XNAS:SHFL Quarterly Report 10-Q Filing - 7/31/2012

Effective Date 7/31/2012

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended July 31, 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: 0-20820
SHUFFLE MASTER, INC.
(Exact name of registrant as specified in its charter)
Minnesota
 
41-1448495
(State or Other Jurisdiction
 
(IRS Employer Identification No.)
of Incorporation or Organization)
   
     
1106 Palms Airport Drive, Las Vegas
NV
89119
(Address of Principal
(State)
(Zip Code)
Executive Offices)
   
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):
 
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
(Do not check if a smaller reporting company)
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 September 04, 2012, there were 55,958,372 shares of our $.01 par value common stock outstanding.
 
 
1

 

SHUFFLE MASTER, INC.
QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED JULY 31, 2012
TABLE OF CONTENTS
 
   
Page
PART I—FINANCIAL INFORMATION
Item 1.
Financial Statements (unaudited):
 
 
Condensed Consolidated Statements of Operations for the Three and Nine Months ended July 31, 2012 and 2011
3
 
Condensed Consolidated Balance Sheets as of July 31, 2012 and October 31, 2011
4
 
Condensed Consolidated Statements of Cash Flows for the Nine Months ended July 31, 2012 and 2011
5
 
Notes to Condensed Consolidated Financial Statements
6
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
20
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
43
Item 4.
Controls and Procedures
43
PART II—OTHER INFORMATION
Item 1.
Legal Proceedings
43
Item 1A.
Risk Factors
43
Item 2.
Unregistered Sale of Equity Securities and Use of Proceeds
44
Item 3.
Defaults Upon Senior Securities
44
Item 4.
Mine Safety Disclosures
44
Item 5.
Other Information
44
Item 6.
Exhibits
44
Signatures
45
 
 
2

 
 
PART I

ITEM 1.  FINANCIAL STATEMENTS
 
SHUFFLE MASTER, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
 
   
Three Months Ended
July 31,
   
Nine Months Ended
July 31,
 
   
2012
   
2011
   
2012
   
2011
 
Revenue:
                       
Product leases and royalties
  $ 27,830     $ 24,785     $ 80,730     $ 72,625  
Product sales and service
    35,556       33,542       104,763       89,400  
Total revenue
    63,386       58,327       185,493       162,025  
Costs and expenses:
                               
Cost of leases and royalties
    9,475       8,970       27,853       24,506  
Cost of sales and service
    13,889       13,135       39,308       36,035  
Gross profit
    40,022       36,222       118,332       101,484  
Selling, general and administrative
    19,007       16,816       55,991       50,077  
Research and development
    7,622       6,695       23,074       19,494  
Total costs and expenses
    49,993       45,616       146,226       130,112  
                                 
Income from operations
    13,393       12,711       39,267       31,913  
                                 
Other income (expense):
                               
Interest income
    116       177       429       429  
Interest expense
    (367 )     (659 )     (1,222 )     (2,031 )
Other, net
    180       457       209       (504 )
Total other income (expense)
    (71 )     (25 )     (584 )     (2,106 )
Income before income taxes
    13,322       12,686       38,683       29,807  
Income tax provision
    2,898       3,560       10,875       7,931  
Net income
  $ 10,424     $ 9,126     $ 27,808     $ 21,876  
                                 
Basic earnings per share:
  $ 0.19     $ 0.17     $ 0.50     $ 0.40  
Diluted earnings per share:
  $ 0.18     $ 0.17     $ 0.49     $ 0.40  
                                 
Weighted average shares outstanding:
                               
Basic
    56,284       54,446       55,700       54,317  
Diluted
    57,029       55,123       56,445       55,009  
 
See Notes to Unaudited Condensed Consolidated Financial Statements.
 
 
3

 
 
SHUFFLE MASTER, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
(Unaudited)
 
   
July 31,
2012
   
October 31,
2011
 
             
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 28,030     $ 22,189  
Accounts receivable, net of allowance for bad debts of $447 and $402
    38,299       39,713  
Investment in sales-type leases and notes receivable, net of allowance for bad debts of $26 and $44
    7,939       5,006  
Inventories
    25,648       24,335  
Prepaid income taxes
    7,991       3,279  
Deferred income taxes
    5,072       4,911  
Other current assets
    6,753       4,291  
Total current assets
    119,732       103,724  
Investment in sales-type leases and notes receivable, net of current portion
and net of allowance for bad debts of $4 and $5
    6,304       3,704  
Products leased and held for lease, net
    35,791       35,196  
Property and equipment, net
    15,860       12,849  
Intangible assets, net
    65,144       66,517  
Goodwill
    83,523       85,392  
Deferred income taxes
    2,863       3,038  
Other assets
    2,586       2,467  
Total assets
  $ 331,803     $ 312,887  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Current liabilities:
               
Accounts payable
  $ 5,995     $ 5,001  
Accrued liabilities and other current liabilities
    19,618       21,135  
Deferred income taxes
    83       96  
Customer deposits
    3,480       3,407  
Income tax payable
    6,187       2,595  
Deferred revenue
    4,503       3,862  
Current portion of long-term debt
    500       508  
Total current liabilities
    40,366       36,604  
Long-term debt, net of current portion
    15,749       38,757  
Other long-term liabilities
    1,818       2,969  
Deferred income taxes
    2,953       942  
Total liabilities
    60,886       79,272  
Commitments and Contingencies (See Note 11)
               
Shareholders' equity:
               
Common stock, $0.01 par value; 151,368 shares authorized; 55,900 and 54,196 shares issued and outstanding
    559       542  
Additional paid-in capital
    134,321       114,306  
Retained earnings
    108,646       80,838  
Accumulated other comprehensive income
    27,391       37,929  
Total shareholders' equity
    270,917       233,615  
Total liabilities and shareholders' equity
  $ 331,803     $ 312,887  
 
See Notes to Unaudited Condensed Consolidated Financial Statements.
 
