XNAS:MGAM Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

XNAS:MGAM Fair Value Estimate
Premium
XNAS:MGAM Consider Buying
Premium
XNAS:MGAM Consider Selling
Premium
XNAS:MGAM Fair Value Uncertainty
Premium
XNAS:MGAM Economic Moat
Premium
XNAS:MGAM Stewardship
Premium
 


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-Q
(Mark One)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2012
OR
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ______ to ______
 
Commission File Number: 000-28318
 
Multimedia Games Holding Company, Inc.
(Exact name of Registrant as specified in its charter)
Texas
74-2611034
(State or other jurisdiction of incorporation or organization)
(IRS Employer Identification No.)
206 Wild Basin Road South, Building B
 
Austin, Texas
78746
(Address of principal executive offices)
(Zip Code)

(512) 334-7500
(Registrant’s telephone number, including area code)
 
(Former name, former address and former fiscal year, if changed since last report)
  
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 whether the Registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files): Yes x No o
 
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:
Large Accelerated Filer o
Accelerated Filer x
 
 
Non-Accelerated Filer o
Smaller Reporting Company 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 x

As of July 27, 2012, there were 27,810,242 shares of the Registrant’s common stock, par value $0.01 per share, outstanding.




FORM 10-Q
 
INDEX
 
PART I.  FINANCIAL INFORMATION
 
 
 
 
Item 1.
Financial Statements (Unaudited)
 
 
 
 
 
Condensed Consolidated Balance Sheets
 
 
(As of June 30, 2012 and September 30, 2011)
 
 
 
 
Condensed Consolidated Statements of Operations and Other Comprehensive Income
 
 
(For the three months ended June 30, 2012 and 2011)
 
 
 
 
Condensed Consolidated Statements of Operations and Other Comprehensive Income
 
 
(For the nine months ended June 30, 2012 and 2011)
 
 
 
 
Condensed Consolidated Statements of Cash Flows
 
 
(For the nine months ended June 30, 2012 and 2011)
 
 
 
 
Notes to Condensed Consolidated Financial Statements
 
 
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
 
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
 
 
 
Item 4.
Controls and Procedures
 
 
 
PART II.  OTHER INFORMATION
 
 
 
 
Item 1.
Legal Proceedings
 
 
 
Item 1A.
Risk Factors
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
 
 
Item 6.
Exhibits
 
 
 
Signatures
 
 
 
Exhibit Index
 


2



PART I
FINANCIAL INFORMATION
Item 1. Financial Statements

MULTIMEDIA GAMES HOLDING COMPANY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
As of June 30, 2012 and September 30, 2011
(In thousands, except shares)
(Unaudited)
 
 
June 30,
2012
 
September 30,
2011
ASSETS
 
 
 
 
CURRENT ASSETS:
 
 
 
 
Cash and cash equivalents
 
$
68,318

 
$
46,710

Accounts receivable, net of allowance for doubtful accounts of $339 and $400, respectively
 
16,704

 
16,004

Inventory
 
8,003

 
7,291

Prepaid expenses and other
 
2,775

 
5,300

Current portion of notes receivable, net
 
11,962

 
14,280

Federal and state income tax receivable
 
75

 
142

Total current assets
 
107,837

 
89,727

Property and equipment and leased gaming equipment, net
 
53,199

 
47,399

Long-term portion of notes receivable, net
 
826

 
10,449

Intangible assets, net
 
37,370

 
28,395

Value added tax receivable, net of allowance of $816 and $817, respectively
 
3,103

 
2,787

Other assets
 
2,017

 
2,471

Total assets
 
$
204,352

 
$
181,228

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
 

CURRENT LIABILITIES:
 
 

 
 

Current portion of long-term debt
 
$
3,700

 
$
3,700

Current portion of capital leases
 
141

 

Accounts payable and accrued liabilities
 
24,298

 
25,855

Federal income tax payable
 
418

 

Deferred revenue
 
936

 
1,131

Total current liabilities
 
29,493

 
30,686

Long-term debt, less current portion
 
30,525

 
33,300

Long-term capital leases, less current portion
 
340

 

Other long-term liabilities
 
618

 
679

Deferred revenue, less current portion
 
22

 
661

Total liabilities
 
60,998

 
65,326

Commitments and contingencies (Note 13)
 


 


Stockholders’ equity:
 
 

 
 

Preferred stock: Series A, $0.01 par value, 1,800,000 shares authorized, no shares issued and outstanding
 

 

Series B, $0.01 par value, 200,000 shares authorized, no shares issued and outstanding
 

 

Common stock, $0.01 par value, 75,000,000 shares authorized, 35,889,573 and 34,559,522 shares issued, and 27,769,295 and 26,832,065 shares outstanding, respectively
 
359

 
346

Additional paid-in capital
 
104,546

 
95,063

Treasury stock, 8,120,278 and 7,727,457 common shares at cost, respectively
 
(62,048
)
 
(60,164
)
Retained earnings
 
100,958

 
81,109

Accumulated other comprehensive loss, net
 
(461
)
 
(452
)
Total stockholders’ equity
 
143,354

 
115,902

Total liabilities and stockholders’ equity
 
$
204,352

 
$
181,228


The accompanying notes are an integral part of the condensed consolidated financial statements.

3



MULTIMEDIA GAMES HOLDING COMPANY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND OTHER COMPREHENSIVE INCOME
For the Three Months Ended June 30, 2012 and 2011
(In thousands, except per share data)
(Unaudited)
 
 
Three Months Ended
 
 
June 30,
 
 
2012
 
2011
REVENUES:
 
 
 
 
Gaming operations
 
$
28,419

 
$
24,557

Gaming equipment and system sales
 
11,665

 
8,525

Other
 
380

 
317

Total revenues
 
40,464

 
33,399

OPERATING COSTS AND EXPENSES:
 
 

 
 

Cost of gaming operations revenue(1)
 
2,175

 
2,364

Cost of equipment and system sales
 
4,894

 
3,760

Selling, general and administrative expenses
 
12,062

 
10,498

Write-off, reserve, impairment & settlement charges
 

 
634

Research and development
 
4,090

 
3,332

Amortization and depreciation
 
9,510

 
10,207

Total operating costs and expenses
 
32,731

 
30,795

Operating income
 
7,733

 
2,604

OTHER INCOME (EXPENSE):
 
 

 
 

Interest income
 
308

 
586

Interest expense
 
(330
)
 
(813
)
     Other Income (expense)
 
(10
)
 
213

Income before income taxes
 
7,701

 
2,590

Income tax (expense) benefit
 
(452
)
 
178

Net income
 
$
7,249

 
$
2,768

 
 
 
 
 
Basic income per common share
 
$
0.26

 
$
0.10

Diluted income per common share
 
$
0.25

 
$
0.10

 
 
 
 
 
Other comprehensive income:
 
 
 
 
Foreign Currency translation adjustments
 
(189
)
 
63

Comprehensive income
 
$
7,060

 
$
2,831

 
 
 
 
 
Shares used in net income per common share:
 
 

 
 

Basic
 
27,564

 
27,184

Diluted
 
29,275

 
27,813

________________________________
(1)
Cost of gaming operations revenue excludes depreciation and amortization of gaming equipment, content license rights and other depreciable assets, which are included separately in the amortization and depreciation line item.

The accompanying notes are an integral part of the condensed consolidated financial statements.


4



MULTIMEDIA GAMES HOLDING COMPANY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND OTHER COMPREHENSIVE INCOME
For the Nine Months Ended June 30, 2012 and 2011
(In thousands, except per share data)
(Unaudited)
 
 
Nine Months Ended
 
 
June 30,
 
 
2012
 
2011
REVENUES:
 
 
 
 
Gaming operations
 
$
82,363

 
$
69,978

Gaming equipment and system sales
 
31,372

 
21,035

Other
 
1,056

 
1,119

Total revenues
 
114,791

 
92,132

OPERATING COSTS AND EXPENSES:
 
 

 
 

Cost of gaming operations revenue(1)
 
6,479

 
6,575

Cost of equipment and system sales
 
13,227

 
10,386

Selling, general and administrative expenses
 
36,713

 
31,260

Write-off, reserve, impairment & settlement charges
 

 
837

Research and development
 
11,464

 
9,726

Amortization and depreciation
 
28,712

 
30,527

Total operating costs and expenses
 
96,595

 
89,311

Operating income
 
18,196

 
2,821

OTHER INCOME (EXPENSE):
 
 

 
 

Interest income
 
1,320

 
2,021

Interest expense
 
(1,059
)
 
(2,461
)
     Other Income
 
1,038

 
801

Income before income taxes
 
19,495

 
3,182

Income tax benefit (expense)
 
354

 
(608
)
Net income
 
$
19,849

 
$
2,574

 
 
 
 
 
Basic income per common share
 
$
0.72

 
$
0.09

Diluted income per common share
 
$
0.69

 
$
0.09

 
 
 
 
 
Other comprehensive income:
 
 
 
 
Foreign Currency translation adjustments
 
(9
)
 
686

Comprehensive income
 
$
19,840

 
$
3,260

 
 
 
 
 
Shares used in net income per common share:
 
 

 
 

Basic
 
27,621

 
27,963

Diluted
 
28,940

 
28,610

________________________________
(1)
Cost of gaming operations revenue excludes depreciation and amortization of gaming equipment, content license rights and other depreciable assets, which are included separately in the amortization and depreciation line item.

The accompanying notes are an integral part of the condensed consolidated financial statements.


5



MULTIMEDIA GAMES HOLDING COMPANY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Nine Months Ended June 30, 2012 and 2011
(In thousands)
(Unaudited)
 
Nine Months Ended
 
June 30,
 
2012
 
2011
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
19,849

 
$
2,574

Adjustments to reconcile net income to cash provided by operating activities:
 
 
 
Amortization and depreciation
28,712

 
30,527

Accretion of contract rights
5,752

 
5,269

Share-based compensation
2,668

 
1,295

Other non-cash items
1,052

 
486

Interest income from imputed interest
(1,084
)
 
(1,842
)
Changes in operating assets and liabilities
247

 
15,576

NET CASH PROVIDED BY OPERATING ACTIVITIES
57,196

 
53,885

 
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Acquisition of property and equipment and leased gaming equipment
(35,687
)
 
(26,903
)
Transfer of leased gaming equipment to inventory
3,876

 
1,164

Acquisition of intangible assets
(4,283
)
 
(3,431
)
Advances under development and placement fee agreements
(13,815
)
 
(800
)
Repayments under development agreements
11,933

 
10,747

NET CASH USED IN INVESTING ACTIVITIES
(37,976
)
 
(19,223
)
 
 
 
 
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from exercise of stock options
6,828

 
2,925

Principal payments of long term debt
(2,775
)
 
(562
)
Proceeds from capital lease
548

 

Principal payments of capital leases
(67
)
 

Purchase of treasury stock
(1,884
)
 
(10,036
)
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
2,650

 
(7,673
)
 
 
 
 
EFFECT OF EXCHANGE RATES ON CASH
(262
)
 
455

Net increase in cash and cash equivalents
21,608

 
27,444

Cash and cash equivalents, beginning of period
46,710

 
21,792

Cash and cash equivalents, end of period
68,318

 
49,236

 
 
 
 
SUPPLEMENTAL CASH FLOW DATA:
 

 
 

Interest paid
$
955

 
$
2,203

Income tax refunded, net
$
774

 
$
17,897

NON-CASH TRANSACTIONS:
 

 
 

Property and equipment acquired through capital lease
$
548

 
$

Change in contract rights resulting from imputed interest on development agreement notes receivable
$
12

 
$
93


The accompanying notes are an integral part of the condensed consolidated financial statements.

6





1.      SUMMARY OF COMPANY INFORMATION
 
Business
Multimedia Games Holding Company, Inc. and its subsidiaries (the “Company,” “we,” “us,” “our” or "Multimedia Games") design, manufacture and supply innovative standalone and networked gaming systems to Native American and commercial casino operators in North America, domestic and selected international lottery operators, and charity and commercial bingo gaming facility operators.  

The Company's standalone gaming machines are primarily sold and placed in Class III settings while its central determinant and server-based centrally-linked products and systems are primarily sold and placed in Class II, video lottery terminal and electronic bingo settings. The Company uses the term Class III to refer to traditional slot machines that are placed or sold in commercial jurisdictions as well as compact games located in various tribal gaming jurisdictions. The Class II market is generally understood as the game of chance commonly known as bingo (whether or not electronic, computer, or other technological aids are used in connection therewith) associated with Native American gaming in the United States.

Initially, the Company derived the majority of its revenues from its bingo games, including satellite linked, high stakes bingo games and interactive high speed bingo games played on interconnected electronic player stations placed in participating bingo halls owned primarily by Native American tribes. The Company has expanded its product line and markets served to include Class II and Class III gaming facilities operated by Native American and commercial casinos and derives the majority of its gaming revenues from participation and development agreements, both of which operate on a participation, or revenue share, basis. Under these agreements, the Company places player terminals and systems as well as its proprietary and other licensed game content at a customer's facility in return for a share of the revenues that these terminals and systems generate. In 2009, the Company once again expanded its product offering and began generating revenue from the sale of gaming units and systems that feature proprietary game content and game themes licensed from others. The Company continues to increase these for-sale revenues by expanding into additional gaming jurisdictions and into other segments of the gaming market. The Company also generates revenues by providing the central determinant system operated by the New York State Division of the Lottery for the video lottery terminals installed at racetracks in the State of New York.

Basis of Presentation and Principles of Consolidation
The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes contained within the Company’s Annual Report on Form 10-K for the year ended September 30, 2011. The unaudited condensed consolidated financial statements included herein as of June 30, 2012, and for each of the three- and nine-month periods ended June 30, 2012 and 2011, have been prepared by the Company pursuant to accounting principles generally accepted in the United States ("U.S. GAAP"), and the rules and regulations of the Securities and Exchange Commission ("SEC"). They do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The information presented reflects all adjustments consisting solely of normal recurring adjustments which are, in the opinion of management, considered necessary to present fairly the financial position, results of operations, and cash flows for the periods. Operating results for the period ended June 30, 2012 are not necessarily indicative of the results which will be realized for the year ending September 30, 2012. References to specific U.S. GAAP within this report cite topics within the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). We have evaluated all subsequent events through the date that the condensed consolidated financial statements were issued.  The condensed consolidated balance sheet as of September 30, 2011 was derived from the audited consolidated financial statements as of that date.

The Company currently operates in one business segment. The Company’s financial statements include the accounts of Multimedia Games Holding Company, Inc. and its wholly-owned subsidiaries: Multimedia Games, Inc., MGAM Systems, Inc., MegaBingo International, LLC, Multimedia Games de Mexico 1, S. de R.L. de C.V., and Servicios de Wild Basin S. de R.L. de C.V. Intercompany balances and transactions have been eliminated.

2.      SIGNIFICANT ACCOUNTING POLICIES
 
Accounting Estimates
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Examples include share-based compensation, provisions for doubtful accounts, recoverability of notes, value added tax and other receivable balances, provision for slow-moving or obsolete inventory, estimated useful lives of property and equipment and intangible assets, impairment of property and equipment and intangible assets, valuation of deferred income taxes, and the provision for and disclosure of litigation and loss contingencies. Actual results may differ materially from these estimates in the future.

7




Reclassification
Reclassifications were made to the prior-period financial statements to conform to the current period presentation.  Such reclassifications include the cash flow line item, "transfer of leased gaming equipment to inventory" from previously filed reports, which was combined with the cash flow line item "acquisitions of property and equipment and leased gaming equipment." The statements of operations had the following reclassifications: (i) "cost of gaming operations revenue" was reclassified from "cost of equipment and system sales" and "selling, general and administrative expenses"; (ii) "research and development" was reclassified from "selling, general and administrative expenses"; and (iii) foreign exchange gains and losses have been reclassified to "other income (expense)" from "selling, general and administrative expenses". These reclassifications did not have an impact on the Company’s previously reported results of operations or earnings per share amounts.  Additionally, these reclassifications did not impact compliance with any applicable debt covenants in the Company’s credit agreement.
 
Revenue Recognition
The Company derives revenue from the following sources:
 
n
Gaming Operations
 
Participation or lease revenue generated from the Company’s commercial products, Class III products, Native American Class II products, charity bingo and other bingo products, lottery systems, and Class III back office systems
n
Gaming Equipment and Systems Sales
 
Direct sales of player terminals, licenses, back office systems and other related equipment
n
Other
 
Maintenance and service arrangements and other
 
In accordance with the provision of ASC Topic 605, “Revenue Recognition,” the Company recognizes revenue when all of the following have been satisfied:
 
Persuasive evidence of an arrangement exists;
Delivery has occurred;
Price to the buyer is fixed or determinable; and
Collectibility is probable.
 
Gaming Operations
The majority of the Company’s gaming revenue is generated by its gaming operations under development and lease participation arrangements where the Company provides its customers with player terminals, player terminal-content licenses and back-office equipment, collectively referred to herein as leased gaming equipment. Under these arrangements, the Company retains ownership of the leased gaming equipment installed at customer facilities, and the Company receives revenue based on a percentage of the net win per day generated by the leased gaming equipment or a fixed daily fee based on the number of player terminals installed at the facility. Revenue from lease participation or daily fee arrangements are considered both realizable and earned at the end of each gaming day.

Gaming revenue generated by player terminals deployed at sites under development or placement fee agreements is reduced by the accretion of contract rights from those agreements. Contract rights are amounts allocated to intangible assets for dedicated floor space resulting from such agreements, described under “Development and Placement Fee Agreements.” The related amortization expense, or accretion of contract rights, is netted against its respective revenue category in the condensed consolidated statements of operations.
 
The Company also generates gaming revenues from back-office fees with certain customers. Back-office fees cover the service and maintenance costs for back-office servers installed in each gaming facility to run its gaming equipment, as well as the cost of related software updates. Back-office fees are considered both realizable and earned at the end of each gaming day.
 
Gaming Equipment and System Sales
The Company sells gaming equipment and gaming systems directly to its customers under independent sales contracts through normal credit terms or may grant extended credit terms under contracts secured by the related equipment, with interest recognized at market rates.
 
For sales arrangements with multiple deliverables, the Company applies the guidance from ASU No. 2009-13, “Revenue Recognition (Topic 605), Multiple-Deliverable Revenue Arrangements.”  ASU No. 2009-13 establishes the accounting and reporting guidance for arrangements under which the vendor will perform multiple revenue-generating activities; specifically, how to separate deliverables and how to measure and allocate arrangement consideration to one or more units of accounting.  In

8



addition, the Company applies the guidance from ASU No. 2009-14, “Software (Topic 985), Certain Revenue Arrangements that Include Software Elements,” which affects vendors that sell or lease tangible products in an arrangement that contains software that is more than incidental to the tangible product as a whole and clarifies what guidance should be used in allocating and measuring revenue.  
 
