit our ability to borrow additional funds.
We lease facilities with approximately 83,000 square feet in Nevada for our corporate headquarters, manufacturing, research and development and field service. In addition, we lease an approximately 11,000 square foot facility in Vienna, Austria and an approximately 32,000 square foot facility in Sydney, Australia.
We also own an approximately 48,000 square foot facility in Sydney, Australia that we use for research and development activities as well as manufacturing.
We have other shuffler research and development and other administration activities located in an approximately 5,000 square foot facility in Minnesota.
We believe that our existing properties are suitable and adequate for our current needs and that additional facilities are available in our current locations to support expansion, if required.
For information on Legal Proceedings, see Note 16 to our consolidated financial statements included in Item 8 of this Annual Report.
Litigation is inherently unpredictable. Our current assessment of each matter may change based on future unknown or unexpected events. If any litigation were to have an adverse result that we did not expect, there could be a material impact on our results of operations or financial position. We believe costs associated with litigation will not have a material impact on our financial position or liquidity, but may be material to the results of operations in any given period. We assume no obligation to update the status of pending litigation, except as may be required by applicable law, statute or regulation. We believe that the final disposition of these matters will not have a material adverse effect on our financial position, results of operations or liquidity.
No matters were submitted to a vote of our security holders during the fourth quarter of the fiscal year ended October 31, 2006.
Stock Listing. Our common stock is traded on The NASDAQ National Market under the symbol SHFL. As of January 12, 2007, we had approximately 260 shareholders of record. There are a significantly greater number of shareholders whose shares are held in street name. Based on information we collected as of January 12, 2007, we estimate that we have approximately 14,000 beneficial holders in total. The following table sets forth quarterly high and low prices for trades of our common stock during fiscal 2006 and 2005:
The closing price of our common stock on January 12, 2007, was $25.99 per share.
Dividend Policy. We have not paid dividends on our common stock.
Transfer Agent. Our stock transfer agent and registrar is Wells Fargo Bank Minnesota, N.A., Shareowner Services, 161 North Concord Exchange, South St. Paul, Minnesota 55075, (800) 468-9716.
Securities Authorized for Issuance Under Equity Compensation Plans. The information under the caption Equity Compensation Plan Information in our 2006 Proxy Statement is incorporated herein by reference.
Stock Splits. In December 2004, our board of directors approved a three-for-two common stock split, with new shares distributed in the form of a dividend on January 14, 2005, to shareholders of record on January 3, 2005 (the January 2005 Split). Share and per share amounts have been adjusted for all periods presented herein to reflect the January 2005 Split. In connection with the January 2005 Split, we paid cash of $68 for fractional shares and reclassified to common stock the par value of $0.01 per newly issued share.
In March 2004, our board of directors had earlier approved another three-for-two common stock split, with new shares distributed in the form of a dividend on April 16, 2004, to shareholders of record on April 5, 2004 (the April 2004 Split). Share and per share amounts have been adjusted for all periods presented herein to reflect the April 2004 Split. In connection with the April 2004 Split, we paid cash of $138 for fractional shares and reclassified to common stock the par value of $0.01 per newly issued share.
Stock Repurchases. The following table provides monthly detail regarding our share repurchases during the three month period ended October 31, 2006 (in thousands, except per share amounts):
* In September 2006, our board of directors authorized management to repurchase up to $30,000 of our common stock in the open market under a share repurchase program with no expiration. As of October 31, 2006, $30,166 remained outstanding under our board authorizations.
See Note 2 to the Consolidated Financial Statements, Restatement of Consolidated Financial Statements, for a description of the restatement of our previously filed consolidated financial statements as of October 31, 2006 and for the year then ended.
Earnings per share and weighted average share amounts reflect the effect of the January 2005 Split and the April 2004 Split.
Effective February 1, 2006, we acquired Stargames. Effective May 1, 2004, we acquired Casinos Austria Research & Development GmbH & Co KG and its wholly-owned subsidiaries (CARD). Effective February 24, 2004, we acquired certain assets of BET Technology, Inc. (BTI). These acquisitions, in addition to less significant acquisitions, are included in our consolidated financial statements beginning on the effective date of the transactions; see Note 3 to our consolidated financial statements for further detail on our acquisitions.
Installed Unit Base is the sum of product units or seats under lease or license agreements and inception-to-date sold units or seats. We believe that installed units is an important gauge of segment performance because it measures historical market placements of leased and sold units or seats and it provides insight into potential markets for service and next generation products. Some sold units or seats may no longer be in use by our casino customers or may have been replaced by other models. Accordingly, we are unable to determine precisely the number of units or seats currently in use.
