XNAS:SHFL SHFL Entertainment Inc Quarterly Report 10-Q Filing - 4/30/2012
Effective Date 4/30/2012
| • FORM 10-Q • EXHIBIT 10.1 • EXHIBIT 31.1 • EXHIBIT 31.2 • EXHIBIT 32.1 • EXHIBIT 32.2 • XBRL INSTANCE • XBRL TAXONOMY EXTENSION SCHEMA • XBRL TAXONOMY EXTENSION CALCULATION • XBRL TAXONOMY EXTENSION DEFINITION • XBRL TAXONOMY EXTENSION LABELS • XBRL TAXONOMY EXTENSION PRESENTATION | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Commission file number: 0-20820
 SHUFFLE MASTER, INC.
(Exact name of registrant as specified in its charter)
Registrant’s Telephone Number, Including Area Code: (702) 897-7150
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 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. (Check one):
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 May 31, 2012, there were 55,801,370 shares of our $.01 par value common stock outstanding.
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SHUFFLE MASTER, INC.
QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED APRIL 30, 2012
TABLE OF CONTENTS
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PART I
ITEM 1. FINANCIAL STATEMENTS
SHUFFLE MASTER, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
See Notes to Unaudited Condensed Consolidated Financial Statements.
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SHUFFLE MASTER, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
(Unaudited)
See Notes to Unaudited Condensed Consolidated Financial Statements.
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SHUFFLE MASTER, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands, except per share amounts)
(Unaudited)
See Notes to Unaudited Condensed Consolidated Financial Statements.
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SHUFFLE MASTER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. DESCRIPTION OF BUSINESS AND INTERIM BASIS OF PRESENTATION
Description of business. Unless the context indicates otherwise, references to “Shuffle Master, Inc.,” “we,” “us,” “our,” or the “Company,” include Shuffle Master, Inc. and its consolidated subsidiaries.
We are a leading global gaming supplier committed to making gaming more fun for players and more profitable for operators through product innovation, and superior quality and service. We operate in legalized gaming markets across the globe and provide state-of-the-art, value-add products in four distinct segments: Utility products, which include automatic card shufflers and roulette chip sorters; Proprietary Table Games (“PTG”), which include live games, side bets and progressives as well as our newly introduced i-Gaming, which features online versions of our table games, social gaming and mobile applications; Electronic Table Systems (“ETS”), which include various e-Table game platforms; and Electronic Gaming Machines (“EGM”), which include video slot machines.
We lease, license and sell our products. When we lease or license our products, we generally negotiate a month-to-month operating lease. When we sell our products, we offer our customers a choice between a sale, a longer-term sales-type lease or other long-term financing. We offer our products worldwide in markets that are highly regulated. We manufacture our products at our headquarters and manufacturing facility in Las Vegas, Nevada, as well as at our Australian headquarters and manufacturing facility in Milperra, New South Wales, Australia. In addition, we outsource the manufacturing of certain of our sub-assemblies in the United States, Europe and Asia.
Utility. Our Utility segment develops products for licensed casino operators that enhance table game speed, productivity, profitability and security. Utility products include automatic card shufflers and roulette chip sorters. This segment also includes our i-Shoe® Auto card reading shoe that gathers data and enables casinos to track table game play and our i-Score™ baccarat viewer that displays current game results and trends. These products are intended to cost-effectively provide licensed casino operators and other users with data on table game play for security and marketing purposes, which in turn allows them to increase their profitability.
Proprietary Table Games. Our PTG segment develops and delivers proprietary table games that enhance our casino customers' and other licensed operators' table game operations. Products in this segment include our proprietary table games, side bets, add-ons and progressives as well as our newly introduced i-Gaming products, which feature online versions of our table games, social gaming, and mobile applications. Our proprietary content and features are also added to public domain games such as poker, baccarat, pai gow poker and blackjack table games and to electronic platforms such as Table Master® and i-Table®.
Electronic Table Systems. Our ETS segment develops and delivers various products involving popular table game content using e-Table game platforms. Our primary ETS products are i-Table®, Table Master®, Vegas Star® and Rapid Table Games®. Our i-Table® platform combines an electronic betting interface with a live dealer who deals the cards from our card reading shoe or shuffler that is designed to improve game speed and security while reducing many operating expenses associated with live tables. Our Table Master® and Vegas Star® products feature a virtual dealer which enables us to offer table game content in both traditional gaming markets and in markets where live table games are not permitted, such as some racinos, video lottery and arcade markets. Our Rapid Table Games® product enables the automation of certain components of traditional table games such as data collection, placement of bets, collection of losing bets and payment of winning bets combined with live dealer and game outcomes. This automation provides benefits to both casino operators and players, including greater security and faster speed of play.
Electronic Gaming Machines. Our EGM segment develops and delivers our PC-based video slot machines into select markets, primarily in Australasia. We offer a selection of video slot titles which include a range of bonus round options that can be configured as a network of machines or as stand-alone units. In addition to selling the full EGM complement, we sell software conversion kits that allow existing EGM terminals to be converted to other games on the PC3 and PC4 platform. Popular titles for our EGMs include Cats Hats & Bats™, Eureka Gold Mine 2™, Emerald Fortunes™ and King of Babylon™. In addition, we continue to develop a popular range of games utilizing the Pink Panther™ brand, under license from Metro-Goldwyn-Mayer Studios, Inc. consumer products.