The majority of the Company’s multiple element sales contracts are for some combination of gaming equipment, player terminals, content, system software, license fees, and maintenance. ASU No. 2009-13 states that revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables meet both of the following criteria:

The delivered items have value to the customer on a stand-alone basis. The item or items have value on a stand-alone basis if they are sold separately by any vendor or the customer could resell the delivered item(s) on a stand-alone basis. In the context of a customer's ability to resell the delivered item(s), this criterion does not require the existence of an observable market for the deliverable(s); and

If the arrangement includes a general right of return relative to the delivered items, delivery or performance of the undelivered items is considered probable and substantially in the control of the vendor.

ASU No 2009-13 requires that arrangement consideration be allocated, at the inception of the arrangement, to all deliverables based on their relative selling price (i.e., the relative selling price method). When applying the relative selling price method, a hierarchy is used for estimating the selling price based first on Vendor-Specific Objective Evidence, or VSOE, then Third-Party Evidence, or TPE, and finally management's Estimate of the Selling Price, or ESP.

Revenue related to systems arrangements that contain both software and non-software deliverables requires allocation of the arrangement fee to the separate deliverables using the relative selling price method. Revenue for software deliverables is recognized under software revenue recognition guidance. Revenue resulting from the sale of non-software deliverables, such as gaming devices and other hardware, are accounted for based on other applicable revenue recognition guidance as the devices are tangible products containing both software and non-software components that function together to deliver the product's essential functionality.

In allocating the arrangement fees to separate deliverables, the Company evaluates whether it has VSOE of selling price, TPE or ESP for gaming devices, maintenance and product support fees and other revenue sources. The Company generally uses ESP to determine the selling price used in the allocation of separate deliverables, as VSOE and TPE are not available. The Company determines the ESP on separate deliverables by estimating a margin typically received on such items and applying that margin to the product cost incurred.

Cash and Cash Equivalents
The Company considers all highly liquid investments (i.e., investments which, when purchased, have original maturities of three months or less) to be cash equivalents.

Allowance for Doubtful Accounts
The Company maintains an allowance for doubtful accounts related to its accounts receivable and notes receivable that have been deemed to have a high risk of uncollectibility. Management reviews its accounts receivable and notes receivable on a quarterly basis to determine if any receivables will potentially be uncollectible. Management analyzes historical collection trends and changes in its customer payment patterns, customer concentration, and creditworthiness when evaluating the adequacy of its allowance for doubtful accounts. In its overall allowance for doubtful accounts, the Company includes any receivable balances where uncertainty exists as to whether the account balance has become uncollectible. Based on the information available, management believes the allowance for doubtful accounts is adequate; however, actual write-offs might exceed the recorded allowance.
 
Inventory
The Company’s inventory consists primarily of completed player terminals, related component parts, and back-office computer equipment. Inventories are stated at average costs, which approximate the lower of cost (first in, first out) or market.

Property and Equipment and Leased Gaming Equipment
Property and equipment and leased gaming equipment are stated at cost. The cost of property and equipment and leased gaming equipment is depreciated over their estimated useful lives, generally using the straight-line method for financial reporting, and regulatory acceptable methods for income tax reporting purposes. Player terminals and related components and equipment are included in the Company’s rental pool.  The rental pool can be further delineated as “rental pool – deployed,” which consists of assets deployed at customer sites under participation agreements, and “rental pool – undeployed,” which consists of assets with the Company that are available for customer use. Rental pool – undeployed consists of both new units awaiting deployment to a customer site and previously deployed units currently back with the Company to be refurbished awaiting re-deployment.  Routine

9



maintenance of property and equipment and leased gaming equipment is expensed in the period incurred, while major component upgrades are capitalized and depreciated over the estimated remaining useful life of the component. Sales and retirements of depreciable property are recorded by removing the related cost and accumulated depreciation from the accounts. Gains or losses on sales and retirements of property are reflected in the Company’s results of operations.
 
Management reviews long-lived asset classes for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to its fair value, which considers the future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment recognized is measured by the amount by which the carrying amount of the assets exceeds their fair value. Assets to be disposed of are reported at the lower of the carrying amount or the fair value less costs of disposal. During the three-month periods ended June 30, 2012 and 2011, in the ordinary course of business activities or upon reviewing the nature of the assets, the Company charged operations by recording reserves or writing off $40,000 and $113,000, respectively, of property and equipment and leased gaming equipment.

Development and Placement Fee Agreements
The Company enters into development and placement fee agreements to provide financing for new gaming facilities or for the expansion of existing facilities. All or a portion of the funds provided under development agreements are reimbursed to the Company, while funding under placement fee agreements is not reimbursed. In return, the facility dedicates a percentage of its floor space to placement of the Company's player terminals, and the Company receives a fixed percentage of those player terminals' hold per day over the term of the agreement which is generally for 12 to 83 months. Certain of the agreements contain player terminal performance standards that could allow the facility to reduce a portion of the Company's guaranteed floor space. In addition, certain development agreements allow the facilities to buy out floor space after advances that are subject to repayment have been repaid. The agreements typically provide for a portion of the amounts retained by the gaming facility for their share of the operating profits of the facility to be used to repay some or all of the advances recorded as notes receivable. Placement fees and amounts advanced in excess of those to be reimbursed by the customer for real property and land improvements are allocated to intangible assets and are generally amortized over the term of the contract, which is recorded as a reduction of revenue generated from the gaming facility. In the past and in the future, the Company may by mutual agreement, amend these contracts to reduce its floor space at the facilities. Any proceeds received for the reduction of floor space is first applied against the intangible asset recovered for that particular development or placement fee agreement, if any, and the remaining net book value of the intangible asset is prospectively amortized on a straight-line method over the remaining estimated useful life.

Other Assets
Other assets consist of restricted cash, long-term prepaids, and refundable deposits. At June 30, 2012 and September 30, 2011, the restricted cash balances were $618,000 and $679,000, respectively, representing the fair value of investments held by the Company's prize fulfillment firm related to outstanding MegaBingo® jackpot prizes.
 
Deferred Revenue
Deferred revenue represents amounts from the sale of gaming equipment and systems that have been billed, or for which notes receivable have been executed, but which transaction has not met the Company’s revenue recognition criteria. The cost of the related gaming equipment and systems has been offset against deferred revenue. Amounts are classified between current and long-term liabilities, based upon the expected period in which the revenue will be recognized.
 
Other Long-Term Liabilities
Other long-term liabilities include investments held at fair value by the Company’s prize-fulfillment firm related to outstanding MegaBingo jackpot-prize-winner annuities.  These annuities were $618,000 and $679,000 as of June 30, 2012 and September 30, 2011, respectively.
 
Other Income
Other income (expense) was an expense of $10,000 and income of $1.0 million for the three- and nine-month periods ended June 30, 2012, respectively, and income of $213,000 and $801,000 for the three- and nine-month periods ended June 30, 2011, respectively. Other income primarily resulted from a gain on the exchange of used equipment with our third party equipment suppliers, as well as net gains or losses incurred on foreign currency transactions primarily related to our Mexico operations.

Research and Development Costs
We conduct research and development activities primarily to develop new gaming systems, gaming engines, casino data management systems, casino central monitoring systems, video lottery outcome determination systems, gaming platforms, and gaming content and to add enhancements to our existing product lines. We believe our ability to deliver differentiated, appealing products and services to the marketplace is based in our research and development investments, and we expect to continue to make such investments in the future. These research and development costs consist primarily of salaries and benefits, consulting fees,

10



game lab testing fees, and an allocation of corporate facilities costs related to these activities. Once the technological feasibility of a project has been established, it is transferred from research to development, and capitalization of development costs begins until the product is available for general release. Research and development costs were $4.1 million and $11.5 million for the three- and nine-month periods ended June 30, 2012, respectively, and $3.3 million and $9.7 million for the three- and nine-month periods ended June 30, 2011, respectively.

Fair Value of Financial Instruments
The carrying value of financial instruments reported in the accompanying condensed consolidated balance sheets for cash, accounts receivable, current portion of notes receivable, accounts payable, and accrued expenses payable and other liabilities, approximate fair value due to the immediate or short-term nature or maturity of these financial instruments. The carrying amount for our credit facility approximates fair value due to the fact that the underlying instrument includes provisions to adjust interest rates to approximate fair value.
 
Segment and Related Information
Although the Company has a number of operating divisions, the Company reports as one segment, as these divisions meet the criteria for aggregation as permitted by ASC Topic 280, “Segment Reporting.”  ASC 280-10-50-11, “Aggregation Criteria,” allows for the aggregation of operating segments if the segments have similar economic characteristics and if the segments are similar in each of the following areas:
 
1.
The nature of the products and services
2.
The nature of the production processes
3.
The type or class of customer for their products and services
4.
The methods used to distribute their products or provide their services
5.
The nature of the regulatory environment, if applicable

The Company is engaged in the business of designing, manufacturing, and distributing gaming machines, video lottery terminals, and associated systems and equipment, as well as the maintenance of these machines and equipment.   The Company also supplies the central determinant system for the video lottery terminals installed at racetracks in the State of New York. Our production process is essentially the same for the entire Company and is performed via outsourced manufacturing partners, as well as in-house manufacturing performed primarily at our warehouse and assembly facility in Austin, Texas.  Our customers consist of entities in the business of operating gaming, bingo or lottery facilities, and include Native American Tribes, charity bingo operators, and commercial entities licensed to conduct such business in their jurisdictions.  The distribution of our products is consistent across the entire Company and is generally performed by third-party transportation companies.  The regulatory environment is similar in every jurisdiction in that gaming is regulated and our games must meet the regulatory requirements established.  In addition, the economic characteristics of each customer arrangement are similar in that we obtain revenue via a revenue share arrangement or direct sale of product or service, depending on the customer’s need.  These sources of revenue are consistent with respect to both product line and geographic area.

In addition, discrete financial information, such as costs and expenses, operating income, net income and EBITDA (earnings before interest expense, income taxes, depreciation, amortization, and accretion of contract rights), are not captured or analyzed by product line or geographic area.  Our Chief Operating Decision Maker analyzes our product performance based on average daily play on a game level basis, which is consistent across all product lines and geographic areas.  This average daily performance data along with customer needs are the key drivers for assessing how the Company allocates resources and assesses its operating performance.
 
Costs of Computer Software
Software development costs have been accounted for in accordance with ASC Topic 985, “Software.”  Under ASC Topic 985, capitalization of software development costs begins upon the establishment of technological feasibility and prior to the availability of the product for general release to customers. The Company capitalized software development costs of approximately $1.5 million and $1.3 million during the three-month periods ended June 30, 2012 and 2011, respectively, and $4.1 million and $3.3 million during the nine-month periods ended June 30, 2012 and 2011, respectively. Software development costs primarily consist of personnel costs and gaming lab testing fees. The Company begins to amortize capitalized costs when a product is available for general release to customers. Amortization expense is determined on a product-by-product basis at a rate not less than straight-line basis over the product’s remaining estimated economic life, not to exceed five years. Amortization of software development costs is included in amortization and depreciation in the accompanying condensed consolidated statements of operations.
 
Income Taxes
The Company accounts for income taxes using the asset and liability method and applies the provisions of ASC Topic 740, “Income Taxes.” Under ASC Topic 740, deferred tax liabilities or assets arise from differences between the tax basis of liabilities or assets and their basis for financial reporting, and are subject to tests of recoverability in the case of deferred tax assets. Deferred tax

11



assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is provided for deferred tax assets to the extent realization is not judged to be more likely than not.  Additionally, in accordance with ASC Topic 740, in order to record any financial statement benefit, we are required to determine, based on the technical merits of the position, whether it is more likely than not (a likelihood of more than 50 percent) that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes. If that step is satisfied, then we must measure the tax position to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.

Treasury Stock
The Company utilizes the cost method when accounting for its treasury stock acquisitions and dispositions.
 
Share-Based Compensation
The Company accounts for share-based compensation under the provisions of ASC Topic 718, “Compensation – Stock Compensation.” Among other items, ASC Topic 718 requires the Company to recognize in the financial statements, the cost of employee services received in exchange for awards of equity instruments, based on the grant date fair value of those awards. To measure the fair value of stock option awards granted to employees, the Company currently utilizes the Black-Scholes-Merton option-pricing model. The Company applies the “modified prospective” method, under which compensation cost is recognized in the financial statements beginning with the adoption date for all share-based payments granted after that date, and for all unvested awards granted prior to the adoption date.  Expense is recognized over the required service period, which is generally the vesting period of the options.
 
The Black-Scholes-Merton model incorporates various assumptions, including expected volatility, expected life, and risk-free interest rates. The expected volatility is based on the historical volatility of the Company’s common stock over the most recent period commensurate with the estimated expected life of the Company’s stock options, adjusted for the impact of unusual fluctuations not reasonably expected to recur. The expected life of an award is based on historical experience and on the terms and conditions of the stock awards granted to employees.
 
The Company granted to certain of its employees the option to purchase, in the aggregate, 5,100 shares of the Company's common stock during the three months ended June 30, 2012 at an average fair value per share price of $11.82. Total pretax share-based compensation for the three- and nine-month periods ended June 30, 2012 were $1.2 million and $2.7 million, respectively. Total pretax share-based compensation for the three- and nine-month periods ended June 30, 2011 were $313,000 and $1.3 million, respectively.

In the three-month periods ended June 30, 2012 and 2011, the Company did not recognize an income tax benefit for stock-based compensation arrangements as we determined that it is more likely than not that we will not be able to realize the benefit of deferred tax assets in the foreseeable future. As of June 30, 2012, $5.3 million of unamortized stock compensation expense, including estimated forfeitures, remained, which will be recognized over the vesting periods of the various stock option grants.
 
Foreign Currency Translation
The Company accounts for currency translation in accordance with ASC Topic 830, “Foreign Currency Matters.”  Balance sheet accounts are translated at the exchange rate in effect at each balance sheet date. Income statement accounts are translated at the average rate of exchange prevailing during the period. Translation adjustments resulting from this process are charged or credited to other comprehensive income (loss) a component of shareholder equity, in accordance with ASC Topic 220, “Comprehensive Income.” Transactional currency gains and losses arising from transactions in currencies other than the Company’s local functional currency are included in the condensed consolidated statement of operations in accordance with ASC Topic 830.

Recent Accounting Pronouncements Issued
In April 2010, the FASB issued new accounting guidance related to accruals for casino jackpot liabilities. Specifically, the guidance clarifies that an entity should not accrue jackpot liabilities, or portions thereof, before a jackpot is won if the entity can avoid paying the jackpot. Jackpots should be accrued and charged to revenue when an entity has the obligation to pay the jackpot. The guidance applies to both base and progressive jackpots. The new guidance is effective for fiscal years beginning on or after December 15, 2010. The Company adopted the guidance as of October 1, 2011, and it did not have a material impact on its consolidated results of operations, financial position or cash flows.

In April 2011, the FASB issued Accounting Standards Update (ASU) No. 2011-02, "Receivables (Topic 310) - A Creditor's Determination of Whether a Restructuring is a Troubled Debt Restructuring" (ASU 2011-02). The guidance clarifies whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties for purposes of determining whether

12



a restructuring is a troubled debt restructuring. The new guidance is effective for interim or annual periods beginning after June 15, 2011. The Company adopted the guidance as of October 1, 2011, and it did not have a material impact on its consolidated results of operations, financial position and cash flows.

In May 2011, the FASB issued Accounting Standards Update (ASU) No. 2011-04, "Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS" (ASU 2011-04). The guidance improves the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRS. The new guidance was effective for interim or annual periods beginning after December 15, 2011. The Company adopted the guidance as of October 1, 2011, and it did not have a material impact on its consolidated results of operations, financial position and cash flows.

In June 2011, the FASB issued Accounting Standards Update (ASU) No. 2011-05, "Comprehensive Income (Topic 220) - Presentation of Comprehensive Income" (ASU 2011-05). The guidance improves the comparability, consistency, and transparency of financial reporting and increases the prominence of items reported in comprehensive income, while facilitating the convergence of U.S. GAAP and IFRS. The guidance eliminates the option to present components of other comprehensive income as part of the statement of stockholders' equity, and instead requires a single continuous statement of comprehensive income as part of the statement of operations or a separate, but continuous, statement of other comprehensive income. The new guidance was effective for interim or annual periods beginning after December 15, 2011. The Company adopted the guidance as of January 1, 2012, and it did not have a material impact on its consolidated results of operations, financial position or cash flows, other than the presentation thereof.
 
3.  DEVELOPMENT AND PLACEMENT FEE AGREEMENTS

The Company enters into development and placement fee agreements to provide financing for new gaming facilities or for the expansion or improvement of existing facilities. All or a portion of the funds provided under development agreements are reimbursed to the Company, while funding under placement fee agreements is not reimbursed. In return, the facility dedicates a percentage of its floor space to placement of the Company's player terminals, and the Company receives a fixed percentage of those player terminals' hold per day over the term of the agreement which is generally for 12 to 83 months. Certain of the agreements contain player terminal performance standards that could allow the facility to reduce a portion of the Company's guaranteed floor space. In addition, certain development agreements allow the facilities to buy out floor space after advances that are subject to repayment have been repaid. The agreements typically provide for a portion of the amounts retained by the gaming facility for their share of the operating profits of the facility to be used to repay some or all of the advances recorded as notes receivable. Placement fees and amounts advanced in excess of those to be reimbursed by the customer for real property and land improvements are allocated to intangible assets and are generally amortized over the term of the contract, which is recorded as a reduction of revenue generated from the gaming facility. In the past and in the future, the Company may, by mutual agreement, amend these contracts to reduce its floor space at the facilities. Any proceeds received for the reduction of floor space is first applied against the intangible asset recovered for that particular development or placement fee agreement, if any, and the remaining net book value of the intangible asset is prospectively amortized on a straight-line method over the remaining estimated useful life.

On January 18, 2012, the Company announced that it had extended 1,709 unit placements, or 85% of the 2,009 units currently installed on a revenue sharing basis, at WinStar World Casino and Riverwind Casino operated by the Chickasaw Nation in Oklahoma, for an additional 3.5 years subsequent to the respective future end dates of the original unit placement agreements which occur in the second half of Fiscal 2013.  In consideration of the long-term unit placement extensions, the Company paid unit placement fees of $13.2 million to the Chickasaw Nation.  The Company also agreed to reduce its revenue share percentage on approximately 1,000 units at WinStar World Casino with two pricing adjustments on July 16, 2013 and August 1, 2014, bringing the revenue share percentage on these units in line with the Company's other units deployed within the Chickasaw Nation's gaming facilities.

Management reviews intangible assets related to development and placement fee agreements for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. There were no events or changes in circumstances during the three- and nine-month periods ended June 30, 2012, which required an impairment charge to the carrying value of intangible assets recorded in connection with development and placement fee agreements.  