As discussed in Note 2 to the consolidated financial statements, our financial statements as of and for the year ended October 31, 2006 have been restated. The accompanying managements discussion and analysis gives effect to that restatement.
We develop, manufacture and market technology and entertainment-based products for the gaming industry for placement on the casino floor. Our products primarily relate to our casino customers table game activities and focus on either increasing their profitability, productivity and security or expanding their gaming entertainment offerings.
Our Utility Products include a full line of automatic card shufflers for use with the vast majority of card table games as well as chip sorting machines for use on Roulette tables. We also have acquired and/or are developing other products that automatically gather data to enable casinos to track table game play, such as Table iD (part of our Intelligent Table System), currently in development with International Game Technology (IGT) and Progressive Gaming International Corporation (PGIC).
Our Entertainment Products include our portfolio of live proprietary poker, blackjack, baccarat, and pai gow poker-based table games and side bets as well as several electronic content delivery system platforms including Table Master, Vegas Star, Rapid Table Games and wireless Casino On Demand.
We sell, lease or license our products. When we sell our products, we offer our customers a choice between a sale, a longer-term sales-type lease or other long-term financing. When we lease or license our products, we generally negotiate a month-to-month operating lease. We offer our products worldwide in markets that are highly regulated. We manufacture our products at our headquarters and manufacturing facility in Las Vegas, Nevada, as well as at our Australian headquarters in Milperra, New South Wales. In addition, we outsource the manufacturing of certain of our products in the United States, Europe and Asia Pacific.
All of our product lines compete or will compete with other gaming products, such as slot machines, blackjack tables, keno, craps, and roulette, for space on the casino floor.
Our internet address is www.shufflemaster.com. Through the Investor Relations page on our internet website, our Annual Report on Form 10-K, Proxy Statement, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act are available free of charge, as soon as reasonably practical after such information has been filed or furnished to the Securities and Exchange Commission. Additional information regarding Shuffle Up Productions can be accessed at www.shuffleupproductions.com.
Managements Discussion and Analysis contains forward-looking statements. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in Forward Looking Statements and Risk Factors elsewhere in this Annual Report.
Stargames. On February 1, 2006, we announced that our wholly owned indirect subsidiary, Shuffle Master Australasia Pty. Ltd., had substantially completed its acquisition of Stargames, a gaming company that develops, manufactures and distributes a wide range of innovative electronic
entertainment gaming products to worldwide markets, by purchasing 95% of the outstanding Stargames shares. Effective March 8, 2006, we had acquired 100% of the outstanding Stargames shares for AU $1.55 per share. Accordingly, the results of Stargames have been included in our consolidated financial statements beginning February 1, 2006.
Stargames product offerings are classified as Entertainment Products and include Rapid Table Games and Vegas Star multi-terminal gaming machines, and a broad line of traditional video slot machines designed for the Australian, Asian and Latin American gaming markets. The Rapid series of games, which we previously distributed in the Americas and the Caribbean, combines a live dealer with multi-terminal electronic wagering. Current offerings include Rapid Roulette, Rapid Sic-Bo and Rapid Big Wheel. Vegas Star multi-terminal gaming machines currently feature animated dealers and a selection of public domain table games. The Vegas Star Nova line utilizes Stargames existing slot cabinet to extend the number of wagering terminals for a Vegas Star game, while minimizing the footprint required on the gaming floor.
IGT Agreement. On April 28, 2006, we entered into an agreement (April Agreement) with IGT whereby we assigned, transferred, and conveyed to IGT, our 50% share of future royalties from the licensing of the ENPAT patents to any third party or from otherwise permitting any third party to use the ENPAT patents. The total royalties to be received by IGT is limited to an amount equal to a net present value of $3,000 utilizing a discount factor of 12% (the Royalty Amount). Upon the receipt by IGT of the Royalty Amount, all royalty payments with respect to our 50% share of the ENPAT patents shall resume and be paid to us. The total non-refundable consideration paid to us was $3,000.
