10-Q 1 a06-13226_110q.htm QUARTERLY REPORT PURSUANT TO SECTIONS 13 OR 15(D)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q


(Mark One)

 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended April 30, 2006

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

GRAPHIC

SHUFFLE MASTER, INC.

(Exact name of registrant as specified in its charter)

Minnesota

41-1448495

(State or Other Jurisdiction
of Incorporation or Organization)

(IRS Employer Identification No.)

 

1106 Palms Airport Drive, Las Vegas

NV

89119

(Address of Principal
Executive Offices)

(State)

(Zip Code)

 

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 þ   No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer þ      Accelerated filer o      Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o   Noþ

As of June 9, 2006, there were 35,096,748 shares of our $.01 par value common stock outstanding.

 




SHUFFLE MASTER, INC.

QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED APRIL 30, 2006

TABLE OF CONTENTS

 

 

 

Page

 

 

 

PART I—FINANCIAL INFORMATION

 

 

 

Item 1.

 

Financial Statements (unaudited):

 

 

 

 

 

Condensed Consolidated Statements of Operations
Three and Six months ended April 30, 2006 and 2005

 

1

 

 

 

Condensed Consolidated Balance Sheets
April 30, 2006 and October 31, 2005

 

2

 

 

 

Condensed Consolidated Statements of Cash Flows
Six months ended April 30, 2006 and 2005

 

3

 

 

 

Notes to Condensed Consolidated Financial Statements

 

4

 

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

24

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

53

 

Item 4.

 

Controls and Procedures

 

54

 

 

 

PART II—OTHER INFORMATION

 

 

 

Item 1.

 

Legal Proceedings

 

56

 

Item 1A.

 

Risk Factors

 

56

 

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

58

 

Item 6.

 

Exhibits

 

58

 

Signatures

 

59

 

 

 

 




PART I

ITEM 1.   FINANCIAL STATEMENTS

SHUFFLE MASTER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share amounts)

 

 

Three Months Ended
April 30,

 

Six Months Ended
April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Revenue:

 

 

 

 

 

 

 

 

 

Utility products leases

 

$

6,084

 

$

5,873

 

$

12,094

 

$

11,185

 

Utility products sales and service

 

17,531

 

11,511

 

33,406

 

19,560

 

Entertainment products leases and royalties

 

6,475

 

6,143

 

12,730

 

12,291

 

Entertainment products sales and service

 

13,177

 

3,599

 

18,345

 

9,411

 

Other

 

36

 

2

 

45

 

51

 

Total revenue

 

43,303

 

27,128

 

76,620

 

52,498

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of leases and royalties

 

2,742

 

2,257

 

5,559

 

4,604

 

Cost of sales and service

 

11,712

 

4,449

 

18,816

 

8,031

 

Selling, general and administrative

 

13,363

 

7,895

 

23,360

 

15,779

 

Research and development

 

3,239

 

2,105

 

5,200

 

3,974

 

In-process research and development

 

19,145

 

 

19,145

 

 

Total costs and expenses

 

50,201

 

16,706

 

72,080

 

32,388

 

Equity method investment loss

 

(156

)

 

(156

)

 

Income (loss) from operations

 

(7,054

)

10,422

 

4,384

 

20,110

 

Other income (expense)

 

(2,337

)

141

 

(2,827

)

(194

)

Income (loss) from continuing operations before tax

 

(9,391

)

10,563

 

1,557

 

19,916

 

Provision for income taxes

 

3,241

 

3,734

 

6,971

 

7,008

 

Income (loss) from continuing operations

 

(12,632

)

6,829

 

(5,414

)

12,908

 

Discontinued operations, net of tax

 

(88

)

16

 

47

 

59

 

Net income (loss)

 

$

(12,720

)

$

6,845

 

$

(5,367

)

$

12,967

 

Basic earnings (loss) per share:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

(0.37

)

$

0.19

 

$

(0.16

)

$

0.37

 

Discontinued operations

 

 

 

 

 

Net income (loss)

 

$

(0.37

)

$

0.19

 

$

(0.16

)

$

0.37

 

Diluted earnings (loss) per share:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

(0.37

)

$

0.19

 

$

(0.16

)

$

0.35

 

Discontinued operations

 

 

 

 

 

Net income (loss)

 

$

(0.37

)

$

0.19

 

$

(0.16

)

$

0.35

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

34,555

 

35,301

 

34,522

 

35,116

 

Diluted

 

34,555

 

36,816

 

34,522

 

36,831

 

 

See notes to unaudited condensed consolidated financial statements

1




SHUFFLE MASTER, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands)