 
4

 

SHUFFLE MASTER, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands, except per share amounts)
(Unaudited)
 
   
Nine Months Ended
July 31,
 
   
2012
   
2011
 
 Cash flows from operating activities:
           
 Net income
  $ 27,808     $ 21,876  
 Adjustments to reconcile net income to cash provided by operating activities:
               
 Depreciation and amortization
    18,657       17,951  
 Amortization of debt issuance costs
    357       357  
 Share-based compensation
    3,063       2,184  
 Provision for bad debts
    113       140  
 Write-down for inventory obsolescence
    533       626  
 Profit on sale of leased assets
    (721 )     (4,182 )
 Loss on sale of assets
    231       238  
 Excess tax benefit from exercise of stock options
    (1,370 )     (808 )
 Changes in operating assets and liabilities:
               
 Accounts receivable and investment in sales-type leases and notes receivable
    (5,191 )     3,961  
 Inventories
    (3,261 )     (3,948 )
 Accounts payable and accrued liabilities
    (2,658 )     (21,232 )
 Customer deposits and deferred revenue
    561       825  
 Income taxes payable
    3,300       3,666  
 Deferred income taxes
    2,590       1,036  
 Prepaid income taxes
    (4,714 )     3,812  
 Other
    (3,430 )     10,190  
 Net cash provided by operating activities
    35,868       36,692  
                 
 Cash flows from investing activities:
               
 Proceeds from sale of leased assets
    1,640       6,240  
 Proceeds from sale of assets
    -       86  
 Payments for products leased and held for lease
    (11,227 )     (11,608 )
 Purchases of property and equipment
    (5,852 )     (2,683 )
 Purchases of intangible assets
    (4,333 )     (6,269 )
 Acquisition of business
    (5,500 )     (6,499 )
 Other
    (690 )     (701 )
 Net cash used in investing activities
    (25,962 )     (21,434 )
                 
 Cash flows from financing activities:
               
 Proceeds from Revolver
    11,000       16,500  
 Debt payments on Revolver
    (34,000 )     (15,000 )
 Proceeds from issuances of common stock, net
    16,238       2,156  
 Excess tax benefit from exercise of stock options
    1,370       808  
 Other
    (43 )     (41 )
 Net cash provided by (used in) financing activities
    (5,435 )     4,423  
                 
 Effect of exchange rate changes on cash and cash equivalents
    1,370       522  
                 
 Net increase in cash and cash equivalents
    5,841       20,203  
 Cash and cash equivalents, beginning of period
    22,189       9,988  
 Cash and cash equivalents, end of period
  $ 28,030     $ 30,191  
 
See Notes to Unaudited Condensed Consolidated Financial Statements. 
 
 
5

 

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 online gaming products, which feature 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 online 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 video slot machines into markets including Australia, New Zealand, Asia, Mexico and parts of South America.  We offer a selection of video slot titles developed as stand-alone units or as link progressive machines. In addition to selling the full EGM complement, we sell software conversion kits that allow existing EGM terminals to be converted to other games that operate on the current PC4 operating platform. Popular titles for our EGMs include Cats Hats & Bats™, Eureka Gold Mine 2™ and Emerald Fortunes™.  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.  In 2012 we released a range of games incorporating features and bonus rounds based on the popular 1960’s animated television series, The FlintstonesTM & © Hanna-Barbera s12. Other key releases in 2012 include 88 Fortunes, Samurai Spirit and Epic Quest.
 
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.  
 
 
6

 
 
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 nine months ended July 31, 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 was 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:

 
·
persuasive evidence of an arrangement exists;

 
·
the price to the customer is fixed and determinable;

 
·
delivery has occurred and any acceptance terms have been fulfilled; and

 
·
collection is reasonably assured.

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.
 
 
7

 
 
Fair value measurement disclosure.  In the current year, 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:

 
·
For fair value categorized in Level 3 of the fair value hierarchy:
 
1.
a quantitative disclosure of the unobservable inputs and assumptions used in the measurement,
 
2.
a description of the valuation processes in place (e.g., how the entity decides its valuation policies and procedures, as well as changes in its analyses of fair value measurements, from period to period), and
 
3.
a narrative description of the sensitivity of the fair value to changes in unobservable inputs and interrelationships between those inputs.

 
·
The level in the fair value hierarchy of items that are not measured at fair value in the statement of financial position but whose fair value must be disclosed.

Indefinite-Lived Intangible Asset impairment testing.  In the current quarter, we adopted an ASU to amend and simplify the rules related to testing indefinite-lived intangible assets other than goodwill for impairment.  The revised guidance allows an entity to make an initial qualitative evaluation, based on the entity’s events and circumstances, to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired. The results of this qualitative assessment determine whether it is necessary to perform the currently required annual impairment test.