The following net amounts related to advances made under development and placement fee agreements and were recorded in the following balance sheet captions:
 

13



 
 
June 30,
2012
 
September 30,
2011
Included in:
 
(In thousands)
Notes receivable, net
 
$
11,827

 
$
22,689

Intangible assets – contract rights, net of accumulated amortization
 
$
30,771

 
$
22,697


4.      INVENTORY
 
Inventory consisted of the following (in thousands):
 
 
 
June 30,
2012
 
September 30,
2011
Raw materials and component parts, net
 
$
3,874

 
$
4,971

Work in progress
 
2,511

 
705

Finished goods
 
1,618

 
1,615

Total Inventory
 
$
8,003

 
$
7,291

  
5.      PROPERTY AND EQUIPMENT AND LEASED GAMING EQUIPMENT
 
The Company’s property and equipment and leased gaming equipment consisted of the following (in thousands):
 
 
 
June 30, 2012
 
September 30, 2011
 
 
Cost
 
Accum. Depr.
 
Net Book Value
 
Cost
 
Accum. Depr.
 
Net Book Value
Rental pool – deployed
 
$
166,675

 
$
(123,891
)
 
$
42,784

 
$
167,021

 
$
(128,965
)
 
$
38,056

Rental pool – undeployed (1)
 
48,335

 
(44,128
)
 
4,207

 
77,505

 
(71,068
)
 
6,437

Machinery and equipment
 
10,873

 
(8,443
)
 
2,430

 
12,109

 
(11,041
)
 
1,068

Computer software
 
7,697

 
(6,435
)
 
1,262

 
7,078

 
(6,239
)
 
839

Vehicles
 
2,341

 
(1,438
)
 
903

 
2,215

 
(1,747
)
 
468

Other
 
4,451

 
(2,838
)
 
1,613

 
3,166

 
(2,635
)
 
531

Total property and equipment and leased gaming equipment
 
$
240,372

 
$
(187,173
)
 
$
53,199

 
$
269,094

 
$
(221,695
)
 
$
47,399

______________________________________ 
(1)
Gaming equipment and third-party gaming content licenses begin depreciating when they are available for customer use.
 
In accordance with ASC Topic 360, “Property, Plant, and Equipment,” the Company (i) recognizes an impairment loss only if the carrying amount of a long-lived asset is not recoverable from its undiscounted cash flows; and (ii) measures an impairment loss as the difference between the carrying amount and fair value of the asset. During the three and nine month periods ended June 30, 2012, the Company did not experience a triggering event that would have caused an impairment analysis assessment.
 
During the three and nine month periods ended June 30, 2012, in the ordinary course of business activities or upon reviewing the nature of the assets, the Company disposed or wrote off $40,000 and $631,000, respectively, of third-party gaming content licenses, Native American tribal gaming facilities and portable buildings, vehicles, deployed gaming equipment, or other equipment. In the same periods ended June 30, 2011, the Company disposed or wrote off $113,000 and $378,000, respectively. During the three and nine month periods ended June 30, 2012, the Company sold $1.4 million and $3.9 million, respectively, previously deployed gaming equipment, or other equipment. In the same periods ended June 30, 2011, the Company sold $521,000 and $1.2 million respectively.

The rental pool includes leased gaming equipment that are either placed under participation arrangements at customer facilities (rental pool – deployed) or warehoused by the Company for future deployment (rental pool – undeployed).
 




14



6.      INTANGIBLE ASSETS
 
The Company’s intangible assets consisted of the following (in thousands):
 
 
 
June 30,
2012
 
September 30,
2011
 
Estimated
Useful
Lives
 
 
Cost
Accum. Amort.
Net Book Value
 
Cost
Accum. Amort.
Net Book Value
 
 
Contract rights under development and placement fee agreements
 
$
58,468

$
(27,697
)
$
30,771

 
$
50,483

$
(27,785
)
$
22,698

 
1-7 years
Internally-developed gaming software
 
39,895

(33,925
)
5,970

 
35,904

(30,970
)
4,934

 
1-5 years
Patents and trademarks
 
7,070

(6,441
)
629

 
6,920

(6,157
)
763

 
1-5 years
Other
 
250

(250
)

 
250

(250
)

 
3-5 years
Total intangible assets, net
 
$
105,683

$
(68,313
)
$
37,370

 
$
93,557

$
(65,162
)
$
28,395

 
 
 
Contract rights are amounts allocated to intangible assets for dedicated floor space resulting from development agreements or placement fees. The related amortization expense, or accretion of contract rights, is netted against its respective revenue category in the accompanying condensed consolidated statements of operations.
 
Internally developed gaming software is accounted for under the provisions of ASC Topic 985 “Software” and is stated at cost, which is amortized over the estimated useful life of the software, generally using the straight-line method. The Company amortizes internally-developed games over a twelve month period, gaming engines over an eighteen month period, gaming systems over a three-year period, and its central management systems over a five-year period. Software development costs are capitalized once technological feasibility has been established, and are amortized when the software is placed into service. Any subsequent software maintenance costs, such as bug fixes and subsequent testing, are expensed as incurred. Discontinued software development costs are expensed when the determination to discontinue is made. For the three and nine-month periods ended June 30, 2012, amortization expense related to internally-developed gaming software was $1.0 million and $3.1 million, respectively, and $763,000 and $2.4 million, respectively, for the three- and nine-month periods ended June 30, 2011. During the three- and nine-month periods ended June 30, 2012, the Company had write-offs related to internally-developed gaming software and patents and trademarks of $6,000 and $48,000, respectively, compared to write-offs of $56,000 and $86,000, for the three- and nine-month periods ended June 30, 2011.

Management reviews intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. No triggering events were identified for the three and nine-month periods ended June 30, 2012.
 
7.      NOTES RECEIVABLE
 
The Company’s notes receivable consisted of the following:
 
 
 
June 30,
2012
 
September 30,
2011
 
 
(In thousands)
Notes receivable from development agreements
 
$
12,439

 
$
24,372

Less imputed interest discount reclassed to contract rights
 
(612
)
 
(1,684
)
Notes receivable from equipment sales and other
 
961

 
2,041

Notes receivable, net
 
12,788

 
24,729

Less current portion
 
(11,962
)
 
(14,280
)
Notes receivable – non-current
 
$
826

 
$
10,449

 
Notes receivable from development agreements are generated from reimbursable amounts advanced under development agreements.  Notes receivable from equipment sales consisted of financial instruments issued by customers for the purchase of player terminals and licenses, and bore interest at 2.61% at June 30, 2012. All of the Company’s notes receivable from equipment sales are collateralized by the related equipment sold, although the fair market value of such equipment, if repossessed, may be

15



less than the note receivable outstanding.
 
8.  VALUE ADDED TAX RECEIVABLE
 
The Company's value added tax (VAT) receivable is a receivable from the Mexican taxing authority primarily related to a value added tax levied on product shipments originating outside of Mexico.  At June 30, 2012 and September 30, 2011, the Company’s VAT receivable was $3.1 million and $2.8 million, respectively.  The majority of the VAT receivable relates to equipment shipments that occurred in 2006 and 2007. 
 
The Company has received rulings from the Mexican taxing authority for 2006 and 2007 indicating that the Mexican taxing authority has challenged the registration of certain of the Company's transactions that have generated a VAT receivable of approximately $383,000, all of which has been fully reserved.  Although the Company has fully reserved this amount, it has formally contested these rulings, and continues to believe it has the necessary evidence for a reasonable defense. However, the final resolution of the contested balances remains uncertain and may adversely affect the carrying value of the receivable and may have an adverse effect on the Company's foreign income tax expense. See Note 13 of the Notes to Condensed Consolidated Financial Statements "Commitments and Contingencies."
 
9.  ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
 
The Company’s accounts payable and accrued liabilities consisted of the following:
 
 
 
June 30,
2012
 
September 30,
2011
 
 
(In thousands)
Trade accounts payable
 
$
7,898

 
$
8,781

Accrued expenses
 
6,889

 
7,222

Accrued bonus and salaries
 
6,192

 
5,622

Marketing reserve
 
2,399

 
2,749

Other
 
920

 
1,481

Accounts payable and accrued liabilities
 
$
24,298

 
$
25,855

 
10.      CREDIT AGREEMENT, LONG-TERM DEBT, AND CAPITAL LEASES
 
The Company’s Credit Agreement, long-term debt consisted of the following:
 
 
 
June 30, 2012
 
September 30,
2011
 
 
(In thousands)
Term loan facility
 
$
34,225

 
$
37,000

Less: current portion of long-term debt
 
(3,700
)
 
(3,700
)
Long-term debt, less current portion
 
$
30,525

 
$
33,300



On August 3, 2011, the Company entered into an amended and restated credit agreement with Comerica Bank in its capacity as administrative agent and lead arranger and Wells Fargo Bank, N.A., as syndication agent (the "Amended Credit Agreement") to provide the Company a $74.0 million credit facility which replaced its previous credit facility in its entirety. The Amended Credit Agreement consists of three facilities: an approximately $20.6 million revolving credit facility, a $37.0 million term loan, and an approximately $16.4 million draw-to term loan. The Amended Credit Agreement, and advances made thereunder, matures on August 3, 2016. The term loan is amortized on a straight-line basis over a ten-year period, payable in equal quarterly installments of $925,000. The revolving credit facility and the draw-to term loan provide the Company the ability to finance development and placement agreements, acquisitions, and working capital for general corporate purposes.

The components of the Amended Credit Agreement will be priced based on an applicable margin grid according to the Company's leverage ratio. Assuming that the Company utilizes LIBOR as the key interest rate driver the following margins would apply based on the applicable leverage ratio:

16




 
Level I
Level II
Consolidated Total Leverage Ratio
Less than 0.75 to 1.00
Greater than or equal to 0.75 to 1.00
Term loan
3.00
3.50
Revolving credit facility
2.25
2.75
Draw-to term loan
3.00
3.50

The Company obtained Level I pricing on December 5, 2011 upon delivering its financial statements for the year ended September 30, 2011.

The Amended Credit Agreement is collateralized by substantially all of the Company’s assets. The Company is subject to two primary financial covenants: a total leverage ratio and a fixed charge coverage ratio. The total leverage ratio is calculated as total net funded debt to EBITDA (which is defined as net income before interest expense, tax expense, depreciation and amortization expense, stock compensation expense and any extraordinary, unusual or non-cash non-recurring expenses up to $7.5 million for any trailing twelve month period, less any non-cash income items, including income tax credits, and any extraordinary income or gains). Total net funded debt is defined as total funded debt of the Company less unrestricted cash in excess of $10.0 million. The Company will be required to maintain a total leverage ratio of 1.5 to 1.0.

The fixed charge coverage ratio is calculated as EBITDA minus:

Income tax expense
Dividends or other distributions on equity, not funded by the Amended Credit Agreement
Routine capital expenditures, defined as $2.5 million per quarter
Repurchases or redemptions of capital stock, not funded by the Amended Credit Agreement
Payments and advances under development agreements, not funded by the Amended Credit Agreement

compared to fixed charges, which include interest expense and all regularly scheduled installments of principal. The Company is required to maintain a fixed charge coverage ratio of 1.2 to 1.0.

As of June 30, 2012, the Company was in compliance with all loan covenants, the $34.2 million term loan bore interest at 3.24% and the Company had approximately $37.0 million available under the Amended Credit Agreement, subject to covenant restrictions. Availability under the Amended Credit Agreement is reduced to the extent of a $3.5 million outstanding letter of credit.

Capital lease obligations represent various three-to-five-year loans for the purchase of automobiles and property and equipment totaling approximately $481,000.

11.    INCOME PER COMMON SHARE
 
Income per common share is computed in accordance with ASC Topic 260, “Earnings per Share.” Presented below is a reconciliation of net income available to common shareholders and the differences between weighted average common shares outstanding, which are used in computing basic income per share, and weighted average common and potential shares outstanding, which are used in computing diluted income per share.
 

17



 
 
Three months ended
 
Nine months ended
 
 
June 30,
 
June 30,
 
 
2012
2011
 
2012
2011
Net income available to common shareholders (in thousands)
 
$
7,249

$
2,768

 
$
19,849

$
2,574

Weighted average common shares outstanding
 
27,564,055

27,184,248

 
27,620,817

27,963,097

Effect of dilutive securities:
 
 

 

 
 
 
Options
 
1,711,298

628,606

 
1,319,482

646,465

Weighted average common
and potential shares outstanding
 
29,275,353

27,812,854

 
28,940,299

28,609,562

Basic income per share
 
$
0.26

$
0.10

 
$
0.72

$
0.09

Diluted income per share
 
$
0.25

$
0.10

 
$
0.69

$
0.09


In the three- and nine-month periods ended June 30, 2012, options to purchase approximately 272,167 and 896,033 shares of common stock, with exercise prices ranging from $10.00 to $18.71 for the three month period and $6.73 to $18.71 for the nine-month period ended June 30, 2012, were not included in the computation of dilutive income per share, due to their antidilutive effect.
 
In the three- and nine-month periods ended June 30, 2011, options to purchase approximately 3.7 million and 3.6 million shares of common stock, with exercise prices ranging from $3.69 to $18.71 for the three-month period and$3.50 to $18.71 for the nine-month period, respectively, were not included in the computation of dilutive income per share, due to their antidilutive effect.
  
12.    COMMON STOCK REPURCHASE PROGRAM

On December 3, 2010, the Company announced that its Board of Directors had authorized the repurchase of $15.0 million of its common stock over the next three-year period. During the three-month period ended June 30, 2012, the Company purchased no shares of its common stock. During the nine month period ended June 30, 2012, the Company purchased 392,821 shares of its common stock for approximately $1.9 million at an average cost of $4.78 per share, exclusive of broker fees. From inception of the program through June 30, 2012, the Company has purchased approximately 2.2 million shares of its common stock for $11.9 million at an average cost of $5.36 per share, exclusive of broker fees. At June 30, 2012, approximately $3.1 million remained on the repurchase authorization. The share repurchase program is subject to the Company's Amended Credit Agreement and a 10b5-1 plan, in which purchases may be made from time to time in the open market, subject to certain pricing parameters.

13.      COMMITMENTS AND CONTINGENCIES
 
Litigation and Regulatory Proceedings
 
The Company is subject to the possibility of loss contingencies arising in its business and such contingencies are accounted for in accordance with ASC Topic 450, “Contingencies.” In determining loss contingencies, the Company considers the possibility of a loss as well as the ability to reasonably estimate the amount of such loss or liability. An estimated loss is recorded when it is considered probable that a liability has been incurred and when the amount of loss can be reasonably estimated.
 
The Company is the subject of various pending and threatened claims in the ordinary course of business. The Company believes that any liability resulting from these various other claims will not have a material adverse effect on its results of operations, financial condition, or regulatory licenses or approvals; however, it is possible that extraordinary or unexpected legal fees could adversely impact our financial results during a particular fiscal period. During its ordinary course of business, the Company enters into obligations to defend, indemnify and/or hold harmless various customers, officers, directors, employees, and other third parties. These contractual obligations could give rise to additional litigation costs and involvement in court proceedings.

Alabama Litigation. On July 5, 2012, orders of dismissal were entered for two of the Company's previously outstanding Alabama lawsuits (Adell and Adams), and the Company is currently involved in three lawsuits, as further described below, related to its former charity bingo operations in the state of Alabama. While the Company continues to believe that these lawsuits are no longer material from a pure damages perspective, a finding in any of these cases that electronic charity bingo was illegal in Alabama during the pertinent time frame could potentially have material adverse regulatory consequences for the Company in other jurisdictions. Two of the lawsuits are pending in federal court and were filed on behalf of individuals who claim to be patrons of either White Hall Entertainment Center in Lowndes County, Alabama or VictoryLand in Shorter, Alabama, and include claims

18



related to the alleged illegality of electronic charity bingo in Alabama. The third lawsuit is a civil forfeiture action brought by the State of Alabama that arose out of the seizure of equipment at White Hall Entertainment Center in Lowndes County, Alabama, and in which we intervened. An estimate of possible loss or range of possible losses cannot be made with respect to these matters.

Dollie Williams, et al., v. Macon County Greyhound Park, Inc., et al., a civil action, was filed on March 8, 2010, in the United States District Court for the Middle District of Alabama, Eastern Division, against the Company and others. The plaintiffs, who claim to have been patrons of VictoryLand, allege that the Company participated in gambling operations that violated Alabama state law by supplying to VictoryLand purportedly unlawful electronic bingo machines played by the plaintiffs, and seek recovery of the monies lost on all electronic bingo games played by the plaintiffs in the six months prior to the complaint under Ala. Code Sec. 8-1-150(A). The plaintiffs have requested that the court certify the action as a class action. On March 16, 2012, Walter Bussey and two other named plaintiffs were voluntarily dismissed. The parties currently are engaged in discovery related to class certification issues. The Company continues to vigorously defend this matter, however, given the inherent uncertainties in this litigation, the Company is unable to make any prediction as to the ultimate outcome.  A finding in this case that electronic bingo was illegal in Alabama during the pertinent time frame could have adverse regulatory consequences to the Company in other jurisdictions.

Ozetta Hardy v. Whitehall Gaming Center, LLC, et al., a civil action, was filed against Whitehall Gaming Center, LLC (an entity that does not exist), Cornerstone Community Outreach, Inc., and Freedom Trail Ventures, Ltd., in the Circuit Court of Lowndes County, Alabama. On June 3, 2010, the Company and other manufacturers were added. The plaintiffs, who claim to have been patrons of White Hall, allege that the Company participated in gambling operations that violated Alabama state law by supplying to White Hall purportedly unlawful electronic bingo machines played by the plaintiffs, and seek recovery of the monies lost on all electronic bingo games played by the plaintiffs in the six months prior to the complaint based on Ala. Code, Sec 8-1-150(A). The plaintiffs have requested that the court certify the action as a class action. On July 2, 2010, the defendants removed the case to the United States District Court for the Middle District of Alabama, Northern Division. The court has not ruled on the plaintiffs' motion for class certification. The Company continues to vigorously defend this matter, however given the inherent uncertainties in this litigation, the Company is unable to make any prediction as to the ultimate outcome. A finding in this case that electronic bingo was illegal in Alabama during the pertinent time frame could have adverse regulatory consequences to the Company in other jurisdictions.

State of Alabama v. Chad Dickie, et al., a civil forfeiture action, was filed by the State of Alabama against certain property seized in connection with the March 19, 2009 raid of White Hall Entertainment Center in Lowndes County, including certain of our property. The case was filed in the Circuit Court of Lowndes County on April 21, 2009. On October 15, 2010, we, along with other manufacturers, filed a motion to intervene in the action in order to defend against contentions that our property was used in the operation of illegal gambling activity. On October 21, 2010, the court entered an order granting our motion to intervene. The parties were unable to reach a resolution at mediation, but continue to discuss possible resolution. The Company continues to vigorously defend this matter, however given the inherent uncertainties in this litigation, the Company is unable to make any prediction as to the ultimate outcome.  An unfavorable result in this case, including a finding that electronic bingo was illegal in Alabama during the pertinent time frame, or that the Company violated the law, could have adverse regulatory consequences to the Company in other jurisdictions.