Basis of presentation. The accompanying Unaudited Condensed Consolidated Financial Statements include the results of operations, financial position and cash flows of Shuffle Master, Inc. and its consolidated subsidiaries. All material intercompany balances have been eliminated.
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In the opinion of our management, the accompanying Unaudited Condensed Consolidated Financial Statements include all adjustments necessary to fairly state, in all material respects, our results for the periods presented. These Condensed Consolidated Financial Statements have been prepared by us pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with Generally Accepted Accounting Principles (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and accompanying notes included in our 2011 Annual Report on Form 10-K filed with the SEC on January 5, 2012. The results of operations for the three and six months ended April 30, 2012 are not necessarily indicative of results to be expected for the entire fiscal year.
Reclassification. The Company revised its October 31, 2011, condensed consolidated balance sheet to appropriately classify amounts that were previously included within accounts receivable as current investment in sales-type leases and notes receivable. This revision resulted in a $3.2 million increase in the current investment in sales-type leases and notes receivable with a corresponding reduction to accounts receivable. The revision, which the Company determined is not material, had no impact on total current assets, results of operations or cash flows.
Use of estimates and assumptions. The preparation of our Condensed Consolidated Financial Statements in conformity with GAAP requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the Condensed Consolidated Financial Statements and the reported amounts of revenues and expenses during the reporting periods. Future events and their effects cannot be predicted with certainty; accordingly, our accounting estimates require the exercise of judgment. The accounting estimates used in the preparation of our Condensed Consolidated Financial Statements will change as new events occur, as more experience is acquired, as additional information is obtained and as our operating environment changes. We evaluate and update our assumptions and estimates on an ongoing basis. Actual results could differ from those estimates.
Revenue recognition. We recognize revenues when all of the following have been satisfied:
Revenues are reported net of incentive rebates and discounts. Amounts billed prior to completing the earnings process are deferred until revenue recognition criteria are met.
Product lease and royalty revenue — Lease and royalty revenue is earned from the leasing of our tangible products and the licensing of our intangible products, such as our proprietary table games. When we lease or license our products, we generally negotiate month-to-month fixed fee contracts, or to a lesser extent, enter into participation arrangements whereby casinos pay a fee to us based on a percentage of net win. Lease and royalty revenue commences upon the completed installation of the product. Lease terms are generally cancellable with 30 days' notice. We recognize revenue from our leases and licenses upon installation of our product on a month to month basis.
Product sales and service revenue — We generate sales revenue through the sale of equipment in each product segment, including sales revenue from sales-type leases and the sale of lifetime licenses for our proprietary table games. Our credit sales terms are primarily 60 days or less. Financing for intangible property and sales-type leases for tangible property have payment terms ranging generally from 24 to 36 months and are interest-bearing at market interest rates. Revenue from the sale of equipment is recorded in accordance with the contractual shipping terms. Products placed with customers on a trial basis are not recognized as revenue until the trial period ends, the customer accepts the product and all other relevant criteria have been met. If a customer purchases existing leased equipment, revenue is recorded on the effective date of the purchase agreement. Revenue on service and warranty contracts is recognized as the services are provided over the term of the contracts, which are generally one year. Revenue from the sale of lifetime licenses, under which we have no continuing obligation, is recorded on the effective date of the license agreement.
Multiple element arrangements — Some of our revenue arrangements contain multiple deliverables, such as a product sale combined with a service element or the delivery of a future product. Most of our products and services qualify as separate units of accounting. When vendor specific objective evidence or third-party evidence is not available, the management's best estimate of selling price ("BESP") is the amount we would sell the product or service for individually. The determination of BESP is made based on our normal pricing and discounting practices, which consider multiple factors, such as market conditions, competitive landscape, internal costs and profit objectives. Revenues allocated to future performance obligations elements are deferred and will be recognized upon delivery and customer acceptance.
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Fair value measurement disclosure. In the current quarter, we adopted an Accounting Standards Update (“ASU”) on how to measure fair value and on what disclosures to provide about fair value measurements, which expands disclosure requirements particularly for Level 3 inputs to include following:
Recently issued accounting standards or updates – not yet adopted
Comprehensive income – In June 2011, FASB issued an ASU on presentation of comprehensive income to improve the comparability, consistency and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income. This update changes the requirements for the presentation of other comprehensive income, eliminating the option to present components of other comprehensive income as part of the statement of stockholders' equity, among other items. The guidance requires that all non-owner changes in stockholders' equity be presented in either a single continuous statement of comprehensive income or in two separate but consecutive statements.
This ASU will be effective for our first quarter of fiscal 2013 and as the update only requires a change in presentation, we do not expect the update to have a material impact on our financial statements.