On July 31, 2006, we entered into another agreement with IGT whereby we sold to IGT our remaining 50% ownership in the ENPAT patents. This agreement rescinded certain provisions of the April Agreement whereby we assigned, transferred, and conveyed to IGT our 50% share of the first $3,000 of future royalties from the licensing of the ENPAT patents to any third party or from otherwise permitting any third party to use the ENPAT patents. The consideration for the remaining 50% ownership of the ENPAT patents was the $3,000 previously received from IGT pursuant to the April Agreement between us and IGT, plus a payment of an additional $4,500. This payment was in lieu of the $4,875 that would have been due, at IGTs discretion, under the patent purchase agreement entered into on June 13, 2005 between us and IGT. As a result, IGT shall receive 100% of the future royalties on the ENPAT patents until IGT has earned a total of $17,400 in gross royalties; thereafter IGT will pay us 17 ½% of any gross royalties. The transaction has been reflected in the accompanying consolidated statements of income by recording a gain on sale of patent of $4,566.
Sona Mobile. In January 2006, we entered into a licensing and distribution agreement with Sona Mobile Holdings Corp. (Sona) to license, develop, distribute and market in-casino wireless handheld gaming content and delivery systems to casinos and through other legal gaming modes throughout the world. On January 25, 2006, we completed a private equity investment and purchased approximately 2,300 shares of Sonas common stock at the price of $1.30 per share for approximately $3,000. This private equity investment is pursuant to a stock option agreement between us and Sona dated December 29, 2005. Additionally, as part of our investment in Sona, we received one seat on the Sona Board of Directors and 1,200 warrants to purchase shares of Sonas common stock at a discount to the grant date fair value. On June 30, 2006, we purchased approximately 1,667 additional shares of Sonas common stock at the price of $0.60 per share for approximately $1,000. These shares were purchased through a private equity investment along with other accredited investors. As part of the second private equity investment, we also received an additional 833 warrants to purchase shares of Sonas common stock at prices as specified in the agreement. The investment in Sona is accounted for under the equity method of accounting in accordance with Financial Accounting Standards Board (FASB) APB No. 18 (APB 18), The Equity Method of Accounting for Investments in Common Stock and is included in Other long-term assets in our consolidated balance sheet as of October 31, 2006. Accordingly, we recognized Equity method investment losses of $416 for the twelve
months ended October 31, 2006, which represents our pro rata share of Sonas net loss for the period.
As of October 31, 2006, we determined that the decline in fair value below the carrying value of our investment in Sona was other than temporary. To evaluate the fair value of our investment in Sona, we used the market price of a share of Sona common stock as of October 31, 2006, multiplied by the number of shares owned. In making that determination, we considered forecasts about Sonas financial performance and near-term prospects. As a result, we recognized a pre-tax impairment charge totaling $1,655 during the quarter and year ended October 31, 2006.
Progressive Gaming Licenses. On September 29, 2006, we entered into an agreement whereby we obtained the last license rights to utilize an extensive portfolio of jackpot wagering hardware and method patents held by PGIC. Under the terms of the agreement, we have the right to utilize the suite of over forty patents on tables and other games in any form including live tables, electronic single and multi-player units, and wireless wagering devices. Under the agreement, we also acquired the right to sub-license use of the technology. PGIC has further agreed that it will not grant or permit any additional licenses to other manufacturers or suppliers to the technology in the future. In exchange for a fully-paid, royalty-free, fully-transferable world-wide license to the complete patent suite, we paid $3,500 to PGIC during the three months ended October 31, 2006.
In December 2003, our board of directors approved and we committed to a plan to divest our North America slot products operations and assets, based on our determination that this product line was no longer a strategic fit with our refocused core business strategy of providing products and services for the table game area of casinos. Revenues and costs associated with our slot products are reported as discontinued operations for all periods presented. In January 2004, we entered into agreements pursuant to which we sold substantially all of our slot products assets and substantially completed our divestiture plans.
As a part of the Stargames acquisition, we acquired Professional Vending Services Pty Ltd (PVS), a wholly-owned subsidiary of Stargames. PVS designs, develops and manufactures automatic vending machines. PVS offers exclusive equipment in all main vending segments including snacks, cold drinks, food (hot and cold), coffee and cigarettes. We have determined that the operations of PVS are non-core to our Entertainment Products and Utility Products segments. Accordingly, we entered into an agreement to sell Stargames equity interests in PVS including settlement of all existing liabilities of PVS. The estimated liabilities exceeded assets in the amount of approximately $654. The fair value of PVS working capital has been valued at zero in our preliminary purchase price allocation. The results of operations for PVS were included in Discontinued Operations until the disposition was completed in September 2006.