Ethel Adell, et al., v. Macon County Greyhound Park, Inc., et al., a civil action, was dismissed with prejudice on July 5, 2012.  The action was filed on February 16, 2010, in the United States District Court for the Middle District of Alabama, Eastern Division, on behalf of over 800 plaintiffs against the Company and others. The plaintiffs, who claim to have been patrons of VictoryLand, alleged that the Company participated in gambling operations that violated Alabama state law by supplying to VictoryLand purportedly unlawful electronic bingo machines played by the plaintiffs. The plaintiffs originally sought damages based on Ala. Code, Sec 8-1-150(A), the Alabama Deceptive Trade Practices Act, and the Racketeer Influenced and Corruption Organizations Act 18 U.S.C. sec 1961(1). The case was settled for an immaterial amount with no finding or admission of wrongdoing.

Lafayette Adams, et al. v. Macon County Greyhound Park, Inc., et al., a civil action, was dismissed with prejudice on July 5, 2012.  The action was filed on October 6, 2010, in the Circuit Court of Macon County, Alabama, on behalf of hundreds of plaintiffs against Macon County Greyhound Park, Inc. d/b/a VictoryLand and on January 25, 2011, the Company, along with other manufacturers, was added. The plaintiffs, who claim to have been patrons of VictoryLand, alleged that the Company participated in gambling operations that violated Alabama state law by supplying to VictoryLand purportedly unlawful electronic bingo machines played by the plaintiffs. The plaintiffs sought recovery of gambling losses based on Ala. Code, Sec 8-1-150(A).  On February 22, 2011, the case was removed to the United States District Court for the Middle District of Alabama, Eastern Division. The case was settled for an immaterial amount with no finding or admission of wrongdoing.




19



Mexico Income Tax Audit

The Company's Mexican subsidiary, Multimedia Games de Mexico 1, S. de R.L. de C.V., or Multimedia Games de Mexico, has been under audit by the Mexico taxing authorities for the periods ended December 31, 2006 and 2007.

Regarding the 2006 tax year, on November 8, 2011, the Company filed an appeal against a resolution obtained from the Federal Tribunal of Fiscal and Administrative Justice, which was registered under docket number 25591/10-17-01-6. On March 30, 2012, this appeal was admitted to the Eighteenth Collegiate Tribunal of Administrative Matters of the First Circuit (Federal Court of Mexico), for its final resolution, where it was registered under docket number 214/2012 and is currently pending. Management continues to believe that it has a reasonable defense against this assessment and expects the ultimate assessment to range from $0 to $18,000.

On November 19, 2010, the Company filed before the taxing authorities an administrative appeal against the resolutions set forth by the taxing authorities in ruling number 500-74-02-04-03-2010-9403, which assessed an income and value added tax deficiency to Multimedia Games de Mexico for the 2007 tax year. In ruling number 600-27-00-02-00-2011 MAIB - 13370, issued by the South Local Administration of the Federal District of the Tax Administration Service, the Mexican tax authorities ruled on the appeal and reduced the total amount assessed for the 2007 year to approximately $2.7 million, a significant reduction from the previous assessment of approximately $14.1 million. However, management continues to believe that the Company still has a reasonable defense against this lowered assessment and expects the ultimate assessment to range from $0 to $2.7 million. Accordingly, on December 14, 2011, Multimedia Games de Mexico filed, before the Federal Tribunal of Fiscal and Administrative Justice, a lawsuit against the remaining $2.7 million assessment for 2007. The lawsuit was remitted for its study and resolution to the Eleventh Regional Metropolitan Division of the Federal Tribunal of Fiscal and Administrative Matters, and was registered under docket number 31987/11-17-11-8 and is now pending. Multimedia Games de Mexico has submitted evidentiary documentation in support of its complaint and is awaiting review. In January 2012, a bond of $2.7 million, using a $3.5 million standby letter of credit issued under the Company's domestic credit facility, was provided to the taxing authorities as collateral for the potential assessment based on the taxing authorities' current estimate of tax due; however, because management continues to believe that a loss is not probable, it cannot reasonably estimate the amount at this time, and thus has not recorded a reserve for this matter, although it is possible that an adverse outcome could have an adverse effect upon our financial condition, operating results or cash flow.

14.      SUBSEQUENT EVENTS
 
The Company has evaluated subsequent events through the date the financial statements were issued, and determined that no events, other than those disclosed within the footnotes hereto, have occurred subsequent to June 30, 2012 that warrant additional disclosure or accounting considerations.



20



ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
FUTURE EXPECTATIONS AND FORWARD-LOOKING STATEMENTS
 
Multimedia Games has made forward-looking statements in this Quarterly Report on Form 10-Q that are subject to risks and uncertainties. Such forward-looking statements include, but are not limited to, statements regarding future actions, operating results, liquidity, capital expenditures, cash management and financial discipline, product, system and platform development and enhancements, customer and strategic relationships with third parties, strategies, initiatives, legal and regulatory uncertainties, including outcomes of litigation, the effects of such outcomes upon our business, changes in existing laws and regulations or in the interpretation of such laws and regulations, entry into new markets or jurisdictions or the obtaining of new licenses. The forward-looking statements may be preceded by, followed by or include the words “may,” “might,” “plan,” “estimate,” “expect,” “intend,” “believe,” “should,” “would,” “could,” “anticipate,” “continue,” or the negative or other variations thereof or comparable terminology that convey the uncertainty of future events or outcomes. All forward-looking statements are based on current expectations and projections of future events. We claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 for all forward-looking statements.

Forward-looking statements are not guarantees of performance. You should understand that the factors discussed in Item 1A of Part II of this Quarterly Report, could affect our future results and could cause those results or other outcomes to differ materially from those expressed or implied in the forward-looking statements. Actual results could differ materially from those stated or implied by our forward-looking statements, due to risks and uncertainties associated with our business or under different assumptions or conditions. You should not place undue reliance on any of these forward- looking statements. Any forward-looking statement speaks only as of the date on which it is made, and we disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

Multimedia Games designs, manufactures and supplies innovative standalone and networked gaming systems.  Our standalone player terminals, server-based systems, video lottery terminals, electronic scratch ticket systems, electronic instant lottery systems, back-office systems and bingo systems are used by Native American and commercial casino operators as well as state lottery operators in the United States and in certain international markets.  We have long been a provider of server-based gaming systems known as central determinant and downloadable systems.  These systems are used by Native American gaming operator customers in both Class II and Class III settings, by commercial casino customers, by operators of charity and commercial bingo gaming facilities, and by lottery jurisdictions for operation of their video lottery systems.

We are focused on growing by executing a business plan focused on the following key initiatives: Class II and Class III product expansion in existing and new jurisdictions throughout the country, profit increases through prudent expense management and capital investments, and the creation of products and technologies that can contribute to our growth into new markets, pending regulatory approvals.

As part of our revenue growth initiative, we remain focused on expanding market share through new product introductions and more effective utilization of sales and marketing efforts across the organization. In addition, we continue to derive a majority of our gaming revenues from participation and development agreements, both of which operate on a participation, or revenue share, basis.  Under these agreements, we place player terminals and systems, along with our proprietary and other licensed game content, at a customer's facility in return for a share of the revenues that these terminals and systems generate. We also generate revenue from the sale of gaming units and systems and seek to expand the use of for-sale revenue as we expand into additional gaming markets and jurisdictions throughout the country and with our current customer base. The creation of our proprietary products and market expansion is a key area of focus for our company. As a result of these efforts, during the fiscal third quarter 2012, we saw growth in both our domestic installed base and our unit sale business.  We expect fiscal 2013 revenue growth will be driven by further increases in the domestic installed base as well as growth in new unit sales, although such growth and increases may be at a lower rate than in fiscal 2012.  Based on current fiscal 2013 projections, we expect that our fiscal 2013 tax rate will be in the range of 36%-40%, compared to the fiscal 2012 full year expected effective tax rate of just under 1%. 

In addition, we generate revenues by providing the central determinant system for video lottery terminals installed at racetracks in the State of New York and operated by the New York State Division of the Lottery.  We design and develop content for our gaming systems and also offer game themes that we have licensed from others. We currently operate in one business segment.

21




RESULTS OF OPERATIONS
 
Three- and Nine-Month Periods Ended June 30, 2012 Compared to Three- and Nine-Month Periods Ended June 30, 2011
 
Below are our revenues and costs and expenses for the periods noted above.  This information should be read in conjunction with our Condensed Consolidated Financial Statements and notes thereto.
 
 
 
Three Months Ended
 
Nine Months Ended
 
 
 
June 30,
 
June 30,
 
 
 
2012
 
2011
 
% change
 
2012
 
2011
 
% change
 
 
 
(in thousands)
 
 
 
(in thousands)
 
 
 
Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
Gaming Operations
 
 
 
 
 
 
 
 
 
 
 
 
 
Participation or lease revenue
 
$
24,279

 
$
22,104

 
9.8
 %
 
70,966

 
63,389

 
12.0
 %
 
Lottery
 
4,140

 
2,453

 
68.8
 %
 
11,397

 
6,589

 
73.0
 %
 
Gaming Equipment and Systems Sales
 
 
 
 

 
 
 
 
 
 
 
 
 
Player terminal and equipment sales
 
8,986

 
6,264

 
43.5
 %
 
24,681

 
15,199

 
62.4
 %
 
Systems and Licensing
 
2,679

 
2,261

 
18.5
 %
 
6,691

 
5,836

 
14.7
 %
 
Other Revenue
 
380

 
317

 
19.9
 %
 
1,056

 
1,119

 
(5.6
)%
 
Total Revenue
 
40,464

 
33,399

 
21.2
 %
 
114,791

 
92,132

 
24.6
 %
 
Costs and Expenses
 
 

 
 

 
 

 
 
 
 
 
 
 
Cost of gaming operations revenue
 
2,175

 
2,364

 
(8.0
)%
 
6,479

 
6,575

 
(1.5
)%
 
Cost of equipment and systems sales
 
4,894

 
3,760

 
30.2
 %
 
13,227

 
10,386

 
27.4
 %
 
Selling, general and administrative
 
12,062

 
10,498

 
14.9
 %
 
36,713

 
31,260

 
17.4
 %
 
Write-off, reserve, impairment and settlement charges
 

 
634

 
(100.0
)%
 

 
837

 
(100.0
)%
 
Research and development
 
4,090

 
3,332

 
22.7
 %
 
11,464

 
9,726

 
17.9
 %
 
Amortization and depreciation
 
9,510

 
10,207

 
(6.8
)%
 
28,712

 
30,527

 
(5.9
)%
 
Other income, net
 
(32
)
 
(14
)
 
(128.6
)%
 
1,299

 
361

 
259.8
 %
 

 
 
 
June 30,
 
 
 
 
2012
 
2011
 
% change
End-of-period installed player terminal base:
 
 
 
 
 
 
Oklahoma
 
7,763

 
7,361

 
5.5
 %
Mexico
 
985

 
4,338

 
(77.3
)%
Other
 
2,386

 
1,572

 
51.8
 %
Total participation units
 
11,134

 
13,271

 
(16.1
)%




22



Three Months Ended June 30, 2012, Compared to Three Months Ended June 30, 2011
 
Total revenues for the three months ended June 30, 2012, were $40.5 million, compared to $33.4 million for the three months ended June 30, 2011, a $7.1 million, or 21.2%, increase.
 
Gaming Operations – Participation or Lease revenue
 
Oklahoma gaming revenues were $15.5 million in the three months ended June 30, 2012, compared to $15.4 million in the three months ended June 30, 2011, an increase of $177,000, or 1.2%. The installed base as of June 30, 2012 was 7,763, compared to 7,361 as of June 30, 2011, a 402 unit, or 5.5% increase.   We recently extended the unit placement arrangement with our largest customer; as part of this extension we agreed to decrease the revenue share percentage on certain units at this customer's facilities to bring the revenue share percentage in line with industry standards, . This decrease in revenue share percentage will occur in two pricing adjustments on July 16, 2013 and August 1, 2014. The pricing and unit adjustments at our largest customer are expected to be offset by continued expansion in Oklahoma and other jurisdictions.

Other domestic gaming operations revenue relates to participation or lease revenue primarily from the following states: Washington, California, New York, Wisconsin, and Alabama; and also includes revenue from Texas, Minnesota, Kansas, Idaho, Iowa, Mississippi, Louisiana, Florida, Connecticut, New Mexico, Arizona, Idaho, Indiana, Arkansas and Rhode Island.  Gaming operations revenue from these states combined was $8.5 million in the three months ended June 30, 2012, compared to $5.0 million during the same period of 2011, a $3.5 million, or 70.3%, increase.  The increase in gaming operations revenue in these states was primarily the result of an increase in our installed base of participation games, as well as an increase in back office fees received on player terminals sold in a market which utilizes our back office equipment. The end of period participation unit count for these states increased to 2,386 as of June 30, 2012 from 1,572 as of June 30, 2011, a 51.8% increase in our domestic participation footprint, outside of Oklahoma.

Revenues from the Mexico market were $260,000 in the three months ended June 30, 2012 and $1.8 million during the same period of 2011, a decrease of $1.5 million or 85.2%. The decrease in revenue is attributable to a decrease in Mexico's installed player terminals. As of June 30, 2012, we had installed 985 player terminals in Mexico compared to 4,338 terminals installed at June 30, 2011, a decrease of 3,353, or 77.3%. The reduction in the number of units and corresponding reduction in revenue relates to our planned strategy to optimize our deployed capital in Mexico. As part of this strategy, we have and expect to continue to remove older games from our customer locations and replace units at a conservative pace to maximize the return on investment, and we expect revenues from Mexico to continue to decrease for a period of time.
 
Gaming Operations – Lottery
 
Revenues from the New York Lottery system increased $1.7 million, or 68.8%, to $4.1 million in the three months ended June 30, 2012, from $2.5 million in the three months ended June 30, 2011. The increase is attributable to the opening of the Resorts World Casino in New York, New York, which resulted in the addition of 2,500 video lottery terminals and electronic table games on October 28, 2011 and approximately 2,500 additional units on December 15, 2011. This increased the total number of units within the New York Lottery system from 12,500 as of June 30, 2011 to approximately 17,100 as of June 30, 2012.
 
Gaming Equipment and System Sales –Player Terminal and Equipment Sales
 
Player terminal and equipment sales were $9.0 million for the three months ended June 30, 2012, and $6.3 million for the three months ended June 30, 2011, an increase of $2.7 million, or 43.5%. Revenue from the sale of player terminals for the three months ended June 30, 2012 were $8.4 million on the sale of 543 proprietary units, compared to $3.7 million on the sale of 251 proprietary units for the three month period ended June 30, 2011.  Gaming equipment sales were $155,000 for the three-month period ended June 30, 2012, compared to $563,000 in the June 30, 2011 period.  Generally, gaming equipment sales include ancillary equipment necessary for the full functionality of the player terminals in a casino.  Player terminal and equipment sales also include $466,000 and $2.0 million related to deferred revenue recognized during the three-month periods ended June 30, 2012 and 2011, respectively, due to final execution of deliverables or mutual agreement to changes in contract terms. The increase in this quarter for player terminal and equipment sales is largely attributable to our expansion into new markets.




23



Gaming Equipment and System Sales – Systems and Licensing
 
Systems and licensing sales revenue was $2.7 million for the three months ended June 30, 2012, and $2.2 million for the three months ended June 30, 2011, a $418,000, or 18.5%, increase. Systems and licensing revenue for the three months ended June 30, 2012 relates to (i) $2.0 million of licenses associated with the player terminal sales during the period; (ii) $549,000 of license revenue from game conversions; and (iii) $134,000 of systems and game themes sold in prior periods being amortized to revenue from deferred revenue over the contract period.  Systems and licensing revenue for the three months ended June 30, 2011 relates to (i) $1.4 million of systems and game themes sold in prior periods being recognized from deferred revenue during the period; (ii) $672,000 of licenses associated with the player terminal sales during the period and (iii) $173,000 of license revenue from game conversions. The increase in this quarter for systems and licensing is primarily attributable to sale of licenses related to player terminal sales.
 
Other Revenue

Other revenue was $380,000 for the three months ended June 30, 2012 and $317,000 for the three months ended June 30, 2011, a $63,000, or 19.9%, increase. This increase relates to an increase of maintenance and service contract revenue in the three months ended June 30, 2012.

Cost of Gaming Operations Revenue

Total cost of gaming operations revenue, which includes royalty and participation fees, decreased $189,000, or 8.0%, to $2.2 million in the three months ended June 30, 2012, from $2.4 million in the three months ended June 30, 2011. Costs of gaming operations revenue decreased primarily due to fewer participation fees paid to third-party manufacturers for leased machines.

Cost of Equipment & System Sales

Cost of equipment and system sales increased $1.1 million, or 30.2%, to $4.9 million in the three months ended June 30, 2012, from $3.8 million in the three months ended June 30, 2011. Cost of equipment and system sales for the three months ended June 30, 2012 includes (i) $4.4 million related to player terminal sales; (ii) $278,000 of costs of prior period shipments being amortized from deferred revenue over the contract period; and (iii) $177,000 related to the sale of gaming equipment during the period.  Cost of equipment and system sales for the three months ended June 30, 2011 includes (i) $1.8 million related to player terminal sales; (ii) $1.7 million of costs of prior period shipments being amortized from deferred revenue over the contract period; and (iii) $223,000 related to the sale of gaming equipment during the period.
 
Selling, General and Administrative Expenses
 
Selling, general and administrative expenses, or SG&A, increased approximately $1.6 million, or 14.9%, to $12.1 million for the three months ended June 30, 2012, from $10.5 million in the same period of 2011. This increase was primarily a result of the Company's efforts to retain and attract employees, including (i) an increase in stock compensation expense of $845,000; (ii) an increase in long term incentives of $489,000; and (iii) an increase in salaries and wages and employee benefits of $249,000.

Write-off, reserve, impairment and settlement charges
 
There were no write-off, reserve, impairment and settlement charges for the three month period ended June 30, 2012, compared to $634,000 in the same period of 2011. The charges in the 2011 period consisted of a $484,000 payment for a central system service interruption, and $150,000 related to a Mexico customs audit.

Research & Development
Research and development costs increased approximately $758,000, or 22.7%, to $4.1 million for the three months ended June 30, 2012, from $3.3 million in the same period of 2011. Our research and development costs increased primarily due to salaries and wages, independent testing lab fees and contract labor.

Depreciation and Amortization
 
Depreciation expense decreased $1.0 million, or 10.2%, to $8.4 million for the three months ended June 30, 2012, from

24



$9.3 million for the three month period ended June 30, 2011, primarily as a result of certain assets becoming fully depreciated. Amortization expense increased $258,000, or 29.4%, to $1.1 million for the three months ended June 30, 2012, compared to $877,000 for the same period of 2011, primarily because of an increase in capitalized software costs, which led to an increase in the associated amortization expense.  

Other Income and Expense
 
Interest income decreased $278,000, or 47.4%, to $308,000 for the three months ended June 30, 2012, from $586,000 in the same period of 2011 due to reduced outstanding notes receivable balances. For the three months ended June 30, 2012, the Company recorded imputed interest of $287,000 relating to development agreements with an imputed interest rate range of 5.25% to 9.0%, compared to $552,000 for the same period in 2011

Interest expense decreased $483,000, or 59.4%, to $330,000 for the three months ended June 30, 2012, from $813,000 in the same period of 2011 due to a significant reduction in interest rates charged under our Amended Credit Agreement and a reduction in the outstanding debt balance.

