SHFL entertainment Inc. 10-Q 2007
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended January 31, 2007
For the transition period from to
Commission file number: 0-20820
SHUFFLE MASTER, INC.
(Exact name of registrant as specified in its charter)
Registrants Telephone Number, Including Area Code: (702) 897-7150
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 þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act (Check one):
Large accelerated filer þ Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
As of April 18, 2007, there were 35,221,606 shares of our $.01 par value common stock outstanding.
SHUFFLE MASTER, INC.
QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED JANUARY 31, 2007
TABLE OF CONTENTS
SHUFFLE MASTER, INC.
(Unaudited, in thousands, except per share amounts)
See notes to unaudited condensed consolidated financial statements
See notes to unaudited condensed consolidated financial statements
See notes to unaudited condensed consolidated financial statements
Description of business. Shuffle Master, Inc. (either we, us or the Company) develops, manufactures and markets 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. We view our business in two operating segments, the Utility Products segment and the Entertainment Products segment.
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 (formerly known as 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, wireless Casino On Demand and Shuffle Master Live!, a Malta-based internet gaming site offering our proprietary content and selected public domain content.
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 month-to-month operating leases. 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.
Basis of presentation. The unaudited condensed consolidated financial statements as of January 31, 2007, and for the three month period ended January 31, 2007, have been prepared by us under the rules and regulations of the Securities and Exchange Commission (the SEC). In the opinion of management, the financial information for the three months ended January 31, 2007, reflects all adjustments and accruals, which are of a normal recurring nature, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods.
The financial information as of October 31, 2006, is derived from our audited consolidated financial statements and notes for the fiscal year ended October 31, 2006, included in Item 8 in our Annual Report on Form 10-K/A (10-K/A). The information included in this Form 10-Q should be read in conjunction with managements discussion and analysis and notes to the financial statements in the 10-K/A.
The results of operations for the three months ended January 31, 2007, are not necessarily indicative of the results of operations that may be achieved for the entire fiscal year ending October 31, 2007.
Investments in Unconsolidated Affiliate. Our investment in and the operating results of our 50%-or-less-owned entity that is not required to be consolidated is included in the consolidated financial statements on the basis of the equity method of accounting.
We review our investments in unconsolidated affiliates for other than temporary impairment whenever events or changes in business circumstances indicate that the carrying amount of the investments may not be fully recoverable. Evidence of an impairment loss that is other than temporary might include, but would not necessarily be limited to, a decline in the market price of an investees common stock that is long in duration and severe in nature, the absence of an ability to recover the carrying amount of the investment, or the inability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment. There were no such impairment losses recorded during the three months ended January 31, 2007 and 2006.
Deferred revenue. Deferred revenue consists of amounts collected or billed in excess of recognizable revenue.
Recently Issued Accounting Standards. In February 2007, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 159 The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). SFAS 159 expands the use of fair value measurement by permitting entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. This statement is effective for us beginning in November 2008. We have not yet determined the impact, if any, that SFAS 159 will have on our Consolidated Financial Statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157), which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for us beginning in November 2008. We are evaluating the impact of adopting this statement as a result of any changes to our fair value measurements.
In June 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 prescribes the recognition threshold and measurement criteria for determining the tax benefit amounts to recognize in the financial statements. This interpretation is effective for us beginning in November 2007. We are evaluating the potential impact of adopting this interpretation on our future results of operations, financial position or cash flows.
In September 2006, the SEC issued SAB 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 requires analysis of misstatements using both an income statement (rollover) approach and a balance sheet (iron curtain) approach in assessing materiality and provides for a one-time cumulative effect transition adjustment. SAB 108 is effective for our fiscal year 2007 annual financial statements. We do not expect the adoption of this statement to have a material impact on our results of operations, financial position or cash flows.
2. ACQUISITIONS, DISPOSITIONS AND OTHER SIGNIFICANT TRANSACTIONS
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 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.