Our revenue and results of operations are most affected by unit or seat placements, through sale or lease, of our products. The number and mix of products placed and the average lease or sales price are the most significant factors affecting our gross margins. These factors are, in turn, affected by the gaming industry generally and our customers assessment of our products. To a lesser extent, our overall financial results are affected by fluctuations in selling, general and administrative expenses and our continued investment in research and development activities. Our results for the year ended October 31, 2006, also include a one-time charge recorded in the three months ended April 30, 2006 related to the acquisition of Stargames of $19,145 for in-process research and development (IPR&D). Our margins are also negatively impacted by the amortization of product related intangibles through our acquisition of CARD and Stargames.
We earn our revenue in several ways, including leasing or licensing our products to casino customers, generally under month-to-month fixed fee contracts. Product lease contracts typically include parts and service. We also offer a majority of our products for sale with an optional parts and service contract. A more detailed discussion of our revenue components and related revenue recognition policies is included under the heading Critical Accounting Policies.
Our overall revenue growth was due to increases in both leased and sold units installed base in both our product segments. The increase in the number of units leased and sold resulted from the introduction of new products, greater placements of existing products, acquisitions of products, and the expansion of legal gaming into new jurisdictions. A more detailed discussion of our revenue is included for each of our operating segments under the heading Segment Operating Results.
Fiscal 2006 compared to Fiscal 2005
Overall, total revenue increased for the year ended October 31, 2006 as compared to the prior year period. Consolidated revenue for the year was $162,991 as compared to $112,860 in the prior year. The increase was a result of strong performance in both operating segments as well as our lease and royalties and sales and service business models. We experienced strong results in our sold units installed base within our Utility segment. Our Entertainment segment was favorably impacted by organic growth as well as our acquisition of Stargames effective February 1, 2006. The increase in the number of units sold resulted from greater placements of our products, acquisitions of products, market growth and the expansion of operations both domestically and internationally. A more detailed discussion of our revenue is included for each of our operating segments under the heading Segment Operating Results.
Overall gross margin dollars increased for the year ended October 31, 2006. However, as a percentage of revenue, our gross margin percentage decreased 8.9% for the year ended October 31, 2006 as compared to the same prior year period. The decline in our gross margin percentages are attributed to a shift in product mix year-over-year and the inclusion of the results of Stargames. The margins of the Stargames products are lower than those traditionally experienced in our
Entertainment Products segment. Additionally, amortization of Stargames product related intangibles of $1,545 is included in cost of sales and service in our consolidated statements of income for the year ended October 31, 2006 compared to $0 for the same prior year period. Our sales of Easy Chipper® and Table Master, which are higher cost products, have also increased year-over-year and have unfavorably impacted our overall margin. Additionally, we had fewer lifetime license sales than in the prior period which resulted in an unfavorable impact on gross margin dollars.
Fiscal 2005 compared to Fiscal 2004
Overall, total revenue increased for the year ended October 31, 2005 as compared to the prior year period. Consolidated revenue for the year was $112,860 as compared to $84,783 in the prior year. Our overall revenue growth of $28,077 is attributable to sales and service revenue in both the Utility and Entertainment segments, and to a lesser extent lease and royalty revenue for both operating segments. Additionally, a full year of results for CARD contributed to the year over year growth. Revenue contributed by CARD was approximately $16,089 in fiscal 2005 compared to approximately $7,100 in fiscal 2004. A more detailed discussion of our revenue is included for each of our operating segments under the heading Segment Operating Results.
Overall gross margin dollars increased for the year ended October 31, 2005. However, as a percentage of revenue, our gross margin percentage decreased 3.0% for the year ended October 31, 2005 compared to the same prior year period. The decrease in gross margin percentage year over year is primarily attributed to increased sales of our Table Master and Easy Chipper products which carry slightly lower margins. Additionally, intellectual property amortization expense associated with products related to our CARD and other acquisitions is recorded as cost of sales which reduces our gross margin percentage. Amortization expense related to these products was $4,090 and $1,832 for the years ended October 31, 2005 and 2004, respectively, which resulted in a 3.6% and 2.2% decrease in gross margin percentage for the years ended October 31, 2005 and 2004, respectively.
Selling, General and Administrative Expenses (SG&A). SG&A increased at a higher rate than our revenues during the year ended October 31, 2006. For fiscal 2006 compared to fiscal 2005, the dollar increase primarily reflects the following factors:
· The acquisition of Stargames as of February 1, 2006. SG&A related to Stargames was $10,520 for the year ended October 31, 2006 compared to $0 in the same prior year period. Included in SG&A for the year ended October 31, 2006 is $743 of intangible amortization related to customer relationships.