2. SELECTED BALANCE SHEET DATA
The following provides additional disclosures for selected balance sheet accounts:
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3. INTANGIBLE ASSETS AND GOODWILL
Amortizable intangible assets. All of our recorded intangible assets, excluding goodwill and the StargamesTM and CARDTM tradenames, are subject to amortization. We amortize our intangible assets as the economic benefits of the intangible asset are consumed or otherwise used up. Amortization expense was $2.3 million and $2.5 million for the three months ended April 30, 2012 and 2011, respectively and $4.6 and $4.9 million for the six months ended April 30, 2012 and 2011, respectively. Amortization expenses are included in cost of leases and royalties and cost of sales and service, except for customer relationships which are included in selling, general and administrative expenses.
Amortizable intangible assets are comprised of the following:
The increase in amortizable intangible assets for the six months ended April 30, 2012 relates to our purchase of table games intellectual property and acquisition of licenses to be used in our EGM segment.
Tradenames. Intangibles with an indefinite life, consisting of the Stargames™ and CARD™ tradenames, are not amortized, and were $24.6 million and $25.5 million as of April 30, 2012 and October 31, 2011, respectively.
Goodwill. Changes in the carrying amount of goodwill for the years ended October 31, 2010, 2011 and the six months ended April 30, 2012, are as follows:
The $3.0 million of additional goodwill in our PTG segment relates to the acquisition of games and intellectual property that were treated as a business acquisition for accounting purposes.
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The $0.5 million of additional goodwill in our PTG segment relates to our acquisition of certain assets from Bet Technology, Inc. (“BTI”) in 2004. In 2004, we recorded an initial estimated liability of $7.6 million for contingent installment payments computed as the excess fair value of the acquired assets over the fixed installments and other direct costs. In November 2004, we began paying monthly note installments based on a percentage of certain revenue from BTI games for a period of up to ten years, not to exceed $12.0 million. The final principal and interest payment related to our initial estimated liability of $7.6 million was paid in February 2009 and all payments made subsequently have been recorded as additional goodwill. As of April 30, 2012, we have paid approximately $11.0 million of the $12.0 million maximum amount.
4. DEBT
Debt consisted of the following:
$200.0 million senior secured revolving credit facility. On October 29, 2010, we entered into a senior secured credit agreement (the “Senior Secured Revolving Credit Facility”) with Wells Fargo Securities, LLC and Banc of America Securities LLC, as joint lead arrangers and joint lead bookrunners, Bank of America, N.A., as syndication agent, and Union Bank, N.A., as documentation agent. The Senior Secured Revolving Credit Facility provides for senior secured credit facilities in an aggregate principal amount of $200.0 million consisting of a 5-year revolving credit facility (the “Revolver”) in an aggregate principal amount of $200.0 million with a sub-facility for letters of credit of $25.0 million, a sub-facility for multicurrency borrowings in Euros, Australian dollars and Canadian dollars of $25.0 million, and a sub-facility for swing line loans of $20.0 million, each on customary terms and conditions. The Senior Secured Revolving Credit Facility includes an option to increase the Revolver to $300.0 million, which would require syndication approval.
Loans under the Revolver (other than Swing Line Loans, as defined) bear interest at the Base Rate, as defined, or LIBOR, as elected by us. Base Rate interest is calculated at the Base Rate plus the applicable margin and the Base Rate is the highest of:
Swing Line Loans bear interest at the Base Rate plus the applicable margin. Our effective interest rate as of April 30, 2012 was 2.0%. Borrowings under the Revolver may be used for working capital, capital expenditures and general corporate purposes (including share repurchases).
As of April 30, 2012, the amount drawn under the Revolver was $21.4 million and after considering restrictive financial covenants under the Senior Secured Revolving Credit Facility, we had approximately $178.6 million of available remaining credit under the Revolver. The Revolver matures on October 29, 2015.
Covenants. Our Senior Secured Revolving Credit Facility contains three financial maintenance covenants requiring us to maintain a Total Leverage Ratio, as defined therein, of not more than 3.75 to 1.0, a Senior Leverage Ratio, as defined therein, of not more than 3.0 to 1.0 until October 31, 2013 and not more than 2.75 to 1.00 after October 31, 2013 and Interest Expense Coverage Ratio, as defined therein, in excess of 3.0 to 1.0 at the end of any fiscal quarter. As of April 30, 2012, our Total Leverage Ratio, Senior Leverage Ratio and Interest Expense Coverage Ratio were 0.28 to 1.0, 0.26 to 1.0 and 50.19 to 1.0, respectively.
Guarantors and collateral. The Revolver obligations under our Senior Secured Revolving Credit Facility are guaranteed by each existing and future wholly-owned domestic subsidiary of ours that is not an immaterial subsidiary and are secured by a first priority lien on substantially all of our and our guarantors’ assets.
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5. SHAREHOLDERS’ EQUITY
Common stock repurchases. Our board of directors periodically authorizes us to repurchase shares of our common stock. As of April 30, 2012, $21.1 million remained outstanding under our board authorization. We cancel shares that are repurchased. No shares were repurchased during the three and six months ended April 30, 2012. Although we generally prioritize bank debt reduction over share repurchases we may consider share repurchases when there are anomalies in the share value created by, but not limited to, market conditions.