In accordance with the ASU, we will assess our intangible assets with an indefinite life, consisting of the Stargames™ and CARD™ tradenames to determine whether it is more likely than not that the tradenames are impaired and whether it is necessary to perform the annual impairment test.

Recently issued accounting standards or updates – not yet adopted

Comprehensive income – In June 2011, Financial Accounting Standards Board (“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:
 
 
   
July 31,
2012
   
October 31,
2011
 
   
(In thousands)
 
Net inventories:
           
Raw materials and component parts
  $ 14,433     $ 12,984  
Work-in-process
    3,532       3,947  
Finished goods
    7,683       7,404  
 Total
  $ 25,648     $ 24,335  

 
8

 
 
   
July 31,
2012
   
October 31,
2011
 
   
(In thousands)
 
Other current assets:
           
Other prepaid expenses
  $ 4,236     $ 2,302  
Other receivables
    1,868       1,271  
Other
    649       718  
Total
  $ 6,753     $ 4,291  
 
 

   
July 31,
2012
   
October 31,
2011
 
   
(In thousands)
 
Products leased and held for lease:
           
Utility
  $ 49,910     $ 47,073  
Less: accumulated depreciation
    (33,863 )     (29,891 )
Utility, net
    16,047       17,182  
                 
Proprietary Table Games
    8,878       6,158  
Less: accumulated depreciation
    (4,256 )     (2,496 )
Proprietary Table Games, net
    4,622       3,662  
                 
Electronic Table Systems
    28,461       28,749  
Less: accumulated depreciation
    (15,655 )     (15,571 )
Electronic Table Systems, net
    12,806       13,178  
                 
Electronic Gaming Machines
    3,061       1,266  
Less: accumulated depreciation
    (745 )     (92 )
Electronic Gaming Machines, net
    2,316       1,174  
                 
Total, net
  $ 35,791     $ 35,196  
 
   
July 31,
2012
   
October 31,
2011
 
   
(In thousands)
 
Accrued and other current liabilities:
           
Accrued compensation
  $ 13,776     $ 13,932  
Accrued taxes
    1,784       2,124  
Other accrued liabilities
    4,058       5,079  
Total
  $ 19,618     $ 21,135  
 
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 $2.2 million and $2.5 million for the three months ended July 31, 2012 and 2011, respectively and $6.8 and $7.4 million for the nine months ended July 31, 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.
 
 
9

 

Amortizable intangible assets are comprised of the following:
 
   
Weighted Average
Useful Life
(years)
   
July 31,
2012
   
October 31,
2011
 
         
(In thousands)
 
Amortizable intangible assets:
                 
                   
Patents, games and products
    10       $ 65,807     $ 68,999  
Less: accumulated amortization
              (51,068 )     (52,145 )
                14,739       16,854  
Customer relationships
    10         26,702       25,688  
Less: accumulated amortization
              (14,571 )     (12,829 )
                12,131       12,859  
Licenses and other
  6 - 9       22,971       18,925  
Less: accumulated amortization
              (9,377 )     (7,581 )
                13,594       11,344  
Total
            $ 40,464     $ 41,057  
 
Acquired Intangible Assets.  In the current year, we acquired certain intangible assets relating to the purchase of table game intellectual property and acquisition of licenses to be used in our EGM segment.  We allocated the purchase price to patents, games and products for $0.9 million and to customer relationships for $1.6M, both of which have a weighted-average amortization period of ten years.  We allocated $3.6 million to licenses and other with a weighted-average amortization period of seven years.  Total intangible assets acquired during the nine months ended July 31, 2012 are being amortized over a weighted-average useful life of approximately 8 years.

Tradenames. Intangibles with an indefinite life, consisting of the Stargames™ and CARD™ tradenames, are not amortized, and were $24.7 million and $25.5 million as of July 31, 2012 and October 31, 2011, respectively.
 
Goodwill.  Changes in the carrying amount of goodwill for the years ended October 31, 2010, 2011 and the nine months ended July 31, 2012, are as follows:
 
Activity by Segment
 
Utility
   
Proprietary
Table Games
   
Electronic
Table Systems
   
Electronic
Gaming Machines
   
Total
 
   
(In thousands)
 
                               
Goodwill
  $ 42,560     $ 9,326     $ 34,188     $ 11,995     $ 98,069  
Accumulated impairments
    -       -       (22,137 )     -       (22,137 )
Balance as of October 31, 2010
  $ 42,560     $ 9,326     $ 12,051     $ 11,995     $ 75,932  
                                         
Foreign currency translation adjustment
    1,459       -       1,140       1,135     $ 3,734  
Acquisition
    4,799       -       -       -       4,799  
Other
    -       927       -       -       927  
Balance as of October 31, 2011
  $ 48,818     $ 10,253     $ 13,191     $ 13,130     $ 85,392  
                                         
Foreign currency translation adjustment
    (4,863 )             (348 )     (348 )   $ (5,559 )
Acquisition
            3,000                       3,000  
Other
            690                       690  
Balance as of July 31, 2012
  $ 43,955     $ 13,943     $ 12,843     $ 12,782     $ 83,523  
 
 
The $3.0 million of additional goodwill in our PTG segment relates to the acquisition of intellectual property that was treated as a business acquisition for accounting purposes.
 
The $0.7 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 July 31, 2012, we have paid approximately $11.2 million of the $12.0 million maximum amount.
 