Other income (expense) decreased $223,000 to other expense of $10,000 for the three months ended June 30, 2012, from other income of $213,000 in the same period of 2011, resulting from a decrease in gains on the exchange of used equipment with our third party equipment suppliers, as well as net losses incurred on foreign currency transactions primarily related to our Mexico operations.

Income Taxes
 
Income tax expense increased by $630,000 to $452,000 for the three months ended June 30, 2012, from a tax benefit of $178,000 in the same period of 2011. The current period change is primarily related to changes in the valuation allowance, the Alternative Minimum Tax and state taxes. These figures represent effective income tax rates of 5.9% and (6.9)% for the three months ended June 30, 2012 and 2011, respectively. As of June 30, 2012, we have fully reserved for all of our deferred tax assets as we determined that it is more likely than not that we will not be able to realize the benefit of those assets in the foreseeable future.

Nine Months Ended June 30, 2012, Compared to Nine Months Ended June 30, 2011
 
Total revenues for the nine months ended June 30, 2012, were $114.8 million, compared to $92.1 million for the nine months ended June 30, 2011, a $22.7 million, or 24.6%, increase.
 
Gaming Operations – Participation or Lease Revenue
 
Oklahoma gaming revenues were $47.2 million in the nine months ended June 30, 2012, compared to $45.2 million in the nine months ended June 30, 2011, an increase of $2.0 million, or 4.4%. The increase in revenue is attributable to an increase in Oklahoma’s installed base of participation games and overall increase in game performance. The installed base as of June 30, 2012 was 7,763, compared to 7,361 as of June 30, 2011, a 402 unit, or 5.5%, increase.  During the period we extended the unit placement arrangement with our largest customer; as part of this extension we agreed to decrease the revenue share percentage on approximately 1,000 units to bring them in line with industry standards, as well as other units deployed at this customer's facilities. This decrease in revenue share percentage will occur in two pricing adjustments on July 16, 2013 and August 1, 2014. The pricing and unit adjustments at our largest customer are expected to be offset by continued expansion in Oklahoma and other jurisdictions.

Other domestic gaming operations revenue relates to participation or lease revenue primarily from the following states: Washington, California, New York, Wisconsin, and Alabama; and also includes revenue from Texas, Minnesota, Kansas, Idaho, Iowa, Mississippi, Louisiana, Florida, Connecticut, New Mexico, Arizona, Idaho, Indiana, Arkansas and Rhode Island.  Gaming operations revenue from these states combined was $22.0 million in the nine months ended June 30, 2012, compared to $12.8 million during the same period of 2011, a $9.2 million, or 71.8%, increase.  The increase in gaming operations revenue in these states was primarily the result of an increase in our installed base of participation games, as well as an increase in back office fees received on player terminals sold in a market which utilizes our back office equipment. The end of period participation unit count for these states increased to 2,386 as of June 30, 2012, from 1,572 as of June 30, 2011, a 51.8% increase in our domestic participation footprint outside of Oklahoma.

Revenues from the Mexico market were $1.8 million in the nine months ended June 30, 2012 and $5.4 million during the same period of 2011, a decrease of $3.6 million, or 66.5%. The decrease in revenue is attributable to a decrease in

25



Mexico's installed player terminals. As of June 30, 2012, we had installed 985 player terminals in Mexico compared to 4,338 terminals installed at June 30, 2011, a decrease of 3,353, or 77.3%. The reduction in the number of units and corresponding reduction in revenue relates to our planned strategy to optimize our deployed capital in Mexico. As part of this strategy we have and expect to continue to remove older games from our customer locations and replace units at a conservative pace to maximize the return on investment, and we expect revenues from Mexico to continue to decrease for a period of time.
 
Gaming Operations – Lottery
 
Revenues from the New York Lottery system increased $4.8 million, or 73.0%, to $11.4 million in the nine months ended June 30, 2012, from $6.6 million in the nine months ended June 30, 2011. The increase is attributable to the opening of the Resorts World Casino in New York, NY, which resulted in the addition of 2,500 video lottery terminals and electronic table games on October 28, 2011 and approximately 2,500 additional units on December 15, 2011. This increased the total number of units within the New York Lottery system from 12,500 as of June 30, 2011 to approximately 17,100 as of June 30, 2012.
 
Gaming Equipment and System Sales – Player Terminal and Equipment Sales
 
Player terminal and equipment sales were $24.7 million for the nine months ended June 30, 2012, and $15.2 million for the nine months ended June 30, 2011, an increase of $9.5 million, or 62.4%. Player terminal sales for the nine months ended June 30, 2012 were $21.4 million on the sale of 1,423 proprietary units, compared to sales of $10.4 million on the sale of 692 proprietary units for the nine month period ended June 30, 2011.  Gaming equipment sales were $1.7 million for the nine month periods ended June 30, 2012, and $2.2 million for the nine month periods ended June 30, 2011.  Generally, gaming equipment sales include ancillary equipment necessary for the full functionality of the player terminals in a casino.  Player terminal and equipment sales also include $1.5 million and $2.6 million related to deferred revenue recognized during the nine-month periods ended June 30, 2012 and 2011, respectively, due to final execution of deliverables or mutual agreement to changes in contract terms. The increase in this quarter for player terminal and equipment sales is largely attributable to our expansion into new markets.

Gaming Equipment and System Sales – Systems and Licensing
 
Systems and licensing sales revenue was $6.7 million for the nine months ended June 30, 2012, and $5.8 million for the nine months ended June 30, 2011, a $855,000, or 14.7%, increase. Systems and licensing revenue for the nine months ended June 30, 2012 relates to (i) $4.9 million of licenses associated with the player terminal sales during the period; (ii) $1.3 million of license revenue from game conversions; and (iii) $524,000 of systems and game themes sold in prior periods being amortized to revenue from deferred revenue over the contract period.  Systems and licensing revenue for the nine months ended June 30, 2011 relates to (i) $4.0 million of systems and game themes sold in prior periods being recognized from deferred revenue during the period; (ii) $1.5 million of licenses associated with the player terminal sales during the period; and (iii) $244,000 of license revenue from game conversions. The increase in this quarter for systems and licensing is primarily attributable to sale of licenses related to player terminal sales.
 
Other Revenue

Other revenue was $1.1 million for both the nine months ended June 30, 2012 and 2011 a $63,000, or 5.6%, decrease. This reduction relates to a decrease in maintenance and service contract revenue in the 2012 nine-month period, partially offset by an increase of a gain on disposed assets.

Cost of Gaming Operations Revenue

Total cost of gaming operations revenue, which includes royalty and participation fees, decreased $96,000, or 1.5%, to $6.5 million in the nine months ended June 30, 2012, from $6.6 million in the nine months ended June 30, 2011. Costs of gaming operations revenue decreased primarily due to fewer participation fees paid to third-party manufacturers for leased machines.

Cost of Equipment & System Sales

Cost of equipment and system sales increased $2.8 million, or 27.4%, to $13.2 million in the nine months ended June 30, 2012, from $10.4 million in the nine months ended June 30, 2011. Cost of equipment and system sales for the nine months ended June 30, 2012 includes (i) $11.2 million related to player terminal sales; (ii) $1.1 million related to the sale

26



of gaming equipment during the period;and (iii) $874,000 of costs of prior period shipments being amortized from deferred revenue over the contract period.  Cost of equipment and system sales for the nine months ended June 30, 2011 includes (i) $5.1 million related to player terminal sales; (ii) $4.3 million of costs of prior period shipments being amortized from deferred revenue over the contract period; and (iii) $953,000 relate to the sale of gaming equipment during the period.
 
Selling, General and Administrative Expenses
 
Selling, general, and administrative expenses, or SG&A, increased approximately $5.5 million, or 17.4%, to $36.7 million for the nine months ended June 30, 2012, from $31.3 million in the same period of 2011. This increase was primarily a result of (i) an increase in salaries and wages and employee benefits of $1.9 million to retain and attract employees; (ii) an increase of stock compensation expense of $1.4 million; (iii) an increase in annual incentive of $450,000; (iv) an increase in long-term incentives of $921,000; and (v) an increase in legal and professional fees of $280,000.

Write-off, reserve, impairment and settlement charges
 
There were no write-off, reserve, impairment and settlement charges for the nine month period ended June 30, 2012, compared to $837,000 in the same period of 2011. The charges in the 2011 period consisted of a payment of $484,000 for a central system service interruption, $150,000 related to a Mexico customs audit and impairment of install costs at the Alabama locations for $203,000.

Research & Development
Research and development costs increased approximately $1.7 million, or 17.9%, to $11.5 million for the nine months ended June 30, 2012, from $9.7 million in the same period of 2011. Our research and development costs increased primarily from additional contract labor and game lab testing fees.

Depreciation and Amortization
 
Depreciation expense decreased $2.4 million, or 8.8%, to $25.4 million for the nine months ended June 30, 2012, from $27.8 million for the nine-month period ended June 30, 2011, primarily as a result of certain assets becoming fully depreciated. Amortization expense increased $634,000, or 23.5%, to $3.3 million for the nine months ended June 30, 2012, compared to $2.7 million for the same period of 2011, primarily because of an increase in capitalized software costs, which led to an increase in the associated amortization expense.  

Other Income and Expense
 
Interest income decreased $701,000, or 34.7%, to $1.3 million for the nine months ended June 30, 2012, from $2.0 million in the same period of 2011 due to reduced outstanding notes receivable balances. For the nine months ended June 30, 2012, the Company recorded imputed interest of $1.1 million relating to development agreements with an imputed interest rate range of 5.25% to 9.0%, compared to $1.8 million for the same period in 2011

Interest expense decreased $1.4 million, or 57.0%, to $1.1 million for the nine months ended June 30, 2012, from $2.5 million in the same period of 2011 due to a significant reduction in interest rates charged under our Amended Credit Agreement and a reduction in the outstanding debt balance.

Other income increased $237,000, or 29.6%, to $1.0 million for the nine months ended June 30, 2012, from $801,000 in the same period of 2011 resulting from an increase in gains on the exchange of used equipment with our third party equipment suppliers.

Income Taxes
 
Income tax benefit increased by $962,000 to $354,000 for the nine months ended June 30, 2012, from an expense of $608,000 in the same period of 2011. The current period change is primarily related to changes in the valuation allowance, state taxes, and the release of a reserve for an uncertain tax position. These figures represent effective income tax rates of (1.8)% and 19.1% for the nine months ended June 30, 2012 and 2011, respectively. As of June 30, 2012, we have fully reserved for all of our deferred tax assets as we determined that it is more likely than not that we will not be able to realize the benefit of those assets in the foreseeable future.


27



RECENT ACCOUNTING PRONOUNCEMENTS
 
We monitor new generally accepted accounting principles and disclosure reporting requirements issued by the SEC and other standard setting agencies. Recently issued accounting standards affecting our financial results are described in Note 2 of our unaudited condensed consolidated financial statements.
 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
We prepare our condensed consolidated financial statements in conformity with U.S. GAAP. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based on the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the periods presented. There can be no assurance that actual results will not differ from those estimates. We believe the following represent our most critical accounting policies.
 
Management considers an accounting estimate to be critical if:
 
It requires assumptions to be made that were uncertain at the time the estimate was made (Critical Assumption #1), and

Changes in the estimate or different estimates that could have been selected could have a material impact on our consolidated results of operation or financial condition (Critical Assumption #2).

Revenue Recognition. As further discussed in the discussion of our Revenue Recognition policy in Note 2 of our condensed consolidated financial statements, revenue from sales arrangements with multiple deliverables, is applied using the guidance from ASU No. 2009-13, “Revenue Recognition (Topic 605), Multiple-Deliverable Revenue Arrangements.”  ASU No. 2009-13 establishes the accounting and reporting guidance for arrangements under which the vendor will perform multiple revenue-generating activities; specifically, how to separate deliverables and how to measure and allocate arrangement consideration to one or more units of accounting.  In addition, the Company applies the guidance from ASU No. 2009-14, “Software (Topic 985), Certain Revenue Arrangements that Include Software Elements,” which affects vendors that sell or lease tangible products in an arrangement that contains software that is more than incidental to the tangible product as a whole and clarifying what guidance should be used in allocating and measuring revenue.  
 
The majority of the Company’s multiple element sales contracts are for some combination of gaming equipment, player terminals, content, system software, license fees, and maintenance. ASU No. 2009-13 states that revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables meet both of the following criteria:

The delivered items have value to the customer on a stand-alone basis. The item or items have value on a stand-alone basis if they are sold separately by any vendor or the customer could resell the delivered item(s) on a stand-alone basis. In the context of a customer's ability to resell the delivered item(s), this criterion does not require the existence of an observable market for the deliverable(s); and

If the arrangement includes a general right of return relative to the delivered items, delivery or performance of the undelivered items is considered probable and substantially in the control of the vendor.

ASU No 2009-13 requires that arrangement consideration be allocated, at the inception of the arrangement, to all deliverables based on their relative selling price (i.e., the relative selling price method). When applying the relative selling price method, a hierarchy is used for estimating the selling price based first on Vendor-Specific Objective Evidence (“VSOE”), then Third-Party Evidence (“TPE”) and finally management's Estimate of the Selling Price (“ESP”).

ASU No 2009-14 amends the scope of software revenue recognition to exclude all tangible products containing both software and non software components that function together to deliver the tangible product's essential functionality. As a result, certain tangible products that were previously accounted for under the scope of software revenue recognition guidance (Accounting Standards Codification Subtopic 985-605) will no longer be accounted for as software.

Revenue related to systems arrangements that contain both software and non-software deliverables require allocation of the arrangement fee to the separate deliverables using the relative selling price method. Revenue for software deliverables is recognized under software revenue recognition guidance. Revenue resulting from the sale of non-software deliverables, such as gaming devices and other hardware, are accounted for based on other applicable revenue recognition guidance as the devices are tangible products containing both software and non-software components that function together to deliver the product's essential functionality.


28



In allocating the arrangement fees to separate deliverables, the Company evaluates whether it has VSOE of selling price, TPE or ESP for gaming devices, maintenance and product support fees and other revenue sources. The Company generally uses ESP to determine the selling price used in the allocation of separate deliverables, as VSOE and TPE are not available. The Company determines the ESP on separate deliverables by estimating a margin typically received on such items and applying that margin to the product cost incurred.

Assumptions/Approach Used: The determination estimated selling prices is a subjective measure, where we have made determinations about our ability to price certain aspects of transactions.
 
Effect if Different Assumptions Used: When we have determined that an estimated selling price can be determined for all elements of an arrangement, then the estimated selling prices are allocated to all elements of the arrangement, including the value of products and services delivered or performed, as well as all hardware and software that is undelivered. The allocated value of all of the delivered elements are recognized as revenue, while the allocated value of all undelivered elements is deferred until such items are delivered.
 
Share-Based Compensation Expense. We recognize compensation expense for all share-based payments in accordance with ASC Topic 718, “Compensation-Stock Compensation” and ASC Subtopic 505-50, “Equity-Based Payments to Non-Employees.” Under the fair value recognition provisions of ASC Topic 718 and Subtopic 505-50, we recognize share-based compensation net of an estimated forfeiture rate, and only recognize compensation cost for those shares expected to vest on a straight-line basis over the service period of the award.
 
Assumptions/Approach Used: Determining the appropriate fair value model and calculating the fair value of share-based payment awards requires the input of highly subjective assumptions, including the expected life of the share-based payment awards, and stock price volatility. Management determined that volatility is based on historical volatility trends.  In addition, we are required to estimate the expected forfeiture rate, and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the share-based compensation expense could be significantly different from what we have recorded in the current period.
 
Effect if Different Assumptions Used: The assumptions used in calculating the fair value of share-based payment awards, along with the forfeiture rate estimation, represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.
 
Property and Equipment and Leased Gaming Equipment. Property and equipment and leased gaming equipment is stated at cost. The cost of property and equipment and leased gaming equipment is depreciated over their estimated useful lives, generally using the straight-line method for financial reporting, and regulatory acceptable methods for tax reporting purposes. Player terminals and related components and equipment are included in the Company’s rental pool.  The rental pool can be further delineated as “rental pool – deployed,” which consists of assets deployed at customer sites under participation agreements, and “rental pool – undeployed,” which consists of assets with the Company that are available for customer use. Rental pool – undeployed consists of both new units awaiting deployment to a customer site and previously deployed units currently back with the Company to be refurbished awaiting re-deployment. Routine maintenance of property and equipment and leased gaming equipment is expensed in the period incurred, while major component upgrades are capitalized and depreciated over the estimated useful life (Critical Assumption #1) of the component. Sales and retirements of depreciable property are recorded by removing the related cost and accumulated depreciation from the accounts. Gains or losses on sales and retirements of property are reflected in our results of operations.

Management reviews long-lived asset classes for impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. For impairment analysis purposes, the Company’s rental pool is viewed as a fungible pool of assets; including assets in both rental pool-deployed and rental pool-undeployed.  In order to determine whether these assets are impaired, the net book value of the rental pool is compared to an estimate of future net cash flows from all existing facilities. The primary assumption used in determining future cash flows is our estimate of future revenue.  In addition, the Company analyzes the composition of its rental pool to determine the future use of older models and related components for those models.  The impairment analysis for the fiscal year ended September 30, 2011 indicated that we had substantial cash flows to fully recover the carrying value of the entire rental pool.  As of June 30, 2012 and September 30, 2011, rental pool assets totaled $47.0 million and $44.5 million, respectively. (Critical Assumption #2)
 
Assumptions/Approach used for Critical Assumption #1: The carrying value of the asset is determined based upon management’s assumptions as to the useful life of the asset, where the assets are depreciated over the estimated life on a straight line basis, where the useful life of items in the rental pool has been determined by management to be three years.

29



 
Effect if different assumptions used for Critical Assumption #1: While we believe that the useful lives that have been determined for our fixed assets are reasonable, different assumptions could materially affect the carrying value of the assets, as well as the depreciation expense recorded in each respective period related to those assets. During the three-month period ended June 30, 2012, a significant portion of the $9.5 million of depreciation and amortization expense related to assets in the rental pool. If the depreciable life of assets in our rental pool were changed from three years to another period of time, we could incur a materially different amount of depreciation expense during the period.
 
Assumptions/Approach used for Critical Assumption #2: Recoverability of assets to be held and used is measured through considerations of the future undiscounted cash flows expected to be generated by the assets as a group, as opposed to analysis by individual asset.  We also reviewed the future undiscounted cash flows of assets in place at specific locations for further analysis. If such assets are considered to be impaired, the impairment recognized is measured by the amount by which the carrying amount of the assets exceeds their fair value. Assets to be disposed of are reported at the lower of the carrying amount or the fair value less costs of disposal. The carrying value of the asset is determined based upon management’s assumptions as to the useful life of the asset, where the assets are depreciated over the estimated life on a straight-line basis.
 