The timing of our common stock repurchases pursuant to our board of directors’ authorization is dependent on future opportunities and on our views, as they may change from time to time, as to the most prudent uses of our capital resources, including cash and borrowing capacity.
Other comprehensive income. For the three and six months ended April 30, 2012 and 2011, other comprehensive income consisted primarily of foreign currency translation adjustments. The following table provides information related to other comprehensive income:
Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains and losses that under GAAP are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency.
Additional paid in capital. For the six months ended April 30, 2012, the activity in additional paid in capital consisted of $14.1 million in proceeds received from stock option exercises and $2.8 million in share-based compensation expense and related tax effect/benefit from stock option activity.
6. SHARE-BASED COMPENSATION
Share-based award plans. In February 2004, our board of directors adopted and, in March 2004, our shareholders approved the Shuffle Master, Inc. 2004 Equity Incentive Plan (the “2004 Plan”) and the Shuffle Master, Inc. 2004 Equity Incentive Plan for Non-Employee Directors (the “2004 Directors’ Plan”). These approved plans replaced our prior plans and no further options may be granted from the prior plans. Both the 2004 Plan and the 2004 Directors’ Plan provide for the grant of stock options, stock appreciation rights (none issued) and restricted stock. In addition, the 2004 Plan provides for the grant of restricted stock units. Awards granted under the plans (collectively “Awards”) may be granted individually or in any combination. Stock options may not be granted at an exercise price less than the market value of our common stock on the date of grant and may not be subsequently repriced. Equity granted under the 2004 Plan generally vests in equal increments over four years and expires in ten years. Equity granted under the 2004 Directors’ Plan generally vests over periods of one to two years.
The 2004 Plan provides for the grants of Awards to our officers, other employees and contractors. The maximum number of Awards which may be granted is 2.7 million of which no more than 1.9 million may be granted as restricted stock. The 2004 Directors’ Plan provides for the grants of Awards to our non-employee directors. The maximum number of Awards which may be granted is 1.1 million of which no more than 0.8 million may be granted as restricted stock.
In January 2009, our board of directors adopted and, in March 2009, our shareholders approved the Shuffle Master, Inc. 2004 Equity Incentive Plan (as amended and restated on January 28, 2009) (the “Amended 2004 Plan”). The Amended 2004 Plan increased the number of shares available for issuance in addition to other related technical changes. Subject to the Amended 2004 Plan, the aggregate number of shares that may be granted under the Amended 2004 Plan may not exceed 5.2 million shares of which no more than 2.6 million shares may be granted as restricted stock.
As of April 30, 2012, under the Amended 2004 Plan and 2004 Directors’ Plan, there were 0.9 million and 0.2 million shares available for grant, respectively.
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A summary of activity related to stock options is presented below:
There were no stock options granted during the three months ended April 30, 2012 and the weighted average grant date fair value of stock options granted during the six months ended April 30, 2012 was $6.23. The weighted average grant date fair value of stock options granted during the three and six months ended April 30, 2011 was $5.16 and $5.67, respectively.
For the three and six months ended April 30, 2012, 1.0 million and 1.3 million stock options were exercised, respectively. The tax effect/benefit from stock option exercises affected our deferred tax asset or income tax payable as well as our additional paid-in capital by an equal amount and had no effect on our income tax provision. As of April 30, 2012, there was approximately $5.2 million of unamortized compensation expense related to stock options, which expense is expected to be recognized over a weighted-average period of 1.9 years.
A summary of activity related to restricted stock is presented below:
The total value of each restricted stock grant, based on the fair market value of the stock on the date of grant, is amortized to compensation expense over the related vesting period. As of April 30, 2012, there was approximately $7.3 million of unamortized compensation expense related to restricted stock, which expense is expected to be recognized over a weighted-average period of 2.0 years.
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Recognition of compensation expense. The following table shows information about compensation costs recognized:
Option valuation models require the input of certain assumptions and changes in assumptions used can materially affect the fair value estimate. Expected volatility is based on a combination of implied and historical factors related to our common stock. Expected term represents the estimated weighted-average time between grant date and its exercise date and is based on historical factors. Expected dividend yield is based on our expectation that dividends will not be paid within the average expected life of existing options. Risk free interest rate is based on U.S. Treasury rates appropriate for the expected term. We estimate the fair value of each stock option award on the grant date using the Black-Scholes valuation model incorporating the weighted-average assumptions noted in the following table:
7. INCOME TAXES
Our effective income tax rate from continuing operations for the three and six months ended April 30, 2012 was 32.4% and 31.5%, respectively. Our effective income tax rate from continuing operations for the three and six months ended April 30, 2011 was 24.2% and 25.5%, respectively. The higher effective income tax rate for the six months ended April 30, 2012 compared to the prior year period is attributable to nondeductible expenses recorded in the current period for transaction costs related to the Ongame (as defined below under Note 11) acquisition and changes in valuation allowances. Our effective income tax rate may fluctuate due to changes in the amount and mix of domestic and foreign income, changes in tax legislation, changes in valuation allowances and changes in assessments of uncertain tax positions and related accumulated interest and penalties.