Consideration to Stargames consisted of an Australian-denominated cash payment of AU $148,441 or US $112,147. In addition, we incurred total direct acquisition costs, consisting primarily of legal and due diligence fees, of approximately US $4,228. See Note 5 for information regarding the financing of the Stargames acquisition. The following table sets forth the determination of the consideration paid for Stargames at the date of acquisition:
The transaction was accounted for as a purchase and, accordingly, the preliminary purchase price was allocated to the underlying assets acquired and liabilities assumed based upon their estimated fair values at the date of the acquisition. We are currently in the process of determining, with the assistance of an independent appraiser, the fair values based on discounted cash flows and estimates by us. The purchase price allocation is preliminary and may be adjusted for up to one year after the acquisition. The following table sets forth the preliminary allocation of the purchase price as of Janaury 31, 2007:
The acquisition of Stargames enhances the products in our Entertainment Products segment as well as providing for additional electronic platforms for our branded content. Additionally, we acquired a strong brand name as well as an experienced and talented management team. These factors result in the recognition of certain intangible assets, discussed below, and significant goodwill. Developed technology is being amortized on a straight-line basis over its useful life and is charged to cost of sales and service, a component of gross margin. Customer relationships are being amortized on a straight-line basis over their useful life and are reflected in selling, general and administrative expenses in the consolidated statement of operations.
A project-by-project valuation using the guidance in SFAS No. 141, Business Combinations 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.
In-process research and development (IPR&D) is defined as a development project that has been initiated and achieved material progress but has not yet resulted in a technologically feasible product and has no alternative future use. The fair value is determined using the multi-period excess earnings 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 and after a contributory charge on 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 forecast of future cash flows required the following assumptions to be made:
· Revenue that is likely to result from specific IPR&D projects, including the likelihood of approval of the product, estimated number of units to be sold, estimated selling prices, estimated market penetration and estimated market share and year-over-year rates over the product life cycles;
· Cost of sales related to the potential products using historical data, industry data or other sources of market data;
· Sales and marketing expense using historical data, industry data or other market data;
· General and administrative expenses; and
· Research and development expenses.
As required by FIN 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method, the portion of the purchase price allocated to IPR&D of $19,145 was immediately expensed in the quarter ended April 30, 2006.
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 results of operations for PVS were included in Discontinued Operations until the disposition was completed in September 2006.
The operating results for Stargames are included in the accompanying condensed consolidated statements of operations from the date of the acquisition. The following unaudited pro forma condensed consolidated financial information has been prepared assuming the Stargames acquisition had occurred on November 1, 2005, and is as follows:
The unaudited pro forma condensed consolidated financial statements have been prepared based upon currently available information and assumptions that are deemed appropriate by management. The pro forma information is for informational purposes only and is not intended to be indicative of the actual consolidated financial position or consolidated results that would have been reported had the transactions occurred on the dates indicated, nor does this information represent a forecast of the consolidated financial position at any future date or the combined financial results for any future period.
Historical financial information for Stargames for the three months ended January 31, 2007 includes certain non-recurring expenses of approximately $2,000 included in selling, general, and administrative expenses. These expenses include a success fee related to the ultimate sale of Stargames and accrued expense related to a potential Australian Goods and Services Tax liability associated with export sales in the period December 2001 through November 2005.
We maintain provisions for bad debts for estimated credit losses that result from the inability of our customers to make required payments. The provisions for bad debts are estimated based on historical experience and specific customer collection issues.
Sales-type leases and other notes receivables related to our financing for sales of our intellectual property products are interest-bearing at market interest rates, require monthly installment payments over periods ranging generally from 30 to 60 months and contain bargain purchase options. Future minimum lease payments (principal, deferred revenue and interest) to be received for both sales-type leases and notes receivable are as follows:
Total debt issuance costs incurred with the issuance of long-term debt are capitalized and amortized as interest expense using the effective interest method. Amortization of debt issuance costs were $348 and $258 for the three months ended January 31, 2007 and 2006, respectively.
Deposits are primarily comprised of a $3,000 security deposit related to our patent infringement lawsuit against VendingData Corporation and deposits associated with equipment purchases. See Note 12 for more information related to the VendingData litigation.
Amortizable intangible assets. All of our recorded intangible assets, excluding goodwill and the Stargames and CARD trademarks, are subject to amortization. Amortization expense was $2,664 and
$1,639 for three months ended January 31, 2007 and 2006, respectively. Amortized intangible assets are comprised of the following as of January 31, 2007:
Trademark. Intangibles with an indefinite life consisting of the Stargames and CARD trademarks are not amortized and were $18,664 and $18,591 as of January 31, 2007 and October 31, 2006, respectively.
Goodwill. Changes in the carrying amount of goodwill for the three months ended January 31, 2007, are as follows:
All of our goodwill originated from the acquisitions of foreign subsidiaries. For foreign income tax purposes, goodwill is amortized using the straight-line method and deducted over its statutory fifteen year life. Goodwill has been assigned to our Utility and Entertainment Products segments, as defined under SFAS 142.