 
10

 

4. DEBT

Debt consisted of the following:
 
   
July 31,
2012
   
October 31,
2011
 
   
(In thousands)
 
Revolver
  $ 14,446     $ 37,446  
Other debt
    1,803       1,819  
Total debt
    16,249       39,265  
Less: current portion
    (500 )     (508 )
Total long-term debt
  $ 15,749     $ 38,757  
 
 
$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:

 
·
the Federal Funds Rate plus .50%;

 
·
the prime commercial lending rate of the Administrative Agent, as defined; and

 
·
the one month LIBOR rate for such day plus 2.00%.

Swing Line Loans bear interest at the Base Rate plus the applicable margin. Our effective interest rate as of July 31, 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 July 31, 2012, the amount drawn under the Revolver was $14.4 million and after considering restrictive financial covenants under the Senior Secured Revolving Credit Facility, we had approximately $185.6 million of available remaining credit under the Revolver. The Revolver matures on October 29, 2015.

On May 31, 2012 the Senior Secured Revolving Credit Facility was amended to clarify and define certain restrictive covenants.

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 July 31, 2012, our Total Leverage Ratio, Senior Leverage Ratio and Interest Expense Coverage Ratio were 0.19 to 1.0, 0.17 to 1.0 and 63.36 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.  
 
 
11

 
 
5. SHAREHOLDERS’ EQUITY
 
Common stock repurchases. Our board of directors periodically authorizes us to repurchase shares of our common stock.  As of July 31, 2012, $21.1 million remained outstanding under our board authorization.  We cancel shares that are repurchased.  No shares were repurchased during the three and nine months ended July 31, 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 nine months ended July 31, 2012 and 2011, other comprehensive income consisted primarily of foreign currency translation adjustments.  The following table provides information related to other comprehensive income:
 
   
Three Months Ended
July 31,
   
Nine Months Ended
July 31,
 
   
2012
   
2011
   
2012
   
2011
 
   
( In thousands)
 
Net income
  $ 10,424     $ 9,126     $ 27,808     $ 21,876  
Currency translation adjustment
    (3,436 )     (2,136 )     (10,538 )     13,965  
Total comprehensive income
  $ 6,988     $ 6,990     $ 17,270     $ 35,841  
 
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 nine months ended July 31, 2012, the activity in additional paid in capital consisted of $16.2 million in proceeds received from stock option exercises and $3.1 million in share-based compensation expense and $0.7 million of 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 stock options expire 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 July 31, 2012, under the Amended 2004 Plan and 2004 Directors’ Plan, there were 1.0 million and 0.2 million shares available for grant, respectively.
 
 
12

 
 
A summary of activity related to stock options is presented below:
 
   
Shares
   
Weighted
Average
Exercise
Price
   
Weighted
Average
Remaining
Contractual
Term
   
Aggregate
Intrinsic
Value
 
   
(In thousands, except per share amount)
 
Outstanding at November 1, 2011
    4,638     $ 14.04              
Granted
    440       12.20              
Exercised
    (1,495 )     10.86              
Forfeited or expired
    (338 )     17.51              
                             
Outstanding at July 31, 2012
    3,245     $ 14.90       5.6     $ 12,093  
                                 
Fully vested and expected to vest at July 31, 2012
    3,213     $ 14.93       5.5     $ 11,991  
                                 
Exercisable at July 31, 2012
    2,165     $ 17.29       4.1     $ 7,209  
 
 
 
For the three and nine months ended July 31, 2012, we granted 0.01 million and 0.4 million stock options with a weighted average grant date fair value of $7.39 and $6.26, respectively. The weighted average grant date fair value of stock options granted during the three and nine months ended July 31, 2011 was $5.53 and $10.86, respectively.

For the three and nine months ended July 31, 2012, 0.2 million and 1.5 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 July 31, 2012, there was approximately $4.1 million of unamortized compensation expense related to stock options, which expense is expected to be recognized over a weighted-average period of 1.8 years.

A summary of activity related to restricted stock is presented below:
 
   
Shares
   
Weighted
Average
Grant-Date
Fair Value
   
Remaining
Vesting
Period
   
Aggregate
Intrinsic
Value
 
   
(In thousands, except per share amount)
 
Nonvested at November 1, 2011
    394     $ 10.53              
Granted
    455       12.35              
Vested
    (136 )     11.40              
Forfeited
    (50 )     9.23              
                             
Nonvested at July 31, 2012
    663     $ 11.70       1.6     $ 9,679  
                                 
Expected to vest
    636     $ 11.69       1.6     $ 9,297  
 
 
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 July 31, 2012, there was approximately $6.0 million of unamortized compensation expense related to restricted stock, which expense is expected to be recognized over a weighted-average period of 1.9 years.
 