· SG&A was also negatively impacted for the year ended October 31, 2006 by additional professional fees related to the delayed filing of our Form 10-K for fiscal year 2005 of approximately $800.
· Corporate legal fees were $4,946 and $3,825 for the years ended October 31, 2006 and 2005, respectively. The legal fees in the prior year were favorably impacted by the $800 legal settlement related to the VendingData I litigation and a $1,471 reimbursement of certain legal fees pursuant to the terms of the patent purchase agreement with IGT. Current period legal fees relate predominately to the MP Games I and II litigation (See Note 16 to our consolidated financial statements). We expect that our legal fees will continue to vary from period to period depending on our level of legal activity to protect our intellectual property and our involvement in non-routine transactions.
· Share-based compensation expense under SFAS 123R allocated to SG&A was $5,108, including $1,997 of amortization of restricted stock compensation, for the year ended October 31, 2006, compared to $759, in the same prior year period.
· Payroll and related expenses, excluding Stargames, increased approximately $3,300, or 14.5%, from fiscal 2005, primarily due to an increase in the number of employees in order to support the growth of our business.
· Favorable collections efforts, primarily at Stargames, resulted in a credit of ($537) in the provision for bad debts for the year ended October 31, 2006 compared to $229 for the same prior year period.
Excluding the impact of the costs associated with the expensing of share-based compensation and our additional professional fees related to the delayed filing of our Form 10-K for fiscal 2005, SG&A as a percentage of revenue for the year ended October 31, 2006 and 2005 was 27.8% and 26.4%, respectively.
On April 28, 2006, we entered into the April Agreement with IGT whereby we assigned, transferred, and conveyed to IGT, our 50% share of future royalties from the licensing of the ENPAT patents to any third party or from otherwise permitting any third party to use the ENPAT patents. The total royalties to be received by IGT is limited to an amount equal to a net present value of $3,000 utilizing a discount factor of 12% (the Royalty Amount). Upon the receipt by IGT of the Royalty Amount, all royalty payments with respect to our 50% share of the ENPAT patents shall resume and be paid to us. The total non-refundable consideration paid to us was $3,000.
On July 31, 2006, we entered into a second agreement with IGT whereby we sold to IGT our remaining 50% ownership in the ENPAT patents. This agreement rescinded certain provisions of the April Agreement whereby we assigned, transferred, and conveyed to IGT our 50% share of the first $3,000 of future royalties from the licensing of the ENPAT patents to any third party or from otherwise permitting any third party to use the ENPAT patents. The consideration for the remaining 50% ownership of the ENPAT patents was the $3,000 previously received from IGT pursuant to the April Agreement between us and IGT, plus a payment of an additional $4,500. This payment was in lieu of the $4,875 that would have been due, at IGTs discretion, under the patent purchase agreement entered into on June 13, 2005 between us and IGT. As a result, IGT shall receive 100% of the future royalties on the ENPAT patents until IGT has earned a total of $17,400 in gross royalties; thereafter IGT will pay us 17 ½% of any gross royalties. The transaction has been reflected in the accompanying consolidated statements of income by recording a gain on sale of patent of $4,566.
Research and Development Expenses (R&D). Our R&D in all periods presented is distributed among all of our product lines, as we have continued to invest in new product development. For fiscal 2006, R&D increased primarily due to the acquisition of Stargames. R&D expense related to Stargames for the year ended October 31, 2006 was $5,359 compared to $0 for the same prior year period. Additionally, share-based compensation expense allocated to R&D under SFAS 123R was $302 for the year ended October 31, 2006 compared to $0 for the same prior year period.
R&D includes amortization of our patents for products still under development. Amortization for the year ended October 31, 2006 included amortization of our 50% ownership interest in the ENPAT
patents. Our R&D costs will be favorably impacted in the future by the sale of our remaining 50% ownership interest in the ENPAT patents to IGT on July 31, 2006. See Note 3 to our consolidated financial statements.
As required by FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method (FIN 4), the portion of the purchase price allocated to IPR&D of $19,145 was immediately expensed during the three months ended April 30, 2006.