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8. EARNINGS PER SHARE
Shares used to compute basic and diluted earnings per share from operations are as follows:
9. FAIR VALUE MEASUREMENT
We utilize a three level hierarchy that defines the assumptions used to measure certain assets and liabilities at fair value.
Cash and cash equivalents, accounts receivable, the current portion of our investment in sales-type leases and notes receivable are not presented in the table below as their carrying value approximates fair value due to their short term nature. It is impracticable to estimate the fair value of the long-term portion of our investment in sales-type leases and notes receivable as it is comprised of many insignificant balances, customers with different credit profiles and various interest rates. The fair value of our Revolver as of April 30, 2012 and October 31, 2011 has been calculated based on market borrowing rates available as of April 30, 2012 and October 31, 2011, respectively, for debt with similar terms and maturities. The following table provides the fair value measurement information about the Company’s long-term debt.
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10. OPERATING SEGMENTS
The following provides financial information concerning our reportable segments of our operations:
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REVENUE BY GEOGRAPHIC AREA
The following provides financial information concerning our revenues by geographic area:
11. COMMITMENTS AND CONTINGENCIES
Ongame Network Ltd. On March 5, 2012, through our wholly-owned subsidiary Shuffle Master International, Inc., we entered into a definitive agreement to acquire Ongame Network Ltd., a limited liability company incorporated and existing under the laws of Gibraltar (“Ongame”), from bwin.party services (Austria) GmbH (“bwin.party”). Ongame is one of the world’s largest business to business online poker providers.
The acquisition is subject to completion of certain conditions, including the continued material accuracy of the parties’ representations and warranties; the performance of and compliance with all covenants in the definitive agreement; and the receipt of required regulatory approvals. The closing of the transaction is expected to occur not more than nine months following execution of the definitive agreement (the “Closing”). As consideration for the acquisition of the shares of Ongame, and indirectly the acquisition of Ongame’s subsidiaries, at the Closing we will pay €19.5 million (approximately $25.8 million using the translation rate available as of April 30, 2012) in cash, subject to certain adjustments at Closing. We may also become obligated to additionally pay up to €10 million in cash within five years of Closing contingent upon the commencement of legalized, real-money online poker in the U.S. occurring, if at all, within five years of Closing. The €10 million (approximately $13.2 million using the translation rate available as of April 30, 2012) contingent payment decreases through the five-year period. The contingent payment will be €10 million if real-money online poker is legalized in the U.S. on or before 730 days following Closing, €7 million if legalized on or after 731 days following Closing and on or before 1,095 days following Closing, €5 million on or after 1,096 days following Closing and on or before 1,461 days following Closing, and €3 million on or after 1,462 days following Closing and on or before 1,826 days following Closing. We expect to fund the acquisition with cash on hand and availability on the Senior Secured Revolving Credit Facility.
The obligations of the signatories under the definitive agreement are guaranteed by each party’s ultimate parent entity to the benefit of the respective other party.
Employment agreements. We have entered into employment agreements with our corporate officers and certain other key employees with durations ranging from one to four years. Significant contract provisions include minimum annual base salaries, healthcare benefits, bonus compensation if performance measures are achieved and non-compete provisions. These contracts are primarily “at will” employment agreements, under which the employee or we may terminate employment. If we terminate any of these employees without cause, we are obligated to pay the employee severance benefits as specified in their individual employment agreement. As of April 30, 2012 and October 31, 2011, minimum aggregate severance benefits totaled $7.4 million and $6.6 million, respectively.
Legal proceedings. In the ordinary course of business, we are involved in various legal proceedings and other matters that are complex in nature and have outcomes that are difficult to predict. We record accruals for such contingencies to the extent that we conclude that it is probable that a loss will be incurred and the amount of loss can be reasonably estimated. We have not recorded any loss accruals for these contingencies other than as we have considered reasonable for the matters noted below. Our assessment of each matter may change based on future unexpected events. An unexpected adverse judgment in any pending litigation could cause a material impact on our business operations, intellectual property, results of operations or financial position. Unless otherwise expressly stated, we believe costs associated with litigation will not have a material impact on our financial position or liquidity, but may be material to the results of operations in any given period. We assume no obligation to update the status of pending litigation after the date of this Form 10-Q, except as may be required by applicable law, statute or regulation.