 
13

 
 
Recognition of compensation expense.  The following table shows information about compensation costs recognized:
 
   
Three Months Ended
July 31,
   
Nine Months Ended
July 31,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands)
 
Compensation costs:
                       
Stock options
  $ 363     $ 483     $ 1,366     $ 1,471  
Restricted stock
    651       223       1,697       713  
Total compensation cost
  $ 1,014     $ 706     $ 3,063     $ 2,184  
Related tax benefit
  $ (375 )   $ (245 )   $ (1,088 )   $ (761 )
 

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:
 
   
Three Months Ended
July 31, 2012
   
Nine Months Ended
July 31, 2012
 
Option valuation assumptions:
           
Expected dividend yield
 
None
   
None
 
Expected volatility
    62.2 %     64.8 %
Risk-free interest rate
    0.6 %     0.7 %
Expected term (in years)
 
4.4
   
4.5
 
 
 
7. INCOME TAXES

Our effective income tax rate from continuing operations for the three and nine months ended July 31, 2012 was 21.8% and 28.1%, respectively. Our effective income tax rate from continuing operations for the three and nine months ended July 31, 2011 was 28.1% and 26.6%, respectively. The lower effective income tax rate for the three months ended July 31, 2012 compared to the prior year period is primarily attributable to due diligence and transaction costs incurred in the prior quarter which became deductible in the current quarter due to our decision not to proceed with the acquisition of Ongame Network Ltd (“Ongame”).  The rate was also favorably impacted by the recognition of certain unrecognized tax benefits for which the statute of limitations expired.  The higher effective income tax rate for the nine months ended July 31, 2012 compared to the prior year period is primarily attributable to the changes in geographic income before taxes. 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.
 
 
14

 

8. EARNINGS PER SHARE
 
Shares used to compute basic and diluted earnings per share from operations are as follows:
 
   
Three Months Ended
July 31,
   
Nine Months Ended
July 31,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands, except per share amount)
 
Net income available to common shares (1)
  $ 10,424     $ 9,126     $ 27,808     $ 21,876  
                                 
Basic
                               
Weighted average shares
    56,284       54,446       55,700       54,317  
                                 
Diluted
                               
Weighted average shares, basic
    56,284       54,446       55,700       54,317  
Dilutive effect of options
    745       677       745       692  
Weighted average shares, diluted
    57,029       55,123       56,445       55,009  
                                 
Basic earnings per share
  $ 0.19     $ 0.17     $ 0.50     $ 0.40  
Diluted earnings per share
  $ 0.18     $ 0.17     $ 0.49     $ 0.40  
                                 
Weighted average anti-dilutive shares excluded from diluted EPS
    1,593       3,484       1,981       3,312  
 
(1) Net income available to participating securities was not significant.
 
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.  As of July 31, 2012 our investment in sales-type leases and notes receivable had an approximate 5.5% effective interest rate and a 2 year average maturity.

The fair value of our Revolver as of July 31, 2012 and October 31, 2011 has been calculated based on market borrowing rates available as of July 31, 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.
 
   
Carrying Value
July 31, 2012
   
Fair Value
July 31, 2012
   
Carrying Value
October 31, 2011
   
Fair Value
October 31, 2011
 
Fair Value
Hierarchy
                           
Revolver
  $ 14,446     $ 14,495     $ 37,446     $ 37,679  
Level 2

 
15

 

10. OPERATING SEGMENTS
 
The following provides financial information concerning our reportable segments of our operations:
 
   
Three Months Ended
July 31,
   
Nine Months Ended
July 31,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands)
 
Revenue:
                       
Utility
  $ 24,382     $ 22,575     $ 68,988     $ 59,108  
Proprietary Table Games
    12,994       10,994       38,623       32,766  
Electronic Table Systems
    6,053       6,793       21,183       26,721  
Electronic Gaming Machines
    19,957       17,965       56,699       43,430  
    $ 63,386     $ 58,327     $ 185,493     $ 162,025  
Gross profit:
                               
Utility
  $ 15,285     $ 12,852     $ 42,622     $ 35,284  
Proprietary Table Games
    10,634       8,671       31,994       26,338  
Electronic Table Systems
    2,055       3,197       8,868       12,684  
Electronic Gaming Machines
    12,048       11,502       34,848       27,178  
    $ 40,022     $ 36,222     $ 118,332     $ 101,484  
Operating income:
                               
Utility
  $ 13,334     $ 11,208     $ 36,986     $ 30,294  
Proprietary Table Games
    8,481       7,445       25,122       23,205  
Electronic Table Systems
    (846 )     328       (967 )     3,860  
Electronic Gaming Machines
    8,701       8,336       24,948       18,493  
Unallocated Corporate
    (16,277 )     (14,606 )     (46,822 )     (43,939 )
    $ 13,393     $ 12,711     $ 39,267     $ 31,913  
Depreciation and amortization:
                               
Utility
  $ 1,874     $ 2,252     $ 5,549     $ 5,451  
Proprietary Table Games
    1,359       1,414       3,962       4,183  
Electronic Table Systems
    1,630       1,397       4,940       5,300  
Electronic Gaming Machines
    336       38       879       166  
Unallocated Corporate
    1,061       974       3,327       2,851  
    $ 6,260     $ 6,075     $ 18,657     $ 17,951  
Capital expenditures:
                               
Utility
  $ 1,557     $ 2,171     $ 3,767     $ 6,537  
Proprietary Table Games
    1,109       668       3,313       6,843  
Electronic Table Systems
    2,634       1,299       4,860       4,376  
Electronic Gaming Machines
    211       354       5,341       421  
Unallocated Corporate
    852       659       4,131       2,383  
    $ 6,363     $ 5,151     $ 21,412     $ 20,560  
 
 
16

 

REVENUE BY GEOGRAPHIC AREA

The following provides financial information concerning our revenues by geographic area:
 
   
Three Months Ended
July 31,
   
Nine Months Ended
July 31,
 
   
2012
   
2011
   
2012
   
2011
 
   
(Dollars in thousands)
 
Revenue:
                                               