Effect if different assumptions used for Critical Assumption #2: Impairment testing requires judgment, including estimations of useful lives of the assets, estimated cash flows, and determinations of fair value. While we believe our estimates of useful lives and cash flows are reasonable, different assumptions could materially affect the measurement of useful lives, recoverability and fair value. If actual cash flows fall below initial forecasts, we may need to record additional amortization and/or impairment charges. Additionally, while we believe that analysis of the recoverability of assets in our rental pool is accurately assessed from a homogenous level due to the interchangeability of player stations and parts, if these assets were to be reviewed for impairment using another approach, there could be different outcomes to any impairment analysis performed.
 
Development and Placement Fee Agreements. We enter into development and placement fee agreements to provide financing for new gaming facilities or for the expansion of existing facilities. In return, the facility dedicates a percentage of its floor space to exclusive placement of our player terminals, and we receive a fixed percentage of those player terminals’ win per day over the term of the agreement. Certain of the agreements contain player terminal performance standards that could allow the facility to reduce a portion of our guaranteed floor space. In addition, certain development agreements allow the facilities to buy out floor space after advances that are subject to repayment have been repaid. The development agreements typically provide for a portion of the amounts retained by the gaming facility for their share of the hold to be used to repay some or all of the advances recorded as notes receivable. Placement fees and amounts advanced in excess of those to be reimbursed by the customer for real property and land improvements are allocated to intangible assets and are generally amortized over the life of the contract, using the straight-line method of amortization (Critical Assumption #1), which is recorded as a reduction of revenue generated from the gaming facility. In the past and in the future, we may by mutual agreement and for consideration, amend these contracts to reduce our floor space at the facilities. Any proceeds received for the reduction of floor space is first applied against the intangible asset for that particular development agreement, if any.
 
Management reviews intangible assets related to development and placement fee agreements for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable (Critical Assumption #2). For the three-month period ended June 30, 2012, there was no impairment to the assets’ carrying values.
 
Assumptions/Approach used for Critical Assumption #1: Placement fees and amounts advanced in excess of those to be reimbursed by the customer for real property and land improvements are allocated to intangible assets and are generally amortized over the life of the contract, using the straight-line method of amortization, which is recorded as a reduction of revenue generated from the gaming facility. We use a straight-line amortization method, as a pattern of future benefits cannot be readily determined.

Effect if Different Assumptions used for Critical Assumption #1: While we believe that the use of the straight-line method of amortization is the best way to account for the costs associated with the costs of acquiring exclusive floor space rights at our customers facilities, the use of an alternative method could have a material effect on the amount recorded as a reduction to revenue in the current reporting period.
 
Assumptions/Approach used for Critical Assumption #2: We estimate cash flows directly associated with the use of the intangible assets to test recoverability and remaining useful lives based upon the forecasted utilization of the asset and expected product revenues. In developing estimated cash flows, we incorporate assumptions regarding future performance, including estimations of win per day and estimated units. When the carrying amount exceeds the undiscounted cash flows expected to result from the use and eventual disposition of the asset, we then compare the carrying amount to its current fair value. We recognize an impairment loss if the carrying amount is not recoverable and exceeds its fair value.
 

30



Effect if Different Assumptions used for Critical Assumption #2: Impairment testing requires judgment, including estimations of cash flows, and determinations of fair value. While we believe our estimates of future revenues and cash flows are reasonable, different assumptions could materially affect the measurement of useful lives, recoverability and fair value. If actual cash flows fall below initial forecasts, we may need to record additional amortization and/or impairment charges.
 
Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts related to our accounts receivable and notes receivable that have been deemed to have a high risk of uncollectibility. Management reviews our accounts receivable and notes receivable on a monthly basis to determine if any receivables will potentially be uncollectible. Management analyzes historical collection trends and changes in our customer payment patterns, customer concentration, and creditworthiness when evaluating the adequacy of our allowance for doubtful accounts. In our overall allowance for doubtful accounts, we include any receivable balances where uncertainty exists as to whether the account balance has become uncollectible. Based on the information available, management believes the allowance for doubtful accounts is adequate; however, actual write-offs may vary from the recorded allowance.
 
Income Taxes.  In accordance with ASC Topic 740, “Income Taxes”, we have recorded deferred tax assets and liabilities to account for the expected future tax benefits and consequences of events that have been recognized in our financial statements and our tax returns. There are several items that result in deferred tax asset and liability impact to the balance sheet. If we conclude that it is more likely than not that all or some portion of the deferred tax assets will not be realized under accounting standards, they are reduced by a valuation allowance to remove the benefit of recovering those deferred tax assets from our financial statements.

Additionally, in accordance with ASC Topic 740, as of June 30, 2012, we have not recorded a liability associated with uncertain tax positions.

ASC Topic 740 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In order to record any financial statement benefit, we are required to determine, based on the technical merits of the position, whether it is more likely than not (a likelihood of more than 50 percent) that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes. If that step is satisfied, then we must measure the tax position to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.

Assumptions/Approach Used: Numerous judgments and assumptions are inherent in the determination of future taxable income and tax return filing positions that we take, including factors such as future operating conditions. As of June 30, 2012, management considered the likelihood of realizing the future benefits associated with the Company's existing deductible temporary differences and carryforwards. As a result of this analysis, and based on a cumulative loss in the prior three fiscal years, management determined that it is not more likely than not that the future benefit associated with all of the Company's existing deductible temporary differences and carryforwards in the U.S. and Mexico will be realized. As a result, the Company maintains a valuation allowance against all of its deferred tax assets.
 
Effect if Different Assumptions Used: Management, along with consultation from an independent public accounting firm used in tax consultation, continually evaluate complicated tax law requirements and their effect on our current and future tax liability and our tax filing positions. The ultimate utilization of our gross deferred tax assets, primarily associated with the tax basis of our property and equipment and leased gaming equipment, is largely dependent upon our ability to generate taxable income in the future or carryback losses to prior years with taxable income. Our liability for uncertain tax positions is dependent upon our judgment on the amount of financial statement benefit that an uncertain tax position will realize upon ultimate settlement and on the probabilities of the outcomes that could be realized upon ultimate settlement of an uncertain tax position using the facts, circumstances and information available at the reporting date to establish the appropriate amount of financial statement benefit.

The Company maintains a valuation allowance when management believes it is more likely than not that all or a portion of a deferred tax asset will not be realized. Changes in a valuation allowance from period to period are included in the tax provision in the period of change. Management evaluates the recoverability of our deferred income tax assets by assessing the need for a valuation allowance on a quarterly basis. If we determine that it is more likely than not that our deferred tax assets will be recovered, the valuation allowance will be reduced.

As of June 30, 2012, management determined that it is not more likely than not that the future benefit associated with all of the Company's existing deductible temporary differences and carryforwards in the U.S. and Mexico will be realized. As a result, the Company maintains a valuation allowance against all of its deferred tax assets.


31



LIQUIDITY AND CAPITAL RESOURCES
 
As of June 30, 2012, we had $68.3 million in unrestricted cash and cash equivalents, compared to $46.7 million as of September 30, 2011. During the nine-month period ended June 30, 2012 and 2011, we received approximately $13.0 million and $11.9 million, respectively, from notes receivable, of which $11.9 million and $10.7 million were collected on development agreements. In addition, during the nine-month period ended June 30, 2012 and 2011 we received $6.8 million and $2.9 million, respectively, for proceeds from the exercise of stock options. Our working capital as of June 30, 2012, was $78.3 million, compared to a working capital of $59.0 million at September 30, 2011. The increase in working capital was primarily the result of an increase in cash collections from notes receivable, exercises of stock options and an increase in inventory. During the nine-month period ended June 30, 2012, we used $31.8 million for net capital expenditures of property and equipment, compared to $25.7 million for the nine month period ended June 30, 2011.  In addition, we have $34.2 million outstanding and $37.0 million available for future borrowings under the Amended Credit Agreement, subject to covenant restrictions (see the discussion of our credit agreement in Note 10 and below). Availability under the Amended Credit Agreement is reduced to the extent of a $3.5 million outstanding letter of credit.

Our principal sources of liquidity have been cash generated by operations, available cash and cash equivalents, and amounts available under our Amended Credit Agreement. Absent any significant change in market condition, we expect anticipated working capital and capital expenditure requirements for the next twelve months will be funded by these sources. There can be no assurance, however, that we will continue to generate cash flows at or above current levels or that our Amended Credit Agreement and other sources of capital will be available to us in the future.
 
As of June 30, 2012, our total contractual cash obligations were as follows (in thousands):
 
 
 
Payments due by period
 
 
Less than
1 year
 
1-3 years
 
3-5 years
 
More than 5 years
 
Total
Credit Agreement Term Loan(1)
 
$
3,700

 
$
7,400

 
$
23,125

 
$

 
$
34,225

Capital Leases(2)
 
141

 
281

 
59

 


 
481

Operating leases(3)
 
1,349

 
3,369

 
1,848

 
42

 
6,608

Purchase commitments(4)
 
16,102

 

 

 

 
16,102

Total
 
$
21,292

 
$
11,050

 
$
25,032

 
$
42

 
$
57,416

 
(1)
Consists of amounts borrowed under the term loan to our Amended Credit Agreement at the Eurodollar rate plus the applicable spread (3.24% as of June 30, 2012).
(2)
Consists of amounts borrowed for certain capital leases with interest rates ranging from 2.4% to 12.4%.
(3)
Consists of operating leases for our facilities and office equipment.
(4)
Consists primarily of inventory purchase orders and includes payment for and commitments to purchase third party gaming content licenses.

During the nine-month period ended June 30, 2012, we generated $57.2 million in cash from our operations, an increase of $3.3 million, or 6.1%, from $53.9 million during the same period of 2011. The increase was primarily the result of a $17.3 million increase in net income, partially offset by an increase in inventories to accommodate expected future demand for our products and a decrease of accounts payables.

Cash used in investing activities increased $18.8 million, or 97.6%, to $38.0 million in the nine month period ended June 30, 2012, from $19.2 million in the nine month period ended June 30, 2011. The increase was primarily the result of increases in placement fee agreement payments of $13.0 million, and in net capital expenditures of property and equipment of $6.1 million, partially offset by an increase in repayments under development agreements of $1.2 million. Additions to property and equipment and leased gaming equipment consisted of the following:
 

32



 
 
Nine Months Ended
 
 
2012
 
2011
 
 
(In thousands)
Gaming equipment
 
$
30,458

 
$
21,748

Third-party gaming content licenses
 
1,692

 
3,579

Other
 
3,537

 
1,576

Additions to property and equipment and leased gaming equipment, gross
 
35,687

 
26,903

Less transfer of leased gaming equipment to inventory
 
(3,876
)
 
(1,164
)
Additions to property and equipment and leased gaming equipment, net
 
$
31,811

 
$
25,739

 
Cash provided by financing activities increased by $10.3 million, or 134.5%, to $2.7 million in the nine month period ended June 30, 2012, from a usage of $7.7 million in the same period of 2011. The increase was primarily the result of a $8.2 million decrease in the purchase of treasury stock, and a $3.9 million increase of proceeds related to the exercise of stock options during the nine-month period ended June 30, 2012 compared to the nine-month period ended June 30, 2011.
 
Our capital expenditures for the next 12 months will depend upon the number of new player terminals that we are able to place into service at new or existing facilities and the actual number of repairs and equipment upgrades to the player terminals that are currently in the field. We intend to increase the number of new player terminals through expansion into new markets, which we expect to increase our capital expenditures.
 
Credit Agreement
 
See discussion of our credit agreement in Note 10 – Credit Agreement, Long-Term Debt and Capital Leases.
 
The Amended Credit Agreement provides us with the ability to finance development and placement agreements, acquisitions and working capital for general corporate purposes. Advances under the revolving credit commitment, the term loan, and draw-to loan mature on August 3, 2016, and bear interest at the Eurodollar rate plus the applicable margins, determined by a leverage ratio calculation of net funded debt to EBITDA.
 
We are currently in compliance with the covenants in the Amended Credit Agreement; however, we cannot be certain that we will be able to achieve our operating objectives for fiscal 2012 and that we will continue to meet our covenants in the Amended Credit Agreement in the future.
 
If we fail to remain in compliance with the covenants of the Amended Credit Agreement, we will be required to seek modification or waiver of the provisions of that agreement and potentially secure additional sources of capital. We cannot be certain that, if required, we will be able to successfully negotiate additional changes to or waivers of the Amended Credit Agreement. Alternatively, we may incur significant costs related to obtaining requisite waivers or renegotiation of the Amended Credit Agreement that could have a material and adverse effect on our operating results.

Our performance and financial results are, to a certain extent, subject to (i) general conditions in or affecting the Native American gaming industry, and (ii) general economic, political, financial, competitive, and regulatory factors beyond our control. If our business does not continue to generate cash flow at appropriate levels or if we receive a material judgment against us in a lawsuit (See generally Part II, Item 1A. Risk Factors), we may need to raise additional financing. Sources of additional financing might include additional bank debt or the public or private sale of equity or debt securities. However, sufficient funds may not be available, on terms acceptable to us or at all, from these sources, or any others, to enable us to make necessary capital expenditures and to make discretionary investments in the future. 
 
Stock Repurchase Authorizations
 
On December 3, 2010, we announced that our Board of Directors had authorized the repurchase of $15.0 million of our common stock over the next three year period. During the three month period ended June 30, 2012, we did not purchase any shares of our common stock. During the nine-month period ended June 30, 2012, we purchased 392,821 shares of our common stock for approximately $1.9 million at an average cost of $4.78 per share, exclusive of broker fees. From inception of the program through June 30, 2012, the Company has purchased approximately $2.2 million shares of its common stock for $11.9 million at an average cost of $5.36 per share, exclusive of broker fees. At June 30, 2012 approximately $3.1 million remained on the repurchase authorization. The share repurchase program is subject to the Company's Amended Credit Agreement and a 10b5-1 plan, in which purchases may be made from time to time in the open market, subject to certain pricing parameters.

33



 
Stock-Based Compensation
 
At June 30, 2012, we had approximately 4.3 million options to purchase common stock outstanding, with exercise prices ranging from $1.61 to $18.71 per share, of which, approximately 2.0 million of the outstanding options to purchase common stock were exercisable.
 
During the nine months ended June 30, 2012, options to purchase 1.1 million shares of common stock were granted at a weighted average exercise price of $6.90 per share, and we issued 1.3 million shares of common stock as a result of stock option exercises with a weighted average exercise price of $5.13. The Company also granted to certain of its directors restricted stock in the aggregate of 48,000 shares during the nine-months ended June 30, 2012 at an average fair value per share price of $10.16.

At June 30, 2011, we had approximately 5.9 million options to purchase common stock outstanding, with exercise prices ranging from $1.61 to $18.71 per share, of which, approximately 3.5 million of the outstanding options to purchase common stock were exercisable.
 
During the nine-months ended June 30, 2011, options to purchase 523,700 shares of common stock were granted at a weighted average exercise price of $4.65 per share, and we issued 764,540 shares of common stock as a result of stock option exercises with a weighted average exercise price of $3.83.
 
SEASONALITY
 
We believe our operations are not materially affected by seasonal factors, although we have experienced fluctuations in our revenues from period to period.
 
CONTINGENCIES
 
For information regarding contingencies, see “Item 1. Condensed Financial Statements – Note 13 - Commitments and Contingencies” and “PART II – Item 1. Legal Proceedings.”

OFF-BALANCE SHEET ARRANGEMENTS
As of June 30, 2012, the Company had an outstanding letter of credit issued under our domestic credit facility to ensure payment to certain Mexican governmental agencies in the amount of $3.5 million.  Such off-balance sheet arrangements are not reasonably likely to have a material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or resources. See Note 13 of the Notes to Condensed Consolidated Financial Statements "Commitments and Contingencies."



34



ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
We are subject to market risks in the ordinary course of business, primarily associated with interest rate fluctuations, primarily with respect to our operations in Mexico.
 
In connection with the development agreements we enter into with some of our customers, we advance funds for the construction and development of gaming facilities, which are generally required to be repaid. As a result of our adjustable-interest-rate notes payable and fixed-interest-rate-notes receivable described in “Item 1. Condensed Financial Statements, Note 7 Notes Receivable "and "Note 10 Credit Agreement, Long-Term Debt and Capital Leases,” we are subject to market risk with respect to interest rate fluctuations. Any material increase in prevailing interest rates could cause us to incur significantly higher interest expense. These factors have not increased significantly since the beginning of our fiscal year 2012. Accordingly, there has been no significant change in the Company's strategies to manage any of these exposures during the first nine months of 2012.
 
We account for currency translation from our Mexico operations in accordance with ASC Topic 830, “Foreign Currency Matters.” Balance sheet accounts are translated at the exchange rate in effect at each balance sheet date. Income statement accounts are translated at the average rate of exchange prevailing during the period. Translation adjustments resulting from this process are charged or credited to other comprehensive income. We do not currently manage this exposure with derivative financial instruments. These factors have not increased significantly since the beginning of our fiscal year 2012. Accordingly, there has been no significant change in the Company's strategies to manage any of these exposures during the first nine months of 2012.
 
ITEM 4.
CONTROLS AND PROCEDURES

Evaluation of Disclosure Control and Procedures. As of the end of the period covered by this report, an evaluation was carried out under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of management’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) to ensure information required to be disclosed in our filings under the Securities Exchange Act of 1934, is (i) recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms; and (ii) accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can only provide reasonable assurance of achieving desired control objectives, and management is necessarily required to apply its judgment when evaluating the cost-benefit relationship of potential controls and procedures. Based upon the evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that these disclosure controls and procedures were effective at the reasonable assurance level as of June 30, 2012.
 
There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
Changes in Internal Control over Financial Reporting. There were no changes in our internal controls over financial reporting identified in management’s evaluation during the third quarter ended June 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.


35



PART II
OTHER INFORMATION

ITEM 1.
 LEGAL PROCEEDINGS
 
The Company is a party to various material legal proceedings, which are described in the Company's Annual Report on Form 10-K filed for the year ended September 30, 2011 under the caption “Item 3. Legal Proceedings,” which are incorporated herein by reference.  We are also the subject of various pending and threatened claims in the ordinary course of business. While the results of any ultimate resolution cannot be predicted, as of June 30, 2012 it is the opinion of management, based upon discussions with counsel, that any losses resulting from these matters will not have a material adverse effect on our financial position, results of operations, or regulatory licenses or approvals; however, it is possible that extraordinary or unexpected legal fees could adversely impact our financial results during a particular fiscal period.