 

 

April 30,
2006

 

October 31,
2005

 

ASSETS

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

22,147

 

 

$

13,279

 

 

Investments

 

11,778

 

 

20,809

 

 

Accounts receivable, net

 

32,275

 

 

17,865

 

 

Investment in sales-type leases and notes receivable, net

 

8,730

 

 

8,219

 

 

Inventories, net

 

20,751

 

 

9,428

 

 

Prepaid income taxes

 

5,402

 

 

 

 

Deferred income taxes

 

3,062

 

 

1,837

 

 

Other current assets

 

7,925

 

 

3,255

 

 

Total current assets

 

112,070

 

 

74,692

 

 

Investment in sales-type leases and notes receivable, net

 

10,837

 

 

11,136

 

 

Products leased and held for lease, net

 

9,876

 

 

9,163

 

 

Property and equipment, net

 

8,888

 

 

4,144

 

 

Deferred income taxes

 

3,003

 

 

2,400

 

 

Intangible assets, net

 

81,311

 

 

48,477

 

 

Goodwill

 

84,401

 

 

36,017

 

 

Other assets

 

9,727

 

 

7,088

 

 

Total assets

 

$

320,113

 

 

$

193,117

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Accounts payable

 

$

8,620

 

 

$

3,540

 

 

Accrued liabilities

 

9,287

 

 

6,547

 

 

Customer deposits and unearned revenue

 

5,973

 

 

3,518

 

 

Income taxes payable

 

 

 

371

 

 

Note payable and current portion of long-term liabilities

 

110,244

 

 

3,082

 

 

Total current liabilities

 

134,124

 

 

17,058

 

 

Long-term liabilities, net of current portion

 

162,533

 

 

162,659

 

 

Deferred income taxes

 

64

 

 

 

 

Total liabilities

 

296,721

 

 

179,717

 

 

Commitments and contingencies

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

 

 

Preferred stock, no par value; 507 shares authorized; none outstanding

 

 

 

 

 

Common stock, $0.01 par value; 151,875 shares authorized; 35,077 and 34,527 shares issued and outstanding

 

351

 

 

345

 

 

Additional paid-in capital

 

4,944

 

 

 

 

Deferred compensation

 

 

 

(5,788

)

 

Retained earnings

 

11,931

 

 

17,298

 

 

Accumulated other comprehensive income

 

6,166

 

 

1,545

 

 

Total shareholders’ equity

 

23,392

 

 

13,400

 

 

Total liabilities and shareholders’ equity

 

$

320,113

 

 

$

193,117

 

 

 

See notes to unaudited condensed consolidated financial statements

2




SHUFFLE MASTER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

 

Six Months Ended
April 30,

 

 

 

2006

 

2005

 

Cash flows from operating activities:

 

 

 

 

 

Net income (loss)

 

$

(5,367

)

$

12,967

 

Adjustments to reconcile net income (loss) to cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

8,500

 

5,757

 

In-process research and development

 

19,145

 

 

Share-based compensation

 

2,546

 

305

 

Provision for bad debts

 

39

 

122

 

Provision for inventory obsolescence

 

181

 

(50

)

Tax benefit from stock option exercises

 

116

 

4,310

 

Excess tax benefit from stock option exercises

 

(2,371

)

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(2,751

)

(1,085

)

Investment in sales-type leases and notes receivable

 

(181

)

(5,238

)

Inventories

 

(124

)

(1,313

)

Accounts payable and accrued liabilities

 

(3,738

)

1,308

 

Customer deposits and unearned revenue

 

1,872

 

(445

)

Prepaid income taxes

 

(3,062

)

3,629

 

Income taxes, net of stock option exercises

 

(344

)

 

Deferred income taxes

 

1,834

 

(630

)

Other

 

(3,857

)

(474

)

Net cash provided by operating activities

 

12,438

 

19,163

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of investments

 

(12,022

)

(584

)

Proceeds from sale and maturities of investments

 

18,050

 

279

 

Proceeds from sale of leased assets

 

628

 

 

Payments for products leased and held for lease

 

(3,884

)

(3,621

)

Purchases of property and equipment

 

(1,008

)

(806

)

Purchases of intangible assets

 

 

(3,376

)

Acquisition of Stargames, net of cash acquired

 

(114,337

)

 

Other

 

 

(3,416

)

Net cash used by investing activities

 

(112,573

)

(11,524

)

Cash flows from financing activities:

 

 

 

 

 

Proceeds from acquisition financing

 

115,000

 

 

Proceeds from other borrowings

 

5,085

 

 