United States
  $ 28,372       44.8 %   $ 26,578       45.6 %   $ 83,327       44.9 %   $ 76,928       47.5 %
Canada
    2,422       3.8 %     2,696       4.6 %     6,166       3.3 %     5,970       3.7 %
Other North America
    1,046       1.6 %     1,308       2.2 %     3,224       1.8 %     3,668       2.3 %
Europe
    2,085       3.3 %     2,344       4.0 %     6,112       3.3 %     5,986       3.7 %
Australia
    20,785       32.8 %     20,395       35.0 %     64,772       34.9 %     55,909       34.5 %
Asia
    8,240       13.0 %     4,189       7.2 %     20,905       11.3 %     11,965       7.4 %
Other
    436       0.7 %     817       1.4 %     987       0.5 %     1,599       0.9 %
    $ 63,386       100.0 %   $ 58,327       100.0 %   $ 185,493       100.0 %   $ 162,025       100.0 %
 
 
11. COMMITMENTS AND CONTINGENCIES
 
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 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 July 31, 2012 and October 31, 2011, minimum aggregate severance benefits totaled $6.8 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.

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.
 
 
17

 

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 that were initiated at our request before the United States Patent and Trademark Office as to the four patents that are the subject of the lawsuit.   Additionally, in June 2012 the USPTO granted our petitions to reexamine two of the patents that are the subject of the lawsuit, which patents were previously granted a Reexamination Certificate.  We believe that the final results of the reexamination proceedings will be beneficial to us in future Court proceedings. It is possible that all of the reexamination proceedings will conclude in fiscal 2013 and thus the stay may be lifted in fiscal 2013. 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 Rapid Baccarat ® unit displayed by Shuffle Master Asia Limited (“SMAL”).  This seizure related to a claim by a Macau patent holder (the “Patent Holder”) of an  alleged patent infringement.  On October 27, 2009, the Public Prosecutors Office 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 – what is called “abertura de instrução” according to Macau Law. 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 possible 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 that we believe may be controlled by the Patent Holder (collectively, the "First Patent Litigants") requested that the Macau Court enjoin us and certain other exhibitors from infringing the First Patent Litigants' 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, we agreed with Macau Customs to cover our Rapid Table Games™ Multi Game product at the G2E Asia Gaming Show to avoid further legal proceedings.  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 Games TM 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 Public Prosecutors Office is investigating the timing of the lifting of the cover off of the Rapid Table Games TM Multi Game product and whether such action may give rise to any alleged criminal charges against SMAL, its directors,  and the Company (including its subsidiaries)  or its officers. On June 4, 2012, the First Patent Litigants and LT Game Limited (a company that we believe may be controlled by the Patent Holder) (collectively, the “Second Patent Litigants”) filed a writ of summons with the Court seeking monetary damages and other civil relief as a result of the alleged infringement of the First Patent Litigants’ patents by SMAL, and the Company at the G2E Asia Show.  As of June 4, 2012, the other exhibitors referenced above are not defendants in this matter.  As with the infringement claim discussed above, we believe that all of these claims are entirely without merit and we intend to continue to vigorously defend this matter.

On July 10, 2012, LT Game International Ltd. filed a complaint against us in the United States District Court for the District of Nevada. We believe that the plaintiff is controlled by the Patent Holder. In this complaint, LT Game International Ltd. makes various claims against the Company, including unfair competition and tortious interference with current and prospective business and contractual relations.  The complaint seeks injunctive relief and an unspecified amount of damages, including claims for reasonable attorneys’ fees and disbursements, costs, statutory damages under the Lanham Act, treble damages and profits.    On August 17, 2012, an amended complaint was filed with legal claims that are materially the same as the original complaint.  On September 4, 2012, we filed a motion to dismiss the amended complaint.  As with the Second Patent Litigants’ claims discussed above, we believe that this complaint is without merit and we intend to vigorously defend this matter.

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.  The Louisiana State Police Gaming Division concluded  that there was no violation of state law, rule or internal control and Mr. Wright was unsuccessful.
 
 
18

 

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 Complaint 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, that  (a) Axis provide full policy coverage and defense; (b) Axis pay all legal fees and expenses incurred by us in the defense of the Wright Complaint; and (c) Axis make all reasonable efforts to protect us from risk of excess judgment.  The Declaratory Relief Complaint was dismissed with prejudice as discussed above.

TCS South Africa- On August 20, 2012, we sued TCS John Huxley (PTY) LTD. (“TCS South Africa”) in the Court of the Commissioner of Patents for the Republic of South Africa.   The suit alleges that the “A Plus” card shuffler, which is being distributed by TCS South Africa, violates one of our patents.   We seek an enquiry into damages, an interdict against infringement of our patent, and delivery up of any infringing products.  We believe that we have a meritorious case and are vigorously pursuing this claim.

 
19

 

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:

 
·
Business strategies, including with respect to development of new or enhanced products, investment of capital to maximize returns and build our economic engine, and our focus on leasing structures for commercialization of certain products to increase returns and gross margins;

 
·
Increasing our PTG content through development or acquisitions of new proprietary titles;

 
·
Expectations of increases in gross margins and revenues from leasing of certain products;

 
·
The growth opportunities and revenue potential from our i-Table®, i-Table Roulette and MD3 shuffler products;

 
·
The benefits of our products;

 
·
Continued volatility in sales revenue from our Utility segment;

 
·
Expected increases in leasing revenue in the Utility segment, driven by the MD3 shuffler, with the majority of upgrade placements expected to be leases;

 
·
Expectations to begin revenue generation from Vegas Star Live Roulette;

 
·
Expectations that EGM revenues will continue to come from sales of EGMs in Australia;

 
·
Expected growth of additional international markets, including Asia and Latin America;

 
·
Expectations of EGM placements and revenue  in 2012 exceeding 2011 levels.