Alabama Litigation. On July 5, 2012, orders of dismissal were entered for two of our previously outstanding Alabama lawsuits (Adell and Adams), and we are currently involved in three lawsuits, as further described below, related to our former charity bingo operations in the state of Alabama. While we continue to believe that these lawsuits are no longer material from a pure damages perspective, a finding in any of these cases that electronic charity bingo was illegal in Alabama during the pertinent time frame could potentially have material adverse regulatory consequences for us in other jurisdictions. Two of the lawsuits are pending in federal court and were filed on behalf of individuals who claim to be patrons of either White Hall Entertainment Center in Lowndes County, Alabama or VictoryLand in Shorter, Alabama, and include several claims related to the alleged illegality of electronic charity bingo in Alabama. The third lawsuit is a civil forfeiture action brought by the State of Alabama that arose out of the seizure of equipment at White Hall Entertainment Center in Lowndes County, Alabama, and in which we intervened.

Dollie Williams, et al., v. Macon County Greyhound Park, Inc., et al., a civil action, was filed on March 8, 2010, in the United States District Court for the Middle District of Alabama, Eastern Division, against the Company and others. The plaintiffs, who claim to have been patrons of VictoryLand, allege that the Company participated in gambling operations that violated Alabama state law by supplying to VictoryLand purportedly unlawful electronic bingo machines played by the plaintiffs, and seek recovery of  the monies lost on all electronic bingo games played by the plaintiffs in the six months prior to the complaint under Ala. Code Sec. 8-1-150(A). The plaintiffs have requested that the court certify the action as a class action. On March 16, 2012, Walter Bussey and two other named plaintiffs were voluntarily dismissed.  The parties currently are engaged in discovery related to class certification issues.  We continue to vigorously defend this matter, however, given the inherent uncertainties in this litigation, we are unable to make any prediction as to the ultimate outcome.  A finding in this case that electronic bingo was illegal in Alabama during the pertinent time frame could have adverse regulatory consequences to the Company in other jurisdictions.

Ozetta Hardy v. Whitehall Gaming Center, LLC, et al., a civil action, was filed against Whitehall Gaming Center, LLC (an entity that does not exist), Cornerstone Community Outreach, Inc., and Freedom Trail Ventures, Ltd., in the Circuit Court of Lowndes County, Alabama. On June 3, 2010, the Company and other manufacturers were added. The plaintiffs, who claim to have been patrons of White Hall, allege that the Company participated in gambling operations that violated Alabama state law by supplying to White Hall purportedly unlawful electronic bingo machines played by the plaintiffs, and seek recovery of  the monies lost on all electronic bingo games played by the plaintiffs in the six months prior to the complaint based on Ala. Code, Sec 8-1-150(A).The plaintiffs have requested that the court certify the action as a class action. On July 2, 2010, the defendants removed the case to the United States District Court for the Middle District of Alabama, Northern Division.  The Company awaits a ruling on the plaintiffs' motion for class certification, which has been fully briefed and is pending before the court. We continue to vigorously defend this matter, however, given the inherent uncertainties in this litigation, we are unable to make any prediction as to the ultimate outcome.  A finding in this case that electronic bingo was illegal in Alabama during the pertinent time frame could have adverse regulatory consequences to the Company in other jurisdictions.

State of Alabama v. Chad Dickie, et al., a civil forfeiture action, was filed by the State of Alabama against certain property seized in connection with the March 19, 2009 raid of White Hall Entertainment Center in Lowndes County, including certain of our property. The case was filed in the Circuit Court of Lowndes County on April 21, 2009. On October 15, 2010, we, along with other manufacturers, filed a motion to intervene in the action in order to defend against contentions that our property was used in the operation of illegal gambling activity.  On October 21, 2010, the court entered an order granting our motion to intervene. The parties were unable to reach a resolution at mediation, but continue to discuss possible resolution.  We continue to vigorously defend this matter, however, given the inherent uncertainties in this litigation, we are unable to make any prediction as to the ultimate outcome.  An unfavorable result in this case, including a finding that electronic bingo was illegal in Alabama during the pertinent time frame, or that the Company violated the law, could have adverse regulatory consequences to the Company in other jurisdictions.



36



Ethel Adell, et al., v. Macon County Greyhound Park, Inc., et al., a civil action, was dismissed with prejudice on July 5, 2012.  The action was filed on February 16, 2010, in the United States District Court for the Middle District of Alabama, Eastern Division, on behalf of over 800 plaintiffs against the Company and others. The plaintiffs, who claim to have been patrons of VictoryLand, alleged that the Company participated in gambling operations that violated Alabama state law by supplying to VictoryLand purportedly unlawful electronic bingo machines played by the plaintiffs. The plaintiffs originally sought damages based on Ala. Code, Sec 8-1-150(A), the Alabama Deceptive Trade Practices Act, and the Racketeer Influenced and Corruption Organizations Act 18 U.S.C. sec 1961(1). The case was settled for an immaterial amount with no finding or admission of wrongdoing.

Lafayette Adams, et al. v. Macon County Greyhound Park, Inc., et al., a civil action, was dismissed with prejudice on July 5, 2012.  The action was filed on October 6, 2010, in the Circuit Court of Macon County, Alabama, on behalf of hundreds of plaintiffs against Macon County Greyhound Park, Inc. d/b/a VictoryLand and on January 25, 2011, the Company, along with other manufacturers, was added. The plaintiffs, who claim to have been patrons of VictoryLand, alleged that the Company participated in gambling operations that violated Alabama state law by supplying to VictoryLand purportedly unlawful electronic bingo machines played by the plaintiffs. The plaintiffs sought recovery of gambling losses based on Ala. Code, Sec 8-1-150(A).  On February 22, 2011, the case was removed to the United States District Court for the Middle District of Alabama, Eastern Division. The case was settled for an immaterial amount with no finding or admission of wrongdoing.

Mexico Income Tax Audit
Our Mexican subsidiary, Multimedia Games de Mexico 1, S. de R.L. de C.V., or Multimedia Games de Mexico, has been under audit by the Mexico taxing authorities for the periods ended December 31, 2006 and 2007.

Regarding the 2006 tax period, on November 8, 2011, we filed an appeal against a resolution obtained from the Federal Tribunal of Fiscal and Administrative Justice, which was registered under docket number 25591/10-17-01-6. On March 30, 2012, this appeal was admitted to the Eighteenth Collegiate Tribunal of Administrative Matters of the First Circuit (Federal Court of Mexico), for its final resolution, where it was registered under docket number 214/2012 and is currently pending.
  
On November 19, 2010, we filed before the taxing authorities an administrative appeal against the resolutions set forth by the taxing authorities in ruling number 500-74-02-04-03-2010-9403, which assessed an income and value added tax deficiency to Multimedia Games de Mexico for the 2007 tax year. In ruling number 600-27-00-02-00-2011 MAIB - 13370, issued by the South Local Administration of the Federal District of the Tax Administration Service, the Mexican tax authorities ruled on the appeal and reduced the total amount assessed for the 2007 year to approximately $2.7 million, a significant reduction from the previous assessment of approximately $14.1 million. However, management continues to believe that we still have a reasonable defense against this lowered assessment and expects the ultimate assessment to range from $0 to $2.7 million. Accordingly, on December 14, 2011, Multimedia Games de Mexico filed, before the Federal Tribunal of Fiscal and Administrative Justice, a lawsuit against the remaining $2.7 million assessment for 2007. The lawsuit was remitted for its study and resolution to the Eleventh Regional Metropolitan Division of the Federal Tribunal of Fiscal and Administrative Matters, and was registered under docket number 31987/11-17-11-8 and is now pending. Multimedia Games de Mexico has submitted evidentiary documentation in support of its complaint and is awaiting review. In January 2012, a bond of $2.7 million, using a $3.5 million standby letter of credit issued under our domestic credit facility, was provided to the taxing authorities as collateral for the potential assessment based on the taxing authorities' current estimate of tax due; however, because management continues to believe that a loss is not probable, it cannot reasonably estimate the amount at this time, and thus has not recorded a reserve for this matter, although it is possible that an adverse outcome could have an adverse effect upon our financial condition, operating results or cash flow.


37



ITEM 1A.
RISK FACTORS

Investing in our common stock involves risks.  Prospective investors in our common stock should carefully consider, among other things, the following risk factors in connection with the other information and financial statements contained in this Quarterly Report, including “PART I – Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” prior to making an investment decision. We have identified the following important factors that could cause actual results to differ materially from those projected in any forward looking statements we may make from time to time. We operate in a continually changing business environment in which new risk factors emerge from time to time. We can neither predict these new risk factors, nor can we assess the impact, if any, of these new risk factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those projected in any forward looking statement. If any of these risks, or combination of risks, actually occur, our business, financial condition and results of operations could be seriously and materially harmed, and the trading price of our common stock could decline. All forward-looking statements in this document are based on information available to us as of the date hereof, and we assume no obligations to update any such forward-looking statements.

We are largely dependent upon one customer. 

For the nine-month periods ended June 30, 2012 and 2011, approximately 31% and 37%, respectively, of our total net revenues (net of accretion) were from one customer. Our relationship with that customer is largely governed by multiple development or placement fee agreements. Under our development and placement fee agreements, we secure a long-term revenue share percentage and a fixed number of player terminal placements in our customer's facility, in exchange for funding the development and construction of the gaming facility. Some of these agreements are set to terminate pursuant to their terms during the next several years and we may not be able to renegotiate new or substantially similar agreements with that customer. A material decrease in our revenue share with our largest customer would have a material and adverse effect upon our financial condition and results of operations.

We have a significant concentration of revenues in Oklahoma and changes in economic, regulatory and licensing conditions in Oklahoma may adversely affect our business.

For the nine-month periods ended June 30, 2012 and 2011, approximately 41% and 51%, respectively, of our total net revenues (net of accretion) were from Native American tribes located in Oklahoma. A significant concentration of our revenue comes from Oklahoma, and local economic, regulatory and licensing changes may adversely affect our Oklahoma customers, and therefore our development and placement fee agreements and our business, disproportionately to changes in national economic conditions, including adverse economic declines or slower economic recovery from prior declines. While we continue to seek to diversify the markets in which we operate, and to expand in the Oklahoma market, the loss of Oklahoma tribes as customers, including our largest customer, would have a material and adverse effect upon our financial condition and results of operations. In addition, legislation allowing tribal-state compacts in Oklahoma has resulted in increased competition from other vendors, who we believe previously avoided entry into the Oklahoma market due to its uncertain and ambiguous legal environment. The State of Oklahoma permits other types of gaming, both at Native American tribal gaming facilities and at Oklahoma racetracks, and many of our competitors now seek entry into this market. The loss of significant market share to these new gaming opportunities or the increased presence of our competitors’ products in Oklahoma could also have a material adverse effect upon our financial condition and results of operations.  We believe that the introduction of our competitor’s more aggressive Class II machines, with characteristics of traditional slot machines, into the Oklahoma Class II market has adversely affected our operating results and market position in that state and may continue to do so in the future. 

The gaming industry is intensely competitive.  We may not be able to successfully compete in new and existing markets due to research and development, intellectual property and regulatory challenges, and if we are unable to compete effectively, our business could be negatively impacted. 

We operate in an intensely competitive industry against larger companies with significant financial, research design and development, and marketing resources. These larger companies, most of whom have greater resources, are aggressively competing against us in our core business operations, including but not limited to, charity bingo, lottery, Class II, Class III, commercial slot and international bingo/gaming markets. Additionally, new smaller competitors compete against us in our traditional markets, and these smaller competitors may not face the same regulatory and/or compliance restraints that we have. Any increased competition will intensify pressure on our pricing model. We expect to face increased competition as we attempt to enter new markets and new geographical locations. 

There are a number of established, well-financed companies producing gaming devices, game content and systems that compete with our products. Certain of these competitors may have access to greater capital resources than we do, and as a result, may be

38



better positioned to compete in the marketplace. The market is crowded, with International Game Technology, WMS Industries, Inc., Bally Technologies, Inc., Aristocrat Technologies, Inc. and Konami Co. Ltd. comprising the primary competition. Pricing, accuracy, reliability, product features and functions are among the factors affecting a provider's success in selling its system. 

Competition in the gaming industry is intense due to the number of providers, as well as the limited number of facilities and jurisdictions in which they operate. As a result of consolidation among the gaming facilities and the recent cutbacks in spending by facility operators due to the downturn in the economy, the level of competition among providers has increased significantly as the number of potential customers has decreased.  Other members of our industry may independently develop games similar to our games, and competitors may introduce noncompliant games that unfairly compete in certain markets due to uneven regulatory enforcement policies/actions. Additionally, our customers compete with other providers of entertainment for their end user’s entertainment budget. Consequently, our customers might not be able to spend new capital on acquiring gaming equipment. Moreover, our customers might reduce their utilization of revenue share agreements. 

We may not collect all amounts recorded for value added taxes related to our operations in Mexico and may be subject to additional income tax in Mexico which may adversely affect our financial results. 

Our Mexican operations are subject to a value added tax, or VAT, which has been applied to the imports of products originating outside of Mexico. We have an outstanding VAT receivable from the Mexican taxing authority primarily related to VAT levied on product shipments for 2006 and 2007.  At June 30, 2012 and September 30, 2011, the Company’s VAT receivable was $3.1 million and $2.8 million, respectively.  The Mexican taxing authority has ruled on 2006 and 2007 and has challenged the registration of certain of our transactions that have generated approximately $383,000 in VAT receivable.  Although we have fully reserved the VAT receivable, we have also formally contested these rulings, and we continue to believe we have a reasonable defense.  However, the final resolution of the contested balances remains uncertain and may adversely affect the carrying value of the receivable. In addition, the Mexican taxing authorities have completed income tax audits for the 2006 and 2007 periods and have ruled that a revised assessment of approximately $2.7 million should be issued for the 2007 period. Upon appeal, the Mexican taxing authorities have reduced their original assessment and we believe we can continue to provide the necessary evidence for a reasonable defense; however, an adverse determination could result in additional foreign income tax expense, which may adversely affect our financial condition, operating results or cash flow.

Our business operations and product offerings are subject to strict regulatory licenses, findings of suitability, registrations, permits and/or approvals that may limit our existing operations and have a negative impact on our ability to grow, which could be materially adverse to our business and prospects. 

Our ability to conduct our existing traditional business, expand operations, develop and distribute new products, games and systems, and expand into new gaming markets is subject to significant federal, state, local, Native American, and foreign regulations. In the United States and many other countries, gaming must be expressly authorized by law. Once authorized, such activities are subject to extensive and evolving governmental regulation. While we seek to comply with the standards and regulations set forth by each jurisdiction, a government agency or court could disagree with our interpretation of these standards and regulations, could determine that the manufacture and use of certain of our electronic player terminals, and perhaps other key components of our gaming systems that rely to some extent upon electronic equipment to run a game, constitute illegal gaming. An adverse regulatory or judicial determination regarding the legal status of our products could have material adverse consequences for our business, operating results and prospects, and we and our officers and directors could be subject to significant fines and penalties.

In addition, we require new licenses, permits and approvals, including third-party certifications that our games comply with a particular jurisdiction's stated regulations, in order to meet our expectations for new market entry, and such licenses, permits or approvals may not be timely granted to us, or granted to us at all, which could have a material effect on our business in general and new market entry specifically. Obtaining and maintaining all required licenses, findings of suitability, registrations, permits or approvals is time consuming and expensive. The suspension, revocation, nonrenewal or limitation of any of our licenses would have a material adverse effect on our business operations, financial condition results of operations and our ability to maintain key employees. Additionally, the gaming authorities may deny, limit, condition, suspend or revoke a gaming license or related approval for violations of applicable gaming laws and regulations and may impose substantial fines and take other actions, any one of which could have a significant adverse effect on our business, financial condition, and results of operations. If additional gaming laws or regulations are adopted, these regulations could impose restrictions or costs that could have a significant adverse effect on us. Moreover, in addition to the risk of enforcement action, we are also at risk of loss of business reputation in the event of any potential legal or regulatory investigation whether or not we are ultimately accused of or found to have committed any violation. A negative regulatory finding or ruling in one jurisdiction could have adverse consequences in other jurisdictions, including with gaming regulators. Furthermore, the failure to become licensed, or the loss or conditioning of a license, in one market may have the adverse effect of preventing licensing in other markets or the revocation of licenses we already maintain.


39



Further, changes in existing gaming laws or regulations or new interpretations of existing gaming laws may hinder or prevent us from continuing to operate in those jurisdictions where we currently do business, which would harm our operating results. In particular, the enactment of unfavorable legislation or government efforts affecting or directed at manufacturers or gaming operators, such as referendums to increase gaming taxes or requirements to use local distributors, would likely have a negative impact on our operations.

As gaming regulatory requirements vary from jurisdiction to jurisdiction, we are subject to a wide range of complex gaming laws and regulations in the jurisdictions in which we, and intend to, operate which could be time consuming, expensive and distracting to management.  As we expand into new markets, we expect to encounter business, legal, operational and regulatory uncertainties as well as additional responsibilities. We recently entered into several major commercial jurisdictions, including Nevada, Mississippi and Louisiana, and as a result, are subject to increasing legal, regulatory and reporting requirements that will require substantial additional resources. As we enter new jurisdictions, our reporting systems for that particular jurisdiction need to be developed and/or updated, and we may fail to provide timely or adequate notifications or reporting requirements within these new jurisdictions, which could have adverse regulatory consequences for us in that, or in other, jurisdictions, which could affect our business. Entering into new markets may require us to make changes to our gaming systems to ensure that they comply with applicable regulatory requirements, and may require us to obtain additional licenses. We may also encounter additional legal and regulatory challenges that are difficult or impossible to foresee and which could result in an unforeseen adverse impact on planned revenues or costs associated with the new market opportunity. If we are unable to effectively develop and operate within these new markets, then our business, operating results and financial condition would be impaired.  Furthermore, as we attempt to generate new streams of revenue by selling units to new customers in new jurisdictions we may have difficulty implementing an effective sales strategy for jurisdictional specific games. Our failure to successfully implement an effective sales strategy could cause our future operating results to vary materially from what management has forecast.

Generally, our placement of systems, games and technology into new market segments involves a number of business uncertainties, including: 

whether the technical platform on which our gaming units, systems, and products are based will comply or can be modified to comply with the minimum technical requirements for the each of the identified new gaming markets;
whether we are able to successfully pass required field trials and comply with the initial game/system installation requirements for each new jurisdiction;
whether our resources and expertise will enable us to effectively operate and grow in such new markets, including meeting regulatory requirements;
whether our internal processes and controls will continue to function effectively within these new segments;
whether we have enough experience to accurately predict revenues and expenses in these new markets;
whether the diversion of management attention and resources from our traditional business, caused by entering into new market segments, will have harmful effects on our traditional business;
whether we will be able to successfully compete against larger companies who dominate the markets that we are trying to enter; and
whether we can timely perform under our agreements in these new markets because of other unforeseen obstacles.

If we are unable to keep pace with rapid innovations in new technologies or product design and deployment or if we are unable to quickly adapt our development and manufacturing processes to compete, our business and results of operation could be negatively impacted. 