Repurchases of common stock

 

 

(15,256

)

Debt issuance costs

 

(281

)

 

Proceeds from issuances of common stock, net

 

5,710

 

4,835

 

Excess tax benefit from stock option exercises

 

2,371

 

 

Payments of long-term liabilities

 

(18,402

)

(1,736

)

Net cash provided (used) by financing activities

 

109,483

 

(12,157

)

Effect of exchange rate changes on cash

 

(480

)

 

Net increase (decrease) in cash and cash equivalents

 

8,868

 

(4,518

)

Cash and cash equivalents, beginning of period

 

13,279

 

20,580

 

Cash and cash equivalents, end of period

 

$

22,147

 

$

16,062

 

Cash paid for:

 

 

 

 

 

Income taxes, net of refunds

 

$

6,489

 

$

(298

)

Interest

 

2,541

 

982

 

Non-cash transactions:

 

 

 

 

 

Unrealized gain on investments, net of tax

 

$

126

 

$

 

Equity method loss, net of tax

 

$

(102

)

$

 

Note payable for patent purchase

 

 

9,666

 

 

See notes to unaudited condensed consolidated financial statements

3




SHUFFLE MASTER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited, in thousands, except unit and per share amounts)

1.   DESCRIPTION OF BUSINESS AND INTERIM BASIS OF PRESENTATION

Description of business.   On February 1, 2006, we had substantially completed our acquisition of Stargames Limited (“Stargames”). Accordingly, the results of Stargames have been included in our condensed consolidated financial statements beginning February 1, 2006. Stargames is based in Sydney, Australia and develops, manufactures and distributes a wide range of innovative electronic entertainment gaming products to worldwide markets. Stargames has approximately 190 employees including 80 in design and development.

We develop, manufacture and market technology-based products for the gaming industry for placement on the casino floor. Our products primarily relate to our casino customers’ table game activities and are focused on increasing their profitability, productivity and security. Our Utility Products include a full line of automatic card shufflers for use with the vast majority of card table games and chip sorting machines for roulette. In addition, we have acquired or are developing other products to automatically gather data and to enable casinos to track table game play, such as our Intelligent Table System™ product. Our Entertainment Products include our line of live proprietary poker, blackjack, baccarat, and pai gow poker-based table games and our Table Master™ product that delivers our popular branded table game content on a multi-player video platform. In January 2005, we formed Shuffle Up ProductionsTM, Inc. (“Shuffle Up”) to leverage our intellectual property and develop live and broadcast tournament events as well as merchandise based on our extremely popular gaming offerings. In February 2006, we acquired Stargames. Stargames product offerings are classified as Entertainment Products and include Rapid Table GamesTM, Vegas Star® multi-terminal gaming machines, and a broad line of traditional video slot machines designed most specifically for the Australian and Asian gaming markets. The Rapid series of games, which we already distribute in the Americas and the Caribbean, combines a live dealer with multi-terminal electronic wagering. Current offerings include Rapid Roulette®, Rapid Sic-Bo® and Rapid Big Wheel®. Vegas Star® Multi-Terminal Gaming Machines feature animated dealers and a selection of public domain table games. The Vegas Star® Nova line utilizes Stargames’ existing slot cabinet to extend the number of wagering terminals for a Vegas Star game, while minimizing the footprint required on the gaming floor. All of our product lines compete or will compete with other gaming products, such as slot machines, blackjack tables, keno, craps, and roulette, for space on the casino floor.

We sell, lease or license our products. When we sell our products, we offer our customers a choice between a sale, a longer-term sales-type lease or other long-term financing. When we lease or license our products, we generally negotiate a month-to-month operating lease. We offer our products worldwide in markets that are significantly regulated. We manufacture the majority of our products at our headquarters and manufacturing facility in Las Vegas, Nevada. In addition, we outsource the manufacturing of certain of our products in the United States, Europe and Asia Pacific.

In January 2006, we entered into a strategic alliance with Sona Mobile Holdings Corp. (“Sona”) to license, develop, distribute and market “in-casino” wireless handheld gaming content and delivery systems to casinos throughout the world. On January 25, 2006, we completed a private equity investment and purchased approximately 2,300 shares of Sona’s common stock at the price of $1.30 per share for approximately $3,000. This private equity investment is pursuant to a stock option agreement between us and Sona dated December 29, 2005. Additionally, as part of our investment in Sona, we received one seat on the Sona Board of Directors. This investment was accounted for under the equity method of accounting and is included in Other long-term assets in our condensed consolidated balance sheets. Accordingly, we

4




recognized a loss of $156 which represents our pro rata share of Sona’s net loss for the three months ended April 30, 2006.