 
·
Cash and capital resources being sufficient to satisfy requirements for working capital, capital expenditures, debt service and other liquidity requirements of existing operations for at least the next 12 months;

 
·
Company expectations with respect to outstanding litigation;

 
·
Growing capital expenditures in proportion to revenue as a result of our leasing model extending into more capital-intensive products;

 
·
Expectations that there will be no further expenses recognized with respect to the terminated acquisition of Ongame; and

 
·
Expectations with respect to foreign currency exchange rate fluctuation risk.
 
 
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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:

 
·
Failure to maintain our regulatory licenses or obtain new licenses where necessary;

 
·
Legislative and regulatory changes that impact us or our customers;

 
·
Non-compliance with the covenants in our senior secured credit agreement, including as a result of factors that are beyond our control;

 
·
High volatility or extreme changes in foreign currency exchange rates;

 
·
Difficulties or delays in, or being prevented from, carrying out acquisitions and subsequent integration of acquired businesses;

 
·
Difficulties in maintaining and protecting our intellectual property rights;

 
·
Potential infringement of the intellectual property rights of third parties;

 
·
Adverse outcomes with respect to litigation regarding intellectual property, including our payment of damages, constraints on our business and operations and invalidation of our intellectual property;

 
·
Involvement in other legal proceedings, and adverse outcomes with respect to such proceedings which could have a materially adverse effect on our business or prospects;

 
·
Disruption or delays in our or our suppliers’ manufacturing processes that could prevent us from meeting demand for our products;

 
·
Revenue losses in any of our business segments due to technical difficulties or fraudulent activities experienced by end users;

 
·
Inability to obtain market acceptance of products currently in development;

 
·
Inability to maintain a competitive technological position with respect to our competitors and competitive products;

 
·
Lower than expected revenues from our transition in certain products to a lease-based commercialization model;

 
·
Decreased demand for our products, including as a result of developments with respect to competitive products;

 
·
Adverse economic conditions in the gaming industry, which is our sole industry of focus; and

 
·
Adverse developments with respect to economic, political, legal and other risks associated with our international sales and operations.

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.
 
 
21

 
 
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 online gaming products, which feature 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 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.

 
Strategy
 
We believe we enhance our customer and shareholder value through our execution of the following strategic priorities:

 
·
An unwavering commitment to create innovative solutions and services for casino operators and compelling gaming experiences for players through enhanced customer centricity.

 
·
Reinforce our relationships with our customers by providing enhanced efficiencies, security and profitability on the casino floor. We continue to work toward developing innovative products that anticipate and respond to their needs.

 
·
Maintain a cost-conscious mindset, promote a lean culture, and serve as prudent stewards of shareholder capital.

 
·
Seek long-term profitability and sustainability through our recurring revenue model. We plan to continue to invest capital in our lease business to maximize our return and build on our economic engine.

 
·
Foster the spirit of invention and the commitment to innovation that is at the heart of our success.  With nearly 2,500 patents, trademarks and copyrights granted and pending, our pipeline for new intellectual property is robust. We believe our intellectual property collectively represents one of the strongest portfolios in the industry and our success depends upon our ability to preserve and protect these core assets.

 
·
Capitalize on emerging markets and the worldwide proliferation of gaming.  A large part of our success in fiscal 2011 was turning opportunities into achievements.  As new markets continue to emerge across the globe and as existing gaming markets continue to evolve, we strive to make the most of every opportunity that arises.

 
·
Sound balance sheet management to fuel growth through:
 
o
continued investment in our recurring revenue model, global intellectual property and research and development (“R&D”). We believe this will promote growth on the Company’s top and bottom line without relying on the introduction of significant new markets;
 
o
continued examination of acquisitions.  We are seeking opportunities that are accretive to earnings, have strong existing recurring revenues, and merit our efforts of integration; and
 
o
use of our financial resources to improve our return to shareholders through continued deleveraging.

 
·
Promote and foster internal staff development and deepen our bench strength.  We know our success is directly attributable to the caliber of our workforce and we remain committed to each and every employee’s development.  We will continue to set the talent bar high.

 
·
Drive margin improvement across all product categories. Our overall gross margin has shown continuous improvement over the past three fiscal years.  We plan to continue our process improvement initiatives and uncover additional operational efficiencies.

 
·
Capitalize on opportunities created from existing online gaming markets and prepare ourselves for the potential legalization of Internet gambling in the United States.  The gaming landscape is quickly evolving and we will strive to be a leading content-provider in this arena.  We believe online gaming represents a significant opportunity for our future growth.
 
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.
 
 
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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.

The following points should be noted as they relate to each of our segments:

Utility

 
·
We expect to continue increasing lease revenues in our Utility segment within the United States.  One of the current growth drivers for this segment has been the Ace® shuffler upgrade initiative. We expect the next revenue driver to be our new MD3™ shuffler.  The MD3™ shuffler is our next generation upgrade for the legacy MD series shufflers. As the MD1 shuffler reaches its end of life where replacement parts will no longer be available, our strategy is to encourage our customers to upgrade the MD1 shufflers, both leased and previously sold, with the MD3™ shuffler. The majority of these placements are expected to be leases.