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TableMAX – In April 2009, TableMAX IP Holdings, Inc. and TableMAX Gaming, Inc. filed a complaint (the “First Complaint”) against us in the United States District Court for the District of Nevada. This case is a patent infringement claim alleging that our Table Master® product infringes U.S. Patents 5,688,174, 6,921,337 and 7,201,661. The First Complaint sought injunctive relief and an unspecified amount of damages, including claims for attorneys’ fees, costs, increased damages and disbursements. In August 2009, TableMAX Holdings, Inc. and TableMAX Gaming, Inc. voluntarily dismissed the First Complaint. On the same date, TableMAX IP Holdings, Inc., TableMAX Gaming, Inc. and Vegas Amusement, Inc. the alleged owner of Patents 5,688,174, 6,921,337 and 7,201,661, (collectively “TableMAX”), filed a new complaint (the “New Complaint”) making allegations materially the same as the allegations in the First Complaint. In August 2009, TableMAX filed an amended complaint (the “Second Complaint”), which superseded and is materially the same as the New Complaint, except that the plaintiffs added a new claim that Table Master® infringes U.S. Patent 7,575,512, which was issued on August 18, 2009. In August 2009, the plaintiffs filed a Motion for Preliminary Injunction in the Second Complaint that sought to enjoin future sales of our Table Master® product. In October 2009, the Court denied the Motion for Preliminary Injunction without hearing oral argument and the Court also denied without prejudice various motions for summary judgment that we filed. During the discovery process, TableMAX made new allegations that certain of our Vegas Star® products infringe one of the patents in the Second Complaint. In January 2010, TableMAX filed a Second Amended Complaint (the "Third Complaint"), which has materially the same allegations as the Second Complaint, except that it alleges that our Vegas Star® product allegedly infringes all of the patents in suit. A document produced in the discovery process appears to limit TableMAX's allegations of infringement regarding our Vegas Star® product to only one of TableMAX's patents in suit.
The Court set the Markman hearing for December 2010. In November 2010, the Court granted our Motion to Stay. The stay was granted because of pending reexamination proceedings before the United States Patent and Trademark Office as to the four patents that are the subject of the lawsuit. The reexamination proceedings were initiated as a result of our request. We believe that the final results of the reexamination proceedings will be beneficial to us in future Court proceedings. It is possible that all four reexamination proceedings will conclude in fiscal 2012 and thus the stay may be lifted in fiscal 2012. At present, the case remains stayed. We believe that the claim is entirely without merit and we intend to continue to vigorously defend this matter.
Macau Rapid Baccarat ® Patent Issue – On or about June 3, 2009, at the G2E Asia Gaming Show, customs officials from Macau SAR seized a Shuffle Master, Inc. (“SMI”) Rapid Baccarat ® unit related to a claim by a Macau patent holder of our alleged patent infringement. On October 27, 2009, the governmental official in charge of the investigation elected to dismiss the investigation based on a finding that no patent infringement existed based upon the report of the Macau customs officials. In November 2009, the patent holder appealed this finding to the Macau Courts. On or about January 20, 2010, over our objection, the judge considering the patent holder’s appeal found that his appeal was timely filed.
On or about February 2010, we filed an appeal (the “First SMAL Appeal”) to this decision. On or about March 2010, the judge declined to forward the First SMAL Appeal to a higher Macau Court. We filed a further appeal (the “Second SMAL Appeal”) to have the higher Macau court hear the First SMAL Appeal. On June 2, 2010, the Judge denied the patent holder’s request to open a criminal proceeding and decided that the investigation should remain dismissed against SMAL and its directors. The patent holder has subsequently appealed the June 2, 2010, decision to a higher Macau court, which appeal has not yet been heard. In the event the patent holder’s appeal is successful, it is likely that legal proceedings will be commenced against SMAL and its directors in Macau relating to this patent, although, at this time, no such proceedings have been commenced. Such proceedings, if initiated, would be for patent infringement, which we understand is a criminal matter in Macau. The Company does not carry insurance with respect to this matter. We believe that the claim is without merit and we intend to continue to defend this matter vigorously.
On May 4, 2012, the patent holder along with a company apparently controlled by the patent holder (collectively the "patent holders") requested that the Macau Court enjoin us and certain other exhibitors from infringing the patent holders' patents during the G2E Asia Gaming Show held May 22 through May 24. On May 15, 2012, the Macau Court signed a written decision enjoining us and certain other exhibitors from infringing these patents, even though the court decision did not specifically identify which of our products at the G2E Asia Gaming Show would allegedly infringe such patents. On May 22, 2012, Macau Customs instructed the Company to cover our Rapid Table Games™ Multi Game product at the G2E Asia Gaming Show and we complied. On May 23, 2012, we received Court approval to post a bond of approximately $0.1 million in substitution of the injunction and to permit us to display the Rapid Table GamesTM Multi Game product. Notwithstanding that on May 23, 2012, we displayed the Rapid Table Games™ Multi Game product on the advice of our Macau counsel following the Macau Court allowing us to post a bond, we believe that Macau government officials are investigating the timing of lifting of the cover off the Rapid Table GamesTM Multi Game product and whether such action may give rise to any alleged criminal charges against SMAL or its officers. The patent holders are required to file civil action for patent infringement and to attempt to claim other alleged damages within ten days from the date of service of the injunction. As with the other claim, we believe that all of these claims are entirely without merit and we intend to continue to vigorously defend this matter.
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Wright Matter – On November 7, 2009, Sam Wright was playing a Vegas Star ® craps machine at the Harrah’s Casino New Orleans. Mr. Wright played a game that ended in a losing result. After the game concluded, as a result of a malfunction, a false credit meter value of approximately $42.0 million appeared on the machine. On or about April 2010, we received notice that Mr. Wright had filed a patron dispute with the Louisiana State Police Gaming Division. In October 2010, the Louisiana State Police Gaming Division concluded in regard to the patron dispute that there was no violation of state law, rule or internal control. Mr. Wright was unsuccessful in the patron dispute.