Our success is dependent on our ability to develop and sell new products and systems that are attractive not only to our customers, but also to their customers, the end players.  If our gaming devices do not appeal to customers, or if our gaming devices do not meet or sustain revenue and profitability of contractual obligations and expectations, our gaming devices may be replaced by our competitors' devices.  Additionally, we may be unable to enhance existing products in a timely manner in response to changing regulatory, legal or market conditions or customer requirements, or new products or new versions of our existing products may not achieve market acceptance in new or existing markets. Therefore, our future success depends upon our ability to design and market technologically sophisticated products that meet our customer's needs regarding, among other things, ease of use and adaptability, but also that are unique and entertaining such that they achieve high levels of player appeal and sustainability. If we fail to keep pace with our competitors, our business could be adversely affected.

The demands of our customers and the preferences of the end players are continuously changing. As a result, there is constant pressure to develop and market new game content and technologically innovative products. As our revenues are heavily dependent on the earning power and life span of our games and because newer game themes tend to have a shorter life span than more traditional game themes, we face increased pressure to design and deploy new and successful game themes to maintain our revenue stream and remain competitive. Our ability to develop new and innovative products could be adversely affected by:

40




the failure of our new gaming products to become popular with end players;

a decision by our customers or the gaming industry in general to decline to purchases our new gaming devices or to cancel or return previous orders, content or systems in anticipation of newer technologies;

an inability to roll out new games, services or systems on schedule as a result of delays in regulatory product approval in the applicable jurisdictions, or otherwise; and

an increase in the popularity of competitors' games.

There is no assurance that our investments in research and development will lead to successful new technologies or timely new products.  We invest heavily in product development in various disciplines from hardware, software, and firmware engineering to game design, video, multimedia, graphics, and sound. Our newer products are generally more technologically sophisticated and are of a different form than those we have produced in the past and we must continually refine our production capabilities to meet the needs of our product innovation. If we cannot adapt our manufacturing infrastructure to meet the needs of our product innovations, if we are unable to receive the components or resources we require, or if we are unable to make upgrades to our production capacity in a timely manner, our business could be negatively impacted. 

We may not realize satisfactory returns on money lent or otherwise funded to new and existing customers to develop or expand gaming facilities. 

We enter into development and placement fee agreements to provide financing for construction, expansion, or remodeling of gaming facilities, primarily in the State of Oklahoma.  Under our development and placement fee agreements, we secure a long-term revenue share percentage and a fixed number of player terminal placements in the facility, in exchange for funding the development and construction of the gaming facility.  We may not, however, realize the anticipated benefits of any of these strategic relationships or financings as our success in these ventures is dependent upon the timely completion of the gaming facility, the placement of our player terminals, and a favorable regulatory environment.  For example, in fiscal 2010, we took a material impairment charge for a note receivable for money lent in connection with a development agreement for an Alabama facility because of the legal uncertainty of charitable bingo in the State and in fiscal 2011, we removed all charitable bingo machines from charity customer facilities in the State of Alabama due to regulatory changes in the State.

Our development and placement efforts and financing activities may result in operating difficulties, financial risks, or required expenditures that could adversely affect our liquidity.  In connection with one or more of these transactions, and to obtain the necessary development and placement fee funds, we may need to extend secured and unsecured credit to potential or existing customers that may not be repaid, incur debt on terms unfavorable to us or that we are unable to repay, or incur other contingent liabilities. While we believe the increased level of receivables from counterparties to development agreements has allowed us to grow our business, it has also required direct, additional focus of and involvement by management. The failure to maintain controls and processes related to our collection efforts or the deterioration of the financial condition of our customers could negatively impact our business. 

Slow growth in the establishment of new gaming jurisdictions or the number of new casinos and declines in the rate of replacement for existing gaming machines could limit or reduce our future profits. 

While we continue to seek entry into already established gaming jurisdictions, demand for our products is also driven by the establishment of new gaming jurisdictions, the addition of new casinos or expansion of existing casinos within existing gaming jurisdictions and the replacement of existing gaming machines. The establishment or expansion of gaming in any jurisdiction typically requires a public referendum or other legislative action. As a result, gaming continues to be the subject of public debate, and there are numerous active organizations that oppose gaming. Opposition to gaming, such as that which we are experiencing in Alabama, could result in restrictions on or even prohibitions of gaming operations or the expansion of operations in any jurisdiction. In addition, the construction of new casinos or expansion of existing casinos fluctuates with demand, general economic conditions and the availability of financing. The rate of gaming growth in North America has diminished and machine replacements as a percentage of total floor space is at historically low levels. Slow growth in the establishment of new gaming jurisdictions, public protest, political opposition, delays in the opening of new or expanded casinos and continued declines in or low levels of demand for machine replacements, including from greater competition from table games, could reduce the demand for our products and our future profits.




41



Our ability to effectively compete in Native American gaming markets is vulnerable to legal and regulatory uncertainties, including the ability to enforce contractual rights on Native American land. 

Historically, we have derived a majority of our revenue from the placement of Class II player terminals and systems for gaming activities conducted on Native American lands.  Because federally recognized Native American tribes are independent governments with sovereign powers, Native American tribes can enact their own laws and regulate gaming operations and contracts.  Native American tribes maintain their own governmental systems and often their own judicial systems and have the right to tax persons and enterprises conducting business on Native American lands, and also have the right to require licenses and to impose other forms of regulation and regulatory fees on persons and businesses operating on their lands.  In the absence of a specific grant of authority by Congress, states may regulate activities taking place on Native American lands only if the Native American tribe has a specific agreement or compact with the state. Our contracts with Native American tribal customers normally provide that only certain provisions will be subject to the governing law of the state in which a Native American tribe is located.  However, these choice-of-law clauses may not be enforceable. 

Additionally, Native American tribes generally enjoy sovereign immunity from lawsuits similar to that of the individual states and the United States.  Before we can sue or enforce contract rights with a Native American tribe, or an agency or instrumentality of a Native American tribe, the Native American tribe must effectively waive its sovereign immunity with respect to the matter in dispute, which we are not always able to obtain.  For example, our largest customer, who accounts for 31% of our total net revenues (net of accretion) as of June 30, 2012, has not given us a waiver of sovereign immunity.  Without a limited waiver of sovereign immunity, or if such waiver is held to be ineffective, we could be precluded from judicially enforcing any rights or remedies against a Native American tribe, including the right to enter Native American lands to retrieve our property in the event of a breach of contract by the tribe party to that contract.  Even if the waiver of sovereign immunity by a Native American tribe is deemed effective, there will be an issue as to the forum in which a lawsuit can be brought against the Native American tribe.  Federal courts are courts of limited jurisdiction and generally do not have jurisdiction to hear civil cases relating to Native American tribes and we may be unable to enforce any arbitration decision effectively.

Our agreements with Native American tribes are subject to review by regulatory authorities.  For example, our development agreements are subject to review by the NIGC and any such review could require substantial modifications to our agreements or result in the determination that we have a proprietary interest in a Native American tribe’s gaming activity which could materially and adversely affect the terms on which we conduct our business.  The NIGC has previously expressed the view that some of our development agreements could be in violation of the requirements of the Indian Gaming Regulatory Act of 1988 and Native American tribal gaming regulations, which state that the Native American tribes must hold “sole proprietary interest” in the Native American tribes’ gaming operations, which presents additional risk for our business.  The NIGC may also reinterpret applicable laws and regulations, which could affect our agreements with Native American tribes. 

We could be affected by alternative interpretations of the Gambling Devices Act, 15 U.S.C. § 1171, et. seq., or the "Johnson Act," as the customers of our Class II games, the Native American tribes, could be subject to significant fines and penalties if it is ultimately determined they are offering an illegal game, and an adverse regulatory or judicial determination regarding the legal status of our products could have material adverse consequences for our business, operating results and prospects. 

Government enforcement, regulatory action, judicial decisions, and proposed legislative action have in the past, and will likely continue to affect our business, operating results and prospects in Native American tribal lands.  We believe that a number of our competitors have not complied with published regulation restrictions.  We have lost, and could continue to lose, market share to competitors who offer games that do not appear to comply with published regulatory restrictions on Class II games and therefore offer features not available in our products.  The legal and regulatory uncertainties surrounding our Native American tribal agreements could result in a significant and immediate adverse impact on our business and operating results. Additionally, such uncertainties could increase our cost of doing business and could take management’s attention away from operations.  The trading price of our common stock has in the past been, and may in the future be, subject to significant fluctuations based upon market perceptions of the legal status of our products and our ability to compete in all markets, including Native American markets.  Regulatory action against our customers or equipment in these or in other markets could result in machine seizures and significant revenue disruptions, among other adverse consequences.  Moreover, Native American tribal policies and procedures, as well as tribal selection of gaming vendors, are subject to the political and governance environment within each Native American tribe. Changes in tribal leadership or tribal political pressure can affect our business relationships within Native American markets. 

State compacts with our existing Native American tribal customers to allow Class III gaming could reduce demand for our Class II games and our entry into the Class III market may be difficult as we compete against larger companies in the tribal Class III market. 

Certain of our Class II Native American tribal customers have entered into compacts with the states in which they operate to permit

42



the operation of Class III games. While we seek to also provide Class II alternatives in these markets, we believe the number of our Class II game machine placements in those customers’ facilities could decline, and our operating results could be materially and adversely affected.  As our Native American tribal customers continue to transition to gaming under compacts with their respective states, we continue to face significant uncertainty in this market that makes our business in such markets difficult to manage and predict and we may be forced to compete with larger companies that specialize in Class III gaming as these companies move into these newly created Class III compact markets.  We believe the establishment of state compacts depends on a number of political, social, and economic factors that are inherently difficult to ascertain. Accordingly, although we attempt to closely monitor state legislative developments that could affect our business, we may not be able to timely predict if or when a compact could be entered into by one or more of our Native American tribal customers. For example, in Oklahoma, we anticipate that the introduction of Class III games will continue to pressure our market and revenue share percentages and may result in a shift in the market from revenue share arrangements to a sale-based model. 
We may not be successful in protecting our intellectual property rights, or in avoiding claims that either we are infringing upon the intellectual property rights of others or that our intellectual property is not valid and enforceable.
We rely upon patent, copyright, trademark and trade secret laws, license agreements and employee nondisclosure agreements to protect our proprietary rights and technology, but these laws and contractual provisions provide only limited protection. We rely to a greater extent upon proprietary know‑how and continuing technological innovation to maintain our competitive position. Insofar as we rely on trade secrets, unpatented know‑how and innovation, others may be able to independently develop similar technology, or our secrecy could be breached. The issuance of a patent to us does not necessarily mean that our technology or products do not infringe upon the intellectual property rights of others. As we enter into new markets by leveraging our existing technology, and by developing new technology and new products, it becomes more likely that we will become subject to infringement claims from other parties, many of whom have significantly greater resources than we do. Problems with patents or other rights could increase the cost of our products, or delay or preclude new product development and commercialization. If infringement claims against us are valid, we may seek licenses that might not be available to us on acceptable terms or at all. Litigation would be costly and time consuming, but may become necessary to protect our proprietary rights or to defend against infringement claims. We could incur substantial costs and diversion of management resources in the defense of any claims relating to the proprietary rights of others or in asserting claims against others. These expenses could have an adverse effect on our future cash flows and results of operations.  Our assessment of current intellectual property litigation could change in light of the discovery of facts not presently known to us, determinations by judges, juries or others that do not agree with our evaluation of the possible liability or outcome of such litigation, or changes in the patent laws.  If we are found to infringe on the rights of others we could be required to discontinue offering certain products or systems, to pay damages, or purchase a license to use the intellectual property in question from its owner. Litigation can also distract management from the day-to-day operations of the business. We cannot guarantee that our intellectual properties will provide us with a competitive advantage, that it will not be circumvented by our competitors, or that it is all valid and enforceable.
Our success may depend in part on our ability to obtain trademark protection for the names or symbols under which we market our products and to obtain copyright protection and patent protection of our proprietary technologies, intellectual property and other game innovations. We cannot assure you that we will be able to build and maintain goodwill in our trademarks or obtain trademark or patent protection, that any trademark, copyright or issued patent will provide competitive advantages for us, that our intellectual properties will not be successfully challenged or circumvented by competitors, or that our patents and other intellectual property are valid and enforceable.
We also rely on trade secrets and proprietary know-how. We enter into confidentiality agreements with our employees and independent contractors regarding our trade secrets and proprietary information, but we cannot be assured that the obligation to maintain the confidentiality of our trade secrets or proprietary information will be honored. Despite various confidentiality agreements and other trade secret protections, our trade secrets and proprietary know-how could become known to, or independently developed by, competitors.
Some of our products may incorporate open source software. Open source licenses typically mandate that software developed based on source code that is subject to the open source license, or combined in specific ways with such open source software, become subject to the open source license. Open source licenses typically require that source code subject to the license be released or made available to the public. We take steps to ensure that proprietary software we do not wish to disclose is not combined with, or does not incorporate, open source software in ways that would require such proprietary software to be subject to an open source license. However, few courts have interpreted the open source licenses, and the manner in which these licenses may be interpreted and enforced is therefore subject to some uncertainty.
We do not rely upon the term of our customer contracts to retain the business of our customers.
Our contracts with our customers are on a year-to-year or multi-year basis. Except for customers with whom we have entered into development and placement fee agreements, we do not rely upon the stated term of our customer contracts to retain the business of our customers. We rely instead upon providing competitive player terminals, games and systems to give our customers the incentive to continue doing business with us. At any point in time, a significant portion of our business is subject to nonrenewal,

43



which may materially and adversely affect our earnings, financial condition and cash flows. In addition, certain of our customer contracts have "buy out" provisions enabling our customer to purchase machines formerly provided to them under revenue participation arrangements.  To the extent our customers exercise their buy out rights pursuant to these provisions, we recognize revenue from equipment sales in the current period while losing future participation or lease revenue from purchased machines.  This could have the effect of reducing our overall future revenues from these customers and thereby adversely affect our future operating results.
Our games and systems may experience loss based on malfunctions, anomalies or fraudulent activities.
Our games and systems, and games and systems we license or distribute from third parties, could produce false payouts as the result of malfunctions, anomalies or fraudulent activities, which we may be required to pay. We depend on our security precautions and our system of internal controls to prevent fraud. We also depend on regulatory safeguards, which may not be available in all jurisdictions or markets, to protect us against jackpots awarded as a result of malfunctions, anomalies or fraudulent activities. There can be no guarantee that regulatory safeguards in jurisdictions or markets where they do exist, will be sufficient to protect us from liabilities associated with malfunctions, anomalies or fraudulent activities.
The occurrence of malfunctions, anomalies or fraudulent activities could result in litigation against us by our customers based on lost revenue or other claims based in tort or breach of contract. Moreover, these occurrences could result in investigations or disciplinary actions by applicable gaming regulators. Additionally, in the event of such issues with our gaming devices or software, substantial engineering and marketing resources may be diverted from other areas to rectify the problem.
Worsening economic conditions may adversely affect our business.
The demand for entertainment and leisure activities tends to be highly sensitive to consumers' disposable incomes, and thus a decline in general economic conditions, higher levels of unemployment, weakness in the housing markets, higher consumer debt levels, declines in consumer confidence in future economic conditions, higher tax rates, higher interest rates, and other adverse economic conditions may lead to our end users having less discretionary income with which to wager. Additionally, higher airfares, gasoline prices and other costs may adversely affect the number of players visiting our customers' gaming facilities. The gaming industry is currently experiencing a period of reduced demand. A decline in the relative health of the gaming industry and the difficulty or inability of our customers to obtain adequate levels of capital to finance their ongoing operations reduces their resources available to purchase our products and services, which adversely affects our revenues. If we experience a significant unexpected decrease in demand for our products, we could also be required to increase our inventory obsolescence charges. Additionally, a decline in general economic conditions might negatively impact our customers' abilities to pay us in a timely fashion. Our customers' failures to make timely payments could result in an increase in our provision for bad debt.

Litigation may adversely affect our business, financial condition and results of operations. 

We are subject to legal and regulatory requirements applicable to our business and industry.  We are also subject to the risk of litigation by employees, customers, our customer's customers, patent owners, competitors, suppliers, shareholders or others through private actions, class actions, administrative proceedings and other legal proceedings.  Litigation can be lengthy, expensive, and disruptive to our operations and results cannot be predicted with certainty or, sometimes, at all. Current estimates of loss regarding pending litigation may not be reflective of any particular final outcome. The results of rulings, judgments or settlements of pending litigation may result in financial liability that is materially higher than what management has estimated at this time and we may experience adverse publicity associated with litigation, regardless of whether the allegations are valid or whether we are ultimately found liable.  We make no assurances that we will not be subject to liability with respect to current or future litigation. We maintain various forms of insurance coverage; however, substantial rulings, judgments or settlements could exceed the amount of insurance coverage (or any cost allocation agreement with an insurance carrier), may not be covered under our existing insurance policies, or could be excluded under the terms of an existing insurance policy. Moreover, our failure to comply with procedural or operational requirements inherent to our policies may void coverage.  Additionally, failure to secure favorable outcomes in pending litigation could result in adverse consequences to our business, operating results and/or overall financial condition, including without limitation, possible adverse effects on compliance with the terms of our Amended Credit Agreement. 

Casino operations are conducted at the discretion of our customers. 

We seek to provide assistance to our key customers in the form of project management, with a focus on facility layout and planning, gaming floor configuration and customized marketing and promotional initiatives. Our customers, however, are solely responsible for the operations of their facilities and are not required to consult us or take our advice on their operations, marketing, facility layout, gaming floor configuration, or promotional initiatives. Further, our customers are solely responsible for safety and security at their facilities.  Our customers have in the past, and will in the future, remodel and expand their facilities. To the extent that our machines are not a part of an optimized facility layout or gaming floor configuration, are not supported by effective marketing or promotional initiatives or are scheduled to be out of service during a facility remodeling, or our customers' facilities are closed or not visited because of end-users concern for safety, our operating results could suffer. 

44




Demand for our products and the level of play of our products could be adversely affected by changes in player and operator preferences.

As a supplier of gaming machines, we must offer themes and products that appeal to gaming operators and players. There is constant pressure to develop and market new game content and technologically innovative products.  Our revenues are dependent on the earning power and life span of our games. We therefore face continuous pressure to design and deploy new and successful game themes to maintain our revenue and remain competitive.  If we are unable to anticipate or react timely to any significant changes in player preferences, such as a negative change in the trend of acceptance of our newest systems innovations or jackpot fatigue (declining play levels on smaller jackpots), the demand for our gaming products and the level of play of our gaming products could decline. Further, our products could suffer a loss of floor space to table games or other more technologically advanced games or operators may reduce revenue sharing arrangements, each of which would harm our sales and financial results. In addition, general changes in consumer behavior, such as reduced travel activity or redirection of entertainment dollars to other venues, could result in reduced demand and reduced play levels for our gaming products.
The carrying value of our assets is dependent upon our ability to successfully deploy games into new or existing markets.
We have gaming units not deployed as of June 30, 2012, which are considered part of our rental pool. This rental pool is available for deployment in new or existing customer facilities. If the opening of new facilities is altered negatively or the expansion, reduction or closing of an existing facility occurs, the realizable value of these assets could be adversely impacted. In such instances we may be required to recognize im