Notes payable and other long-term liabilities are summarized as follows:
Contingent convertible senior notes. In April 2004, we issued $150,000 of contingent convertible senior notes due 2024 (the Notes) through a private placement under Rule 144A of the Securities Act of 1933. The Notes are unsecured and bear interest at a fixed rate of 1.25% per annum. Interest is payable semi-annually in arrears on April 15 and October 15 of each year, beginning October 15, 2004.
Holders may convert any outstanding Notes into cash and shares of our common stock at an initial conversion price per share of $28.07. This represents a conversion rate of approximately 35.6210 shares of common stock per $1,000 in principal amount of Notes. The value of the cash and shares of our common stock, if any, to be received by a holder converting $1,000 principal amount of the Notes will be determined based on the applicable Conversion Rate, Conversion Value, Principal Return, and other factors, each as defined in the indenture covering these Notes.
The Notes are convertible, at the holders option, into cash and shares of our common stock, under any of the following circumstances:
· during any fiscal quarter commencing after the date of original issuance of the Notes, if the closing sale price of our common stock over a specified number of trading days during the previous quarter is more than 120% of the conversion price of the Notes on the last trading day of the previous quarter;
· if we have called the Notes for redemption and the redemption has not yet occurred;
· during the five trading day period immediately after any five consecutive trading day period in which the trading price of the Notes per $1,000 principal amount for each day of such period was less than 95% of the product of the closing sale price of our common stock on such day multiplied by the number of shares of our common stock issuable upon conversion of $1,000 in principal amount of the Notes, provided that, if on the date of any conversion pursuant to this trading price condition, our common stock price on such date is greater than the conversion price but less than 120% of the conversion price, then the holder will be entitled to receive Conversion Value (as defined in the indenture covering these Notes) equal to the principal amount of the Notes, plus accrued and unpaid interest including liquidated damages, if any; or
· upon the occurrence of specified corporate transactions.
We may call some or all of the Notes at any time on or after April 21, 2009, at a redemption price, payable in cash, of 100% of the principal amount of the Notes, plus accrued and unpaid interest and
including liquidated damages, if any, up to but not including the date of redemption. In addition, the holders may require us to repurchase all or a portion of their Notes on April 15, 2009, 2014 and 2019, at 100% of the principal amount of the Notes, plus accrued and unpaid interest and including liquidated damages, if any, up to but not including the date of repurchase, payable in cash. Upon a change in control, as defined in the indenture governing the Notes, holders may require us to repurchase all or a portion of their Notes, payable in cash equal to 100% of the principal amount of the Notes plus accrued and unpaid interest and liquidated damages, if any, up to but not including the date of repurchase.
$100,000 Senior Secured Revolving Credit Facility. 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 bridge loan originally entered into on January 25, 2006 (the Old Credit Agreement). 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.
The interest rate under the New Credit Agreement is based on the sum of the relevant Base Rate or Eurodollar Rate plus the Applicable Margin, as defined, each as in effect from time to time. The obligations under the revolving credit facility are guaranteed by each wholly-owned domestic subsidiary of ours that is not an immaterial subsidiary and each wholly-owned domestic subsidiary that is not an immaterial subsidiary of the Company established, created or acquired after November 30, 2006, if any. The New Credit Agreement contains customary affirmative and negative covenants for transactions of this nature, including but not limited to restrictions and limitations on the following:
· Permitted acquisitions;
· Incurrence of indebtedness;
· Granting or incurrence of liens;
· Pay dividends and make other distributions in respect of our equity securities;
· Acquire assets and make investments;
· Sales of assets;
· Transactions with affiliates;
· Total Leverage Ratio
· Interest Expense Coverage ratio; and
· Agreements to restrict dividends and other payments from subsidiaries.
Additional information on these covenants may be found in Section 7 and Section 8 of the New Credit Agreement included in our Current Report on Form 8-K, dated December 5, 2006. As of January 31, 2007, $71,180 remained outstanding under the New Credit Agreement.
Stargames credit facility. Stargames has banking facilities with the Australia and New Zealand Banking Group (ANZ). The facilities have a borrowing capacity of AU $12,700; amounts outstanding as of January 31, 2007 were AU $1,500 or US $1,165 at a weighted average interest rate of 6.8%. Interest rates are based on the bank bill swap yield, as defined, plus a margin.