In November 2010, Mr. Wright filed a Petition for Damages (the “Wright Complaint”) with the Civil District Court for the Parish of Orleans, State of Louisiana, naming the Company, Jazz Casino Company, LLC d/b/a Harrah’s New Orleans Casino and Harrah’s New Orleans Management Company (collectively, “Harrah’s) as defendants. The Petition claimed damages of approximately $43.0 million plus possible treble damages, attorneys’ fees and costs. The Company could have had possible indemnity obligations to Harrah’s if a judgment had been entered. In February 2011, all defendants answered the Petition and removed the case to the United States District Court for the Eastern District of Louisiana. On February 2012, the Company attended a Court ordered settlement conference, in which the Wright Complaint and the Declaratory Relief Complaint (discussed below) were settled between the parties without admission of liability by either the Company or Harrah’s. Effective May 8, 2012, the Wright Compliant and the Declaratory Relief Complaint were dismissed with prejudice.
Axis Surplus Insurance Company (“Axis”) was the Company’s insurance carrier with respect to the Wright Complaint. In November 2011, we filed a Complaint for Declaratory Judgment (the “Declaratory Relief Complaint”) in the United States District Court for the Eastern District of Louisiana against Axis seeking, pursuant to our policy (a) Axis to provide full policy coverage and defense; (b) Axis to pay all legal fees and expenses incurred by us in the defense of the Wright Complaint; and (c) Axis to make all reasonable efforts to protect us from risk of excess judgment. The Declaratory Relief Complaint was dismissed with prejudice as discussed above.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Cautionary Statement for Purposes of “Safe Harbor Provisions” of the Private Securities Litigation Reform Act of 1995
This Form 10-Q contains forward-looking statements. We consider such statements to be made under the safe harbor created by the federal securities laws to which we are subject. In some cases, you can identify forward-looking statements by the following words: “may,” “might,” “will,” “could,” “would,” “should,” “expect,” “intend,” “plan,” “objective,” “anticipate,” “believe,” “estimate,” “predict,” “project,” “potential,” “continue,” “ongoing” or the negative of these terms or other comparable terminology intended to identify performance or achievements to be materially different from the information expressed or implied by these forward-looking statements. Examples of such forward looking statements include, without limitation, statements about or relating to the following:
Although we currently believe that we have a reasonable basis for each forward-looking statement contained in this Form 10-Q, we caution you that these statements are based on a combination of facts and factors currently known by us, as well as our projections of the future, about which we cannot be certain. Forward-looking statements reflect and are subject to inherent known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed or implied. Risk factors that could cause actual results to differ materially from those expressed or implied by our forward-looking statements include, but are not limited to, the following:
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In addition, refer to the “Risk Factors” section in Part II, Item 1A of this Form 10-Q, as well as the “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended October 31, 2011, as filed with the Securities and Exchange Commission on January 5, 2011, and as incorporated by reference in Part II, Item 1A of this 10-Q, for a discussion of other important factors that may cause our actual results to differ materially from those expressed or implied by our forward-looking statements. As a result of these factors, we cannot assure that the forward-looking statements will prove to be accurate. Furthermore, if our forward-looking statements prove to be inaccurate, the inaccuracy may be material. In light of the significant uncertainties in these forward-looking statements, these statements should not be regarded as a representation or warranty by us or any other person that we will achieve our objectives and plans in any specified time frame, or at all. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. Our actual future results may be materially different from what we expect. We qualify all of our forward-looking statements by each of these cautionary statements above.
The following discussion should be read in conjunction with “Item 8. Financial Statements and Supplementary Data” in the Form 10-K and the Condensed Consolidated Financial Statements and notes thereto included elsewhere in this Form 10-Q. All information presented herein is based on our fiscal calendar. Unless otherwise stated, references in this report to particular years or quarters refer to our fiscal years ended in October and the associated quarters of those fiscal years.
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Overview
We are a leading global gaming supplier committed to making gaming more fun for players and more profitable for operators through product innovation, and superior quality and service. We operate in legalized gaming markets across the globe and provide state-of-the-art, value-add products in four distinct segments: Utility products, which include automatic card shufflers and roulette chip sorters; Proprietary Table Games (“PTG”), which include live table games, side bets and progressives as well as our newly introduced i-Gaming, which features online versions of our table games, social gaming and mobile applications; Electronic Table Systems (“ETS”), which include various e-Table game platforms; and Electronic Gaming Machines (“EGM”), which include video slot machines. Each segment's activities include the design, development, acquisition, manufacturing, marketing, distribution, installation and servicing of a distinct product line. Our products are manufactured at our headquarters and manufacturing facility in Las Vegas, Nevada, at our Australian headquarters in Milperra, New South Wales, Australia, as well as outsourced, for certain sub-assemblies in the United States, Europe and Asia.