A project-by-project valuation using the guidance in FASB Statement of Financial Accounting Standard No. 141, Business Combinations (SFAS 141) and the American Institute of Certified Public Accountants (AICPA) Practice Aid Assets Acquired in a Business Combination to Be Used In Research and Development Activities: A Focus on Software, Electronic Devices and Pharmaceutical Industries is in the process of being performed by us with the assistance of a valuation specialist to determine the fair value of research and development projects of Stargames.
IPR&D is defined as a development project that has been initiated and achieved material progress but has not yet resulted in a commercially viable product and has no alternative future uses. The fair value was determined using the income approach on a project-by-project basis. This method is based on the present value of earnings attributable to the asset or costs avoided as a result of owning the assets. This method includes risk factors, which include applying an appropriate discount rate that reflects the projects stage of completion, the nature of the product, the scientific data associated with the technology, the current patent situation and market competition. The expensing of IPR&D through purchase accounting allows for the expensing of certain R&D efforts at the acquisition date consistent with the expensing of R&D efforts as they are incurred for in-house development efforts. This charge is preliminary pending completion of our final purchase price allocation which will be finalized within one year from the date of acquisition. Any adjustments to this charge will be adjusted to the income statement caption IPR&D when finalized.
Other income (expense) is comprised of the following for the years ended October 31:
Interest income decreased primarily as a result of a reduction in our investment portfolio. Proceeds of matured investments were not re-invested, but were used to pay down the bridge financing associated with the acquisition of Stargames and stock repurchases. This decrease was partially offset by an increase in interest income attributable to increased interest bearing sales-type leases and notes receivable as of October 31, 2006. For the years ended October 31, 2006, 2005 and 2004, respectively, interest income related to our investment in sales type leases and notes receivable was $1,229 ,$948 and $480.
Interest expense for the periods ended October 31, 2006, 2005 and 2004 is primarily related to the $150,000 of Notes due in April 2024. Interest Expense in 2006 also includes interest expense on the Bridge Loan which matures in November 2006. A more detailed discussion of the Notes and the Bridge Loan are included below under the heading Liquidity and Capital Resources.
Prior to the completion of our CARD acquisition in fiscal 2004, we entered into foreign currency exchange contracts to fix the U.S. dollars estimated to be required to fund the Euro-denominated cash component of the CARD purchase price which resulted in a foreign currency exchange loss of $703. Such contracts do not meet the accounting criteria for hedge accounting, and accordingly, the foreign currency exchange loss is included in our operating results for the year ended October 31, 2004. As of October 31, 2006 and 2005, we had no outstanding foreign exchange contracts.
Our effective income tax rate for continuing operations for the years ended October 31 is as follows:
Excluding the impact of the one-time IPR&D charge in relation to the Stargames acquisition, which is non-deductible for tax purposes, the effective tax rate for the year ended October 31, 2006 would have been 35.3%.
Looking forward, our annual effective tax rate may fluctuate due to changes in our amount and mix of U.S. and foreign income, changes in tax legislation and changes in our estimates of federal tax credits and other tax deductions. We estimate that our fiscal 2007 annual effective tax rate will be approximately 35.0%.
We have not provided U.S. Federal income tax on $4,258 of undistributed earnings of our foreign subsidiaries because we intend to permanently reinvest such earnings outside the United States. Upon distribution of these earnings in the form of dividends or otherwise, we would be subject to U.S. income taxes, subject to adjustment for foreign tax credits. Determination of the amount of unrecognized deferred U.S. income tax liability is not practicable because of the complexities associated with its hypothetical calculation.
In October 2006, our wholly-owned subsidiary, Shuffle Master Management - Service GmbH, the parent entity to CARD, transferred $8,000 to Shuffle Master, Inc. in the form of a dividend. This dividend is subject to United States tax based upon earnings and profits of Shuffle Master Management - Service GMBH. This dividend resulted in $733 of net additional income taxes which is comprised of additional United States tax of approximately $1,855 and a corresponding foreign tax credit benefit of $1,122.
During each of the years ended October 31, 2006, 2005 and 2004, we recorded income tax benefits of $3,908, $5,287 and $5,388, respectively, related to deductions for employee stock option exercises. These tax benefits, which reduced income taxes payable and increased additional paid-in capital by an equal amount, had no effect on our provision for income taxes. Additionally, as part of the fiscal 2004 income tax provision to tax return true-up, we recorded a $229 tax benefit related to employee stock option exercises which reduced income taxes payable and increased additional paid-in capital by an equal amount.