The facilities are secured by a cross guarantee and indemnity between all the operating entities of the Stargames group. The agreements provide for collateralization of all the assets and operations of all members of the Stargames group as well as the operating facilities of Stargames based in Milperra, New South Wales, Australia.
BTI liabilities. In connection with our acquisition of certain assets from Bet Technology, Inc. (BTI) in February 2004, we recorded an initial estimated liability of $7,616 for contingent installment payments computed as the excess fair value of the acquired assets over the fixed installments and other direct costs. Beginning November 2004, we pay monthly note installments based on a percentage of certain revenue from BTI games for a period of up to ten years, not to exceed $12,000. The balance of this liability as of January 31, 2007, was $3,877.
ENPAT note payable. In December 2004, we purchased two RFID technology patents from ENPAT for $12,500. The purchase price was comprised of an initial payment of $2,400 followed by a $1,100 payment in January 2005 and non-interest bearing annual installments through December 2007. The balance as of January 31, 2007, of $2,873 represents the discounted present value of the future payments, including imputed interest of approximately $34. The remaining principal and interest payment of $3,000 is due in December 2007.
Bet the Set 21 contingent consideration. In connection with our acquisition of Bet the Set 21 in June 2005, we recorded contingent consideration of $560. The contingent consideration consists of quarterly payments of 22.5% of adjusted gross revenues, as defined, attributed to the Bet the Set 21 side bet table games up to a maximum of $560. The balance of this liability as of January 31, 2007, was $516.
6. SHAREHOLDERS EQUITY
The following table reconciles the changes in our shareholders equity during the three months ended January 31, 2007:
Common stock repurchases. Our board of directors periodically authorizes us to repurchase shares of our common stock. Under our existing board authorizations, during the three months ended January 31, 2007, we repurchased 75 shares of our common stock for a total cost of $1,933 at an average price of $25.77. During the three months ended January 31, 2006, no shares of our common stock were repurchased. As of January 31, 2007, $28,233 remained outstanding under our board authorizations. We cancel shares that we repurchase.
Tax benefit from stock option exercises. During the three months ended January 31, 2007 and 2006, we realized income tax benefits of $1,564 and $618, respectively, related to deductions for employee stock option exercises. These tax benefits, which reduced income taxes payable and additional paid-in capital by an equal amount, had no affect on our provision for income taxes.
Preferred stock purchase rights. In February 2005, we amended our Shareholder Rights Agreement, dated June 26, 1998 (the Rights Agreement). As more fully described therein, and subject to the terms thereof, the Rights Agreement, as amended, generally gives holders of our common stock rights to acquire shares of our preferred stock upon the occurrence of specified events. The amendment (a) eliminated all requirements in the Rights Agreement that actions, approvals and determinations to be taken or made by our board of directors be taken or made by a majority of the Continuing Directors, and (b) reflects the change of the name of our stock transfer agent to Wells Fargo Bank, N.A. The amendment eliminated from the Rights Agreement those provisions commonly referred to as dead hand provisions.
Share-based award plans. In February 2004, our board of directors adopted and, in March 2004, our shareholders approved the Shuffle Master, Inc. 2004 Equity Incentive Plan (the 2004 Plan) and the Shuffle Master, Inc. 2004 Equity Incentive Plan for Non-Employee Directors (the 2004 Directors Plan). These approved plans replaced our prior plans and no further options may be granted from the prior plans. Both the 2004 Plan and the 2004 Directors Plan provide for the grant of stock options, stock appreciation
rights (none issued), and restricted stock, individually or in any combination (collectively referred to as Awards). On January 18, 2007, we amended our 2004 Equity Incentive Plan (the 2004 Plan) to authorize the grant of restricted stock units. The 2004 Plan now provides for the grant of stock options, stock appreciation rights, restricted stock units and restricted stock as the basis of our long-term incentive program for executive officers and other key employees. Section 12.1 of the 2004 Plan allows the board of directors to amend the 2004 Plan in certain respects at any time or from time to time. Stock options may not be granted at an exercise price less than the market value of our common stock on the date of grant and may not be subsequently repriced. Options granted under the 2004 Plan generally vest in equal increments over four years and expire in ten years. Options granted under the 2004 Directors Plan generally vest immediately and expire in ten years.