Basis of presentation.   The condensed consolidated financial statements of Shuffle Master, Inc. as of April 30, 2006, and for the three and six months ended April 30, 2006 and 2005, are unaudited, but, in the opinion of management, include all adjustments necessary for a fair presentation of the financial results for the interim periods. Our results of operations for the three and six months ended April 30, 2006, are not necessarily indicative of the results to be expected for the fiscal year ending October 31, 2006. These interim statements should be read in conjunction with the audited financial statements and notes thereto included in our annual report on Form 10-K for the year ended October 31, 2005.

2.   ACQUISITIONS, DISPOSITIONS AND OTHER SIGNIFICANT TRANSACTIONS

Stargames.   On February 1, 2006, we announced that our wholly owned indirect subsidiary, Shuffle Master Australasia Pty. Ltd., completed its acquisition of Stargames by purchasing 95% of the outstanding Stargames shares for AU $1.55 per share. Effective March 8, 2006, we had acquired 100% of the outstanding Stargames shares.

Consideration to Stargames consisted of an Australian-denominated cash payment of AU $148,441 or US $112,147 denominated. In addition, we estimate that our total direct acquisition costs, consisting primarily of legal and due diligence fees, to be approximately $2,190. See Note 5 for information regarding the financing of the Stargames acquisition. The following table sets forth the determination of the consideration paid for Stargames at the date of acquisition:

Cash

 

$

112,147

 

Other direct acquisition costs

 

2,190

 

Total purchase price

 

$

114,337

 

 

The transaction was accounted for as a purchase and, accordingly, the preliminary purchase price was allocated to the underlying assets acquired and liabilities assumed based upon their estimated fair values at the date of the acquisition. The preliminary fair values have been prepared based upon an independent appraisal which is currently in process, discounted cash flows and estimates by management. The purchase price allocation is preliminary and may be adjusted for up to one year after the acquisition. The following table sets forth the preliminary allocation of the purchase price:

Estimated fair value of Stargames’ net assets as of January 31, 2006

 

$

13,705

 

Developed technology, average life of 4 years

 

8,338

 

Customer relationships, average life of 10 years

 

10,015

 

Tradename

 

17,291

 

Goodwill

 

46,526

 

In-process research and development

 

19,145

 

Assumed liabilities

 

(683

)

 

 

$

114,337

 

 

This acquisition enhances the products in our Entertainment segment as well as providing for additional electronic platforms for our branded content. Additionally, we acquired a strong brand name as well as an experienced and talented management team. These factors result in the recognition of certain intangible assets, discussed below, and significant goodwill.

A project-by-project valuation using the guidance in FASB Statement of Financial Accounting Standard No. 141, “Business Combinations” and the AICPA Practice Aid “Assets Acquired in a Business Combination to Be Used In Research and Development Activities: A Focus on Software, Electronic

5




Devices and Pharmaceutical Industries” is in the process of being performed by independent valuation specialists to determine the fair value of research and development projects of Stargames.

In-process research and development (“IPR&D”) is defined as a development project that has been initiated and achieved material progress but has not yet resulted in a technologically feasible product and has no alternative future use. The fair value was determined using the multi-period excess earnings approach on a project-by-project basis. This method is based on the present value of earnings attributable to the asset or costs avoided as a result of owning the assets and after a contributory charge on assets. This method includes risk factors, which include applying an appropriate discount rate that reflects the project’s stage of completion, the nature of the product, the scientific data associated with the technology, the current patent situation and market competition.

The forecast of future cash flows required the following assumptions to be made:

·       Revenue that is likely to result from specific IPR&D projects, including the likelihood of approval of the product, estimated number of units to be sold, estimated selling prices, estimated market penetration and estimated market share and year-over-year rates over the product life cycles;

·       Cost of sales related to the potential products using historical data, industry data or other sources of market data;

·       Sales and marketing expense using historical data, industry data or other market data;

·       General and administrative expenses; and

·       Research and development expenses.

As required by Financial Accounting Standards Board (“FASB”) Interpretation No. 4, “Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method”, the portion of the purchase price allocated to in-process research and development of $19,145 was immediately expensed.