We record deferred income taxes to reflect the income tax consequences in future years between the financial reporting and income tax bases of assets and liabilities, and future tax benefits such as net
operating loss carryforwards and other tax credits. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the differences are expected to reverse. We provide valuation allowances to reduce deferred tax assets to an amount that is more likely than not to be realized. We evaluate the likelihood of recovering our deferred tax assets by estimating sources of future taxable income. The provision for income taxes is the sum of the tax currently payable and the change in deferred taxes during the year. Additional information regarding income taxes is included in Note 14 to our consolidated financial statements.
In December 2004, our board of directors approved a three-for-two common stock split, with new shares distributed in the form of a dividend on January 14, 2005, to shareholders of record on January 3, 2005 (the January 2005 Split). Share and per share amounts have been adjusted for all periods presented herein to reflect the January 2005 Split.
In March 2004, our board of directors had earlier approved another three-for-two common stock split, with new shares distributed in the form of a dividend on April 16, 2004, to shareholders of record on April 5, 2004 (the April 2004 Split). Share and per share amounts have been adjusted for all periods presented herein to reflect the April 2004 Split.
We account for the $150,000 of contingent convertible senior notes due 2024 (the Notes) in accordance with FASB Emerging Issues Task Force No. 04-08 (EITF 04-08), The Effect of Contingently Convertible Debt on Diluted Earnings Per Share which requires us to include the dilutive effect of our outstanding Notes shares in our diluted earnings per share calculation, regardless of whether the market price trigger or other contingent conversion feature has been met. Because our Notes include a mandatory cash settlement feature for the principal payment, we applied the treasury stock method. This method results in incremental dilutive shares when the average fair value of our common stock for a reporting period exceeds the initial conversion price per share of $28.07. EITF 04-8 also requires restatement of all prior periods. Because the average fair value of our common stock did not exceed the initial conversion price in any period prior to the year ended October 31, 2005, no restatement of prior periods was required. For certain quarters during the years ended October 31, 2006 and 2005, the average fair value of our common stock exceeded $28.07, and accordingly, the dilutive effect is included in our diluted shares calculation.
We have two reportable segments which are classified as continuing operations, Utility Products and Entertainment Products. Utility Products include our shufflers, chip sorting machines and ITS product lines. Entertainment Products include our Proprietary Table Games, electronic multi-terminal gaming products, electronic gaming machines, and Shuffle Up Productions. Each segments activities include the design, development, acquisition, manufacture, marketing, distribution, installation and servicing of its product lines.
Utility Products. Our strategy in the Utility Products segment is the development of products for our casino customers that enhance table game speed, productivity and security. Currently, Utility Products segment revenue is derived substantially from our automatic card shufflers. We develop and market a full complement of automatic card shufflers for use with the vast majority of card-based table games placed in casinos and other gaming locations, including our own proprietary table games. In addition to selling and servicing, we also lease shufflers, which provides us with recurring revenue. Our current shuffler product portfolio consists of 7 distinct models, including both second and third generation shufflers, in the categories of single deck, multi-deck batch and multi-deck continuous card shufflers. As of October 31, 2006, our shuffler installed base totaled 22,347 units, a 20.2% increase from 18,589 as of October 31, 2005. Our growth strategy for our shuffler business is the development and distribution of next generation, patent protected shufflers which enhance the value proposition for our customers through technological advancements. As a result, we expect to replace our older generation shufflers over time, while at the same time, increasing the penetration of our shufflers in the marketplace.
As part of the CARD acquisition in May 2004, we acquired a next generation chip sorting machine, the Easy Chipper. The Easy Chipper simplifies the handling of gaming chips and accurately tracks chip volume and value, which increases the productivity and security on high volume chip tables such as Roulette. During May 2005, we announced our first Easy Chipper orders, the first release of a new product developed by CARD since the acquisition. During the year ended October 31, 2006, we sold 225 Easy Chipper units, and placed 5 Easy Chipper units on lease. For fiscal 2006, total revenue contribution from the Easy Chipper was approximately $4,667 as compared to $2,600 for the same prior year period.
Our Table iD product remains in the development stage, including our Intelligent Shoe which increases table game security by reading each card as it is removed from the shoe to reduce game manipulation.