 
·
We expect to continue seeing volatility in sales revenue in our Utility segment outside the United States.  While we encourage leasing outside the United States, a large majority of our international Utility product placements historically have been sales.  We are starting to see increased lease activity in international markets such as Australia, Asia and Latin America. Growth drivers for the Utility segment outside the United States are new jurisdictional openings, such as the new openings in Singapore and the Philippines during fiscal 2010, as well as the expansion of existing markets such as Macau. In the current year, we have seen an increase in the demand for our shufflers in Macau, particularly the MD3™ shuffler.

Proprietary Table Games

 
·
Majority of our PTG segment revenue is derived from royalties and leases.  While we have a strong leasing presence in the United States, we are constantly looking to expand our proprietary table games in other parts of the world where the current penetration of proprietary table games is lower.  With the opening of new casino markets in Asia, we have recently seen some successes with new lease placements of our premium table games as well as progressives and side bets.

 
·
Although the majority of our PTG revenue comes from our premium table games, we also offer a number of progressive upgrades and side bets.  These products are available for our own proprietary table game titles as well as public domain games such as poker, blackjack, baccarat and pai gow poker.  These progressives and side bets, offered almost exclusively through leases, are providing a growing share of our total PTG revenue.

 
·
We also pursue opportunities to place PTG products in new properties and jurisdictions in the United States.  Several states have approved live table games over the past year, and we have seen significant placements of our table game products in those new jurisdictions.

 
·
We intend to increase our PTG content through development and acquisition of new proprietary titles. By increasing our footprint with new titles, we hope to increase our domestic market penetration and expand further into international markets.

 
·
We intend to seek enforcement against parties that infringe our intellectual property on the Internet in legalized markets where legal systems and availability of cost-effective remedies are available to us.
 
 
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Electronic Table Systems

 
·
Although we continually pursue opportunities to increase lease revenues in our ETS segment within the United States, we have seen some of our leased ETS products returned from those same markets as some states have approved live table games.  While this has caused some setbacks in the growth of our domestic ETS business, we have been able to return some of these products to service in other markets such as Latin America.  However, the new placements are not yet performing to the same revenue and profitability levels as the units that were removed.

 
·
Through development of new products and enhancements of our existing products we expect to generate revenue and growth for the ETS segment.  New products include the following:
 
o
The new i-Table® and i-Table Roulette™ combine an electronic betting interface with a live table game and graphically-enhanced central display screens.  We expect these products to provide us with growth opportunities in domestic and international markets if they achieve customer acceptance; and
 
o
In Australia and Asia, we have begun generating revenue from placements of our new multi-game feature on Rapid Table Games®, which offers enhanced live statistics at the touch of a button and betting can be conducted across multiple games.

Electronic Gaming Machines

 
·
Our EGM segment is primarily a sales model and we expect to continue to realize the majority of our EGM revenues from sales of EGMs in Australia and Asia.

 
·
We expect that EGM revenue and placements in fiscal 2012 will continue above 2011 levels primarily driven by updated game content as well as our new Super Topbox for the Equinox™ cabinet.

 
·
A portion of our EGM revenue base comes from conversions of existing units to new game titles.  We are continually developing new titles for our existing machines, and installation of these new titles provides us with an ongoing source of conversion revenue.

 
·
We also expect growth in additional international markets such as Asia and Latin America. Initial installations into Asia began during the third quarter 2011, of which a majority was Equinox™.  In the current year we have placed units in Mexico and Latin America

Expenses
 
Our direct expenses primarily include cost of products sold, depreciation of leased assets, 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 DeckMate®2, 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. Our online gaming division is expending R&D dollars on developing online versions of our table games, social gaming and mobile applications. 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.
 
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.
 
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.
 
 
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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.


The following table presents our various revenues and expenses as a percentage of revenue:
 
CONSOLIDATED STATEMENTS OF OPERATIONS
 
   
Three Months Ended
July 31,
   
Nine Months Ended
July 31,
 
   
2012
   
2011
   
2012
   
2011
 
   
(Dollars in thousands)
 
Revenue:
                                               
Utility
  $ 24,382       38.5 %   $ 22,575       38.7 %   $ 68,988       37.2 %   $ 59,108       36.5 %
Proprietary Table Games
    12,994       20.5 %     10,994       18.9 %     38,623       20.8 %     32,766       20.2 %
Electronic Table Systems
    6,053       9.5 %     6,793       11.6 %     21,183       11.4 %     26,721       16.5 %
Electronic Gaming Machines
    19,957       31.5 %     17,965       30.8 %     56,699       30.6 %     43,430       26.8 %
                                                                 
Total revenue
    63,386       100.0 %     58,327       100.0 %     185,493       100.0 %     162,025       100.0 %
Cost of revenue
    23,364       36.9 %     22,105       37.9 %     67,161       36.2 %     60,541       37.4 %
                                                                 
Gross profit
    40,022       63.1 %     36,222       62.1 %     118,332       63.8 %     101,484       62.6 %
Selling, general and administrative
    19,007       30.0 %     16,816       28.8 %     55,991       30.2 %     50,077       30.9 %
Research and development
    7,622       12.0 %     6,695       11.5 %     23,074       12.4 %     19,494       12.0 %
                                                                 
Income from operations
    13,393       21.1 %     12,711       21.8 %