The 2004 Plan provides for the grants of Awards to our officers, other employees and contractors. The maximum number of Awards which may be granted is 2,700 of which no more than 1,890 may be granted as restricted stock. The 2004 Directors Plan provides for the grants of Awards to our non-employee directors. The maximum number of Awards which may be granted is 1,125 of which no more than 788 may be granted as restricted stock.
Recognition of compensation expense. The following table shows information about compensation costs recognized:
Reported share-based compensation expense was classified as follows:
Our effective income tax rate for continuing operations for the three months ended January 31, 2007 and 2006 was 24.2% and 34.1%, respectively. The decrease in our effective income tax rate is primarily due to a one time tax benefit recorded in the three month period ended January 31, 2007 related to research and development tax credits.
Shares used to compute basic and diluted earnings per share from continuing operations are as follows:
We account for our contingent convertible notes in accordance with FASB Emerging Issues Task Force Issue No. 04-8 (EITF 04-8), 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 apply 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. For the three months ended January 31, 2007, the average fair value of our common stock did exceed $28.07, resulting in additional dilutive shares of 12.
Other income (expense) is comprised of the following:
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 January 31, 2007. For the three months ended January 31, 2007, interest income related to our investment in sales type leases and notes receivable was $344 as compared to $291 for the same prior year period.
Interest expense for the three months ended January 31, 2007, is primarily related to the $150,000 of Notes due in April 2024 and the New Credit Agreement. A more detailed discussion of the Notes and the New Credit Agreement are included below under the heading Liquidity and Capital Resources.
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, Table Master products, Shuffle Up Productions and the products developed, manufactured and distributed by Stargames. The Stargames product offerings include Rapid Table Games and Vegas Star multi-terminal gaming machines and a broad line of traditional video slot machines designed more specifically for the Australian and Asian gaming markets. Each segments activities include the design, development, acquisition, manufacture, marketing, distribution, installation and servicing of its product lines. All periods presented have been reclassified to conform to our current reportable segments.
Segment revenues include sale, lease or licensing of products within each reportable segment. 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, including stock option expense, and manufacturing overhead. Corporate general and administrative expenses are not allocated to segments. Capital expenditures include amounts reported in our condensed consolidated statements of cash flows for purchases of leased products, property and equipment, and intangible assets plus the financed or non-cash portion of these purchases which is excluded from cash flows.
The following provides financial information concerning our reportable segments of our continuing operations:
Purchase commitments. From time to time, we enter into commitments with our vendors to purchase inventory at fixed prices or in guaranteed quantities. As of January 31, 2007, our significant inventory purchase commitments totaled $13,345 which are primarily related to our one2six shufflers, Table Master, Vegas Star, Rapid Table Games and the Easy Chipper roulette chip sorter machine.
Employment agreements. We have entered into employment contracts with our corporate officers and certain other key employees with durations ranging typically from one to three years. Significant contract provisions include minimum annual base salaries, healthcare benefits, bonus compensation if performance measures are achieved, and non-compete provisions. These contracts are primarily at will employment agreements, under which the employee or we may terminate employment. If we terminate any of these employees without cause, we are obligated to pay the employee severance benefits as specified in their individual contract. As of January 31, 2007, minimum aggregate severance benefits totaled $5,179 for employment agreements expiring through 2009.
Legal proceedings. Our current material litigation and our current assessments are described below. Litigation is inherently unpredictable. Our assessment of each matter may change based on future unknown or unexpected events. Subject to the foregoing, we believe we will prevail in each of the material litigation actions described below. 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.
VendingData IIIn October 2004, we filed a second patent infringement lawsuit (VendingData II) against VendingData Corporation (VendingData). We settled our first patent infringement lawsuit against VendingData on July 12, 2005 (VendingData I). This second suit alleges that the use, importation and offering for sale of VendingDatas PokerOne shuffler infringes another patent owned by us (a different patent than the patents that were the subject of the VendingData I case). VendingData II was filed in the U.S. District Court for the District of Nevada (the Court) in Las Vegas, Nevada. The complaint seeks an unspecified amount of damages against VendingData and a preliminary and permanent injunction against VendingDatas infringing conduct. VendingData has denied infringement and has also filed a counterclaim for a declaratory judgment of non-infringement.
On November 29, 2004, the Court granted our motion for a preliminary injunction (the Injunction). The Injunction became effective upon our posting of a $3,000 cash security with the Court on November 30, 2004. This security deposit is included in other assets on our consolidated balance sheet. On December 17, 2004, the Court denied VendingDatas two emergency motions to modify the Injunction.