Entertainment Products. Our strategy in the Entertainment Products segment is the development and delivery of proprietary table game content, which enhances our casino customers table game operations. Currently, Entertainment Products segment revenue is derived substantially from our live proprietary table game content. We develop and market a full complement of poker, pai gow poker, baccarat and blackjack table game content. Our current table game portfolio consists of 21 revenue generating titles, including industry leading brands such as Three Card Poker® , Let It Ride®, Four Card Poker® and Fortune Pai Gow Poker®. The majority of these games are licensed to our customers, which provides us with recurring revenue. In fiscal 2003, we began selling lifetime licenses of certain of our proprietary table games. As of October 31, 2006, our proprietary table game installed base totaled 4,219 games, a 14.6% increase from 3,681 games as of October 31, 2005. Our growth strategy for our live proprietary table games business is to broaden our content through increased development and/or acquisition. As a result, we expect to further increase the penetration of our content in the marketplace, as well as create a longer-term replacement opportunity.
As discussed above, our multi-terminal gaming products consist of Table Master, and the Vegas Star and Rapid Table Games products which we acquired through our acquisition of Stargames effective February 1, 2006. These multi-terminal gaming products allow us to expand the distribution of our proprietary table game portfolio. Some of our multi-terminal gaming products enable us to offer table game content into markets where live table games are not permitted, such as racino, video lottery and arcade markets. Our growth strategy for the multi-terminal gaming products is to position these products as a more cost-effective way to offer lower stakes table games to our casino customers.
Table Master is a fixed five station, electronic table game featuring a video screen with a virtual dealer who interacts with players. In addition to selling and servicing, we also lease our Table Master product, which provides us with recurring revenue. In October 2006, we signed a multi-terminal video lottery machine agreement with the Delaware State Lottery System. Under the terms of the agreement, the initial placement consists of 54 units or 270 seats of our Table Master electronic table game platform. The Table Master units will feature a diverse mix of blackjack and poker-based proprietary table game content, including Royal Match 21 Blackjack, Three Card Poker, Let It Ride Bonus with 3 Card Bonus and Dragon Bonus Baccarat.
The Vegas Star multi-terminal gaming machines feature animated virtual dealers, touch screen player betting and a selection of public domain table games including Roulette, Baccarat and Sic-Bo. The Vegas Star has a modular design which makes it easy to add additional play stations as terminal demand increases. Originally designed for the Australian and Asian markets where its market shares exceed 60% and 35% respectively, Vegas Star has rapidly become an integral part of casinos within its two primary markets. Each Vegas Star configuration can accommodate up to 16 player stations, and will eventually offer all of our proprietary game content.
The Rapid Table Games product line combines a live dealer with multi-terminal electronic wagering for popular games like Roulette and Sic-Bo. With over 85% of its installed base currently installed in Australia and Asia, the Rapid Table Games product line focuses on combining popular high-volume gaming content with unparalleled game play, operator usability, systems integration and technical support. Rapid Roulette, the product lines signature offering, currently has the leading Australian market share and accounts for over 90% of the automated Roulette multi-player products currently in use.
Through the acquisition of Stargames, we also acquired a broad line of traditional video slot machines designed more specifically for the Australian and Asian gaming markets where over 90% of the installed base is located. The Electronic Gaming Machines (EGMs) feature a variety of game selections including licensed content provided by WMS Industries. In addition to selling the full EGM complement, we sell conversion kits which allow existing EGM terminals to be converted to other games on the Stargames platform.
Segment revenues include sale, lease or licensing of products within each reportable segment. We measure segment revenue performance in terms of dollars and Installed Unit Base. Installed Unit Base is the sum of product units or seats under lease or license agreements and inception-to-date sold units or seats. As discussed above, we have combined the presentation of our Table Master, Rapid Table Games and Vegas Star products as multi-terminal gaming seats. Due to their modular design, both the Rapid Table Games and Vegas Star products are best analyzed based upon number of seats sold or leased. As our Table Master is a fixed five seat station, we have converted units into five seats rather than one unit. We believe that Installed Base is an important gauge of segment performance because it measures historical market placements of leased and sold seats and it provides insight into potential markets for service and next-generation products. Some sold units or seats may no longer be in use by our casino customers or may have been replaced by other models or products. Accordingly, we are unable to determine precisely the number of units or seats currently in active use.
Segment operating income includes revenues and expenses directly and indirectly associated with the product lines included in each segment. Direct expenses primarily include depreciation of leased assets, amortization of intangible assets, cost of products sold, shipping, installation, commissions, product approval costs, research and development and product related litigation. Indirect expenses include an activity-based allocation of other general product-related costs, the most significant of which are service and selling expenses and manufacturing overhead. Corporate general and administrative expenses are not allocated to segments.
Fiscal 2006 compared to Fiscal 2005