See Note 1 to our Condensed Consolidated Financial Statements for a more detailed discussion of our four segments.
On March 5, 2012, through our wholly-owned subsidiary Shuffle Master International, Inc., we entered into a definitive agreement to acquire Ongame, a limited liability company incorporated and existing under the laws of Gibraltar, from bwin.party services (Austria) GmbH (“Seller”). Ongame is one of the world’s largest business to business online poker providers.
The acquisition is subject to completion of certain conditions, including the continued material accuracy of the parties’ representations and warranties; the performance of and compliance with all covenants in the definitive agreement; and the receipt of required regulatory approvals. The closing of the transaction is expected to occur not more than nine months following execution of the definitive agreement.
Strategy
We believe we enhance our customer and shareholder value through our execution of the following strategic priorities:
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We are focused on our customers and on value-creation for our shareholders. We seek to maintain continuous improvement while keeping innovation at the core of our success. We believe that continued execution of our strategic plan is the best method to foster the growth of our business in fiscal 2012.
Sources of Revenue
We derive our revenue from the lease, license and sale of our products and by providing service to our leased and in some cases, previously sold units. Consistent with our strategy, we have a continuing emphasis on leasing or licensing our products. When we lease or license our products, we generally negotiate month-to-month fixed fee contracts, or to a lesser extent, enter into participation arrangements whereby casinos pay us a fee based on a percentage of net win. Product lease contracts typically include parts and service. When we sell our products, we offer casinos a choice between a cash sale or to a lesser extent, long-term financing. We also offer a majority of our products for sale with an optional parts and service contract.
Currently, Utility segment revenue is derived substantially from our automatic card shufflers. In addition to leasing shufflers, we also sell and service them. In the PTG segment, the majority of games placed are licensed to our customers on month-to-month license arrangements, which provides us with monthly royalty revenue. In the ETS segment, we derive revenue from leases, sales and service contracts. In the EGM segment, we derive revenue from selling the full EGM complement, as well as game conversion kits. Upon the acquisition of Ongame, we will begin consolidating their results of operations which will include revenues from licensing the use of Ongame’s business-to-business online poker platform.
The following points should be noted as they relate to each of our segments:
Utility
Proprietary Table Games
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Electronic Table Systems
Electronic Gaming Machines
Expenses
Our direct expenses primarily include cost of products sold, depreciation of leased assets, and amortization of product-related intangible assets, service, manufacturing overhead, shipping and installation. Indirect expenses include other costs directly identified with each segment, such as R&D, product approval costs, product-related litigation expenses, amortization of patents and other product-related intellectual property, sales commissions and other directly-allocable sales expenses. We continue to expend significant R&D efforts on the development of our newer generation shuffler products, such as the MD3™ and one2six® Plus, our i-Shoe® Auto card recognition products, as well as other table accessories, such as the i-Shoe® and the i-Score™ display. With our expansion into the e-Table markets, we continue to spend significant R&D dollars on developing and implementing new gaming mediums, such as the i-Table®, our newest e-Table that combines a variety of our products to create an exciting new table game experience. We are also spending increased R&D dollars on the new Equinox™ EGM cabinets and related game content. Upon the acquisition of Ongame, we will begin consolidating their results of operations, which will include cost of sales, selling, general and administrative expenses, as well as research and development.
The amounts classified as unallocated corporate expenses consist primarily of costs related to overall corporate management and support functions. These include costs related to executive management, accounting and finance, general sales support, legal and compliance costs, office expenses and other amounts for which allocation to specific segments is not practicable.
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Gross Margin
The number and mix of products placed and the average lease or sales price are the most significant factors affecting our gross margins. Our continuing emphasis on leasing versus selling, the shift in product mix, timing of installations and related upfront installation charges, as well as changes in non-cash depreciation and amortization expenses attributable to our acquisitions, impact our margins.
In general, lease gross margin is greater than the sales gross margin for the same products. However, total gross profit from leasing is lower in a given reporting period than those of a sale due to the much higher price of a sale versus a lease. A number of factors impact gross margins, including the number and mix of products placed and the average lease or sales price of those products. For example, in our PTG segment, premium table games warrant a higher average lease price than a PTG add-on such as a felt side-bet or a progressive. For Utility products, when a new shuffler is introduced into the market, we use introductory lease pricing. After the introductory pricing period expires, the price generally increases to the monthly “list” lease price, which we believe will increase future revenues because most customers keep the products beyond the introductory pricing period. Accordingly, we anticipate that gross margins will increase under our lease model.
We occasionally record inventory adjustments related to obsolescence or declines in the net realizable value of some products. While those adjustments occur in the normal course of business, it can cause negative pressure on our margins. We also occasionally dispose of leased assets that are no longer in service and are no longer usable.
In addition to the lease versus sale strategy, we expect to see continual improvement in our gross margins through value engineering to reduce manufacturing costs. Our focus is currently on savings attributable to component parts, product redesign and lower cost manufacturing opportunities within each of our segments.
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The following table presents our various revenues and expenses as a percentage of revenue:
CONSOLIDATED STATEMENTS OF OPERATIONS
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