In March 2005, the Court of Appeals for the Federal Circuit (the Federal Circuit) stayed the Injunction based on a technical defect in the Courts process in granting the Injunction, and not on its merits. On December 27, 2005, the Federal Circuit vacated the Injunction and ordered the Court to perform a more complete claim construction analysis in order to deal with any future motions on whether or not to reinstate the Injunction. Two of the three judges on the Federal Circuit panel stated that under VendingDatas claim construction the PokerOne likely did not literally infringe. We continue to believe that infringement exists under either our claim construction or VendingDatas claim construction. The Federal Circuit did not rule on which claim construction is the proper one.
In May 2005, the Court held a Markman hearing for construction of the claims. On September 26, 2005, U.S. Magistrate Judge Lawrence R. Leavitt for the District of Nevada issued his Claim Construction Report and Recommendation in the Markman hearing concerning VendingDatas PokerOne shuffler. The Magistrate Judges findings were limited to his interpretation of certain words in the patent claim asserted by us, and he agreed with the interpretation put forth by VendingData. On February 26, 2007, the Court adopted and accepted without modification the Magistrate Judges Recommendation. The Magistrate Judges Recommendation, as adopted by the Court, is not a determination of whether the PokerOne infringes the asserted patent, nor does it speak to the validity of our claims. There can be no guarantee that, upon any further appeal of the Courts adoption of the Magistrate Judges Recommendation, the Federal Circuit will agree with our claim construction.
We intend to continue to enforce our intellectual property rights by moving the litigation forward to resolve our patent infringement claim.
GEIIn July 2004, we filed a patent infringement lawsuit against Gaming Entertainment, Inc. (GEI) in the U.S. District Court for the District of Nevada, in Las Vegas, Nevada. The lawsuit alleges that GEIs 3-5-7 Poker game infringes one of our Three Card Poker® patents and one of our Let-It-Ride® patents. We are seeking a permanent injunction and an as yet undetermined amount of damages against GEI. GEI has answered our complaint, denying infringement, and also seeking a ruling that the patents are invalid. The case is presently in the discovery phase. In November 2005, the Court held a Markman hearing for construction of the claims. The Markman decision is now pending. In March 2006, GEI filed and, we opposed, several summary judgment motions challenging the validity of the Three Card Poker patent involved in this litigation. GEI filed its reply briefs in April 2006, and the summary judgment motions are pending.
AwadaOn April 25 and April 26, 2005, our rescission trial was held in the District Court in Clark County, Nevada in the Awada and Gaming Entertainment, Inc. case against us and our CEO, Mark Yoseloff. At the conclusion of the trial, the court granted our rescission motion, ordering that the subject contract, called the Game Option Agreement, be rescinded and/or void. On May 18, 2005, the Court entered Findings of Fact/Conclusions of Law confirming the Courts rescission ruling. Among the findings, the Court found that the actions of plaintiffs Yehia Awada and Gaming Entertainment, Inc. demonstrated that the plaintiffs never had any intention of conveying to us the exclusive license to the 3-Way Action game, as they had agreed and were required to do under the Game Option Agreement. The Court further found that we had established by a preponderance of the evidence that the plaintiffs had materially failed to perform their obligations under the Game Option Agreement and that we were entitled to the remedy of rescission. On May 5, 2005, the Court ruled on the parties damages requests in connection with the case and as required under Nevada law. Plaintiffs were seeking approximately $13,000 in damages. The Court ordered that the total damages under Nevada law due to the successful rescission of the Game Option Agreement was $130, including all interest. The damages amount was paid in June 2006.
Plaintiffs have appealed the Courts order granting the rescission of the Game Option Agreement to the Nevada Supreme Court. The appeal is pending.
Awada IIOn September 12, 2005, we filed a new lawsuit against defendants Awada and Gaming Entertainment, Inc. The lawsuit alleges that our Four Card Poker® game is being infringed and illegally copied by the defendants Play Four Poker game. The lawsuit claims that the defendants are violating the federal Lanham Act by infringing the trademark/trade dress of our Four Card Poker® game layout, and that the defendants are committing acts of unfair competition, interference with prospective business advantage and conversion. Our action seeks appropriate injunctive relief against defendants Play Four Poker game layout, as well as unspecified monetary damages. On September 15, 2005, the U.S. District Court for the District of Nevada issued a temporary restraining order prohibiting the defendants from displaying or advertising the infringing layout.
On or about December 6, 2005, the defendants answered our complaint and denied all liability. They also filed counterclaims for alleged patent misuse, anti-trust violations based on said patent misuse, patent invalidity, unfair competition, unfair trade practices, and other related claims. The counterclaims seek an unspecified amount of damages, disgorgement of our profits as a result of our alleged unfair trade practices, and preliminary and permanent injunctive relief against our alleged unfair trade practices. The defendants filed these counterclaims against both us and our CEO. We completely and uncategorically deny the defendants counterclaims, and intend to vigorously oppose them. On January 9, 2006, we filed a motion to dismiss all of defendants counterclaims. On January 24, 2006, the defendants filed an opposition to our motion to dismiss. On March 27, 2006, the Court granted our motion for a preliminary injunction and dismissed four of defendants seven counterclaims. On April 19, 2007, the Court granted our summary judgment motions on trade dress
infringement and defendants counterclaims, and all of those counterclaims were dismissed with prejudice. All other claims were dismissed with prejudice, except our trademark infringement claim was dismissed without prejudice.
MP Games IIn July 2004, we filed a complaint against MP Games LLC and certain other defendants in the U.S. District Court for the District of Nevada, in Las Vegas, Nevada. The complaint alleges that the defendants MP21 System infringes two patents owned by us. The complaint also alleges misappropriation of trade secrets against certain, but not all, of the defendants, and also includes claims for correction of named inventor on certain related patents held in the name of certain of the defendants. We are seeking a permanent injunction and damages against all of the defendants. The defendants have answered our complaint denying infringement and also claiming that the two patents are invalid. The defendants have also counterclaimed against us, claiming that we infringe several of their patents, and that we misappropriated certain of their trade secrets, and are seeking damages against us. We deny any infringement, misappropriation or wrongdoing. In May 2005, the Court dismissed defendants breach of contract counterclaim.
In a Two-Party Agreement transaction with IGT, IGT purchased a 50% ownership interest in the two patents which are the subject of this lawsuit, and IGT has been added as a named plaintiff in this lawsuit.
On December 20, 2005, the Court entered its Markman order, construing the disputed claims in the various patents-in-suit. The Court ruled in our favor on a number of disputed terms and in the defendants favor on others. Some or all of these rulings may be overturned on appeal.
In August 2006, the Court dismissed all but one of the defendants trade secret misappropriation claims. Subsequently, pursuant to a partial settlement agreement, the parties dismissed all of their trade secret claims.
Recently, the defendants filed seven summary judgment motions dealing with various non-infringement and invalidity arguments. We also filed a summary judgment motion seeking to invalidate two of the four patents asserted by the defendants. No dates have been set at this time for the hearings on these motions.
In the ordinary course of conducting our business, we are, from time to time, involved in other litigation, administrative proceedings and regulatory government investigations. We believe that the final disposition of any of these or other matters will not have a material adverse effect on our financial position, results of operations or liquidity.
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, wireless Casino On Demand and Shuffle Master Live!, a Malta-based internet gaming site offering our proprietary content and selected public domain content.
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.
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 elsewhere in this quarterly report.
Stargames. On February 1, 2006, we had substantially completed our acquisition of Stargames by purchasing 95% of the outstanding Stargames shares for AU$1.55 per share. Effective March 8, 2006, we had acquired 100% of the outstanding Stargames shares. Consideration to Stargames consisted of an Australian-denominated cash payment of AU $148,441 or US $112,147. In addition, we estimate that our total direct acquisition costs, consisting primarily of legal and due diligence fees, to be approximately US $4,228. See Note 5 to our unaudited condensed consolidated financial statements for information related to the financing of the Stargames acquisition.
The acquisition enhances the products in our Entertainment Products segment as well as provides for additional electronic platforms for our branded content. Additionally, we acquired a strong brand name as well as an experienced and talented management team. These factors result in the recognition of certain intangible assets and significant goodwill.
The transaction was accounted for as a purchase and, accordingly, the preliminary purchase price was allocated to the underlying assets acquired and liabilities assumed based upon their estimated fair values at the date of the acquisition. The preliminary fair values have been prepared based upon an independent appraisal, which is currently in process, discounted cash flows and estimates by management. The purchase price allocation is preliminary and may be adjusted for up to one year after the acquisition.
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 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 margins are also negatively impacted by the amortization of intangibles through our acquisition of CARD and Stargames.