The assumed liabilities referred to above include an estimated settlement for the disposition of the assets and liabilities of Professional Vending Services Pty Ltd (“PVS”), a wholly-owned subsidiary of Stargames. PVS designs, develops, and manufactures automatic vending machines. PVS offers exclusive equipment in all main vending segments including snacks, cold drinks, food (hot and cold), coffee and cigarettes.  We have determined that the operations of PVS are non-core to our Entertainment and Utility segments.  Accordingly, we have entered into a preliminary agreement to sell its equity interests including settlement of all existing liabilities of PVS. The estimated liabilities exceed assets in the amount of approximately $683. The fair value of the PVS net assets acquired have been valued at zero in our preliminary purchase price allocation. The results of operations for PVS will be included in Discontinued Operations until the disposition is complete. See discussion below.

The operating results for Stargames are included in the accompanying condensed consolidated statements of operations from the date of the acquisition. The following unaudited pro forma condensed

6




consolidated financial information has been prepared assuming the Stargames acquisition had occurred on February 1, 2005, November 1, 2004, and November 1, 2005, respectively, is as follows:

 

 

Three Months Ended
April 30, 2005

 

Six Months Ended
April 30, 2005

 

Six Months Ended
April 30, 2006

 

Revenue

 

 

$

34,349

 

 

 

$

75,849

 

 

 

$

86,263

 

 

Operating income

 

 

5,900

 

 

 

16,352

 

 

 

15,444

 

 

Discontinued operations

 

 

(107

)

 

 

(214

)

 

 

134

 

 

Net income

 

 

$

3,527

 

 

 

$

10,314

 

 

 

$

10,095

 

 

Basic earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

$

0.10

 

 

 

$

0.29

 

 

 

$

0.29

 

 

Diluted earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

$

0.10

 

 

 

$

0.28

 

 

 

$

0.29

 

 

 

These unaudited pro forma results are presented for comparative purposes only. The pro forma results are not necessarily indicative of what our actual results would have been had the acquisition of Stargames been completed as of the beginning of the periods presented. The expense for IPR&D for the six months ended April 30, 2006, has not been included in the unaudited pro forma results since such expense is non-recurring in nature.

IGT Agreement.   On April 28, 2006 (the “Effective Date”), we entered into an agreement with International Game Technology (“IGT”) whereby we assigned, transferred, and conveyed to IGT, our 50% share of future royalties from the licensing of the ENPAT patents to any third party or from otherwise permitting any third party to use the ENPAT patents. The total royalties to be received by IGT is limited to an amount equal to a net present value of $3,000 utilizing a discount factor of 12% (the “Royalty Amount”). Upon the receipt by IGT of the Royalty Amount, all royalty payments with respect to our 50% share of the ENPAT patents shall resume and be paid to us. The total consideration paid to us was $3,000 and is non-refundable.  The transaction has been reflected in the accompanying condensed consolidated financial statements by establishing a liability for amounts owed to IGT which will be relieved as future royalties are earned.

Discontinued operations.   In December 2003, our board of directors approved and we committed to a plan to divest our North America slot products operations and assets, based on our determination that this product line was no longer a strategic fit with our refocused core business strategy of providing products and services for the table game area of casinos.  Revenues and costs associated with our slot products are reported as discontinued operations for all periods presented. In January 2004, we entered into agreements pursuant to which we sold substantially all of our slot products assets to IGT.

Discontinued operations related to our discontinued slot operations consisted of the following:

 

 

Three Months
Ended
April 30,

 

Six Months
Ended
April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Revenue

 

 

$

19

 

 

 

$

61

 

 

$

39

 

$

160

 

Income from operations before tax

 

 

$

14

 

 

 

$

25

 

 

$

15

 

$

89

 

Income tax benefit (expense)

 

 

5

 

 

 

(9

)

 

5

 

(31

)

Net income from operations

 

 

19

 

 

 

16

 

 

20

 

58

 

Gain on sale of slot assets

 

 

 

 

 

 

 

208

 

2

 

Income tax expense

 

 

 

 

 

 

 

(74

)

(1

)

Gain on sale of slot assets, net

 

 

 

 

 

 

 

134

 

1

 

Discontinued operations, net

 

 

$

19

 

 

 

$

16

 

 

$

154

 

$

59

 

 

7




As discussed above, the results of PVS for the three months ended April 30, 2006 included in discontinued operations are as follows:

 

 

Three Months Ended
April 30, 2006

 

Revenue

 

 

$

693

 

 

Loss from operations before tax

 

 

(150

)

 

Provision for income taxes

 

 

43

 

 

Net loss

 

 

(107

)

 

 

3.   ACCOUNTS RECEIVABLE, SALES-TYPE LEASES AND NOTES RECEIVABLE, INVENTORIES, AND LEASED PRODUCTS

 

 

April 30,
2006

 

October 31,
 2005

 

Accounts receivable, net:

 

 

 

 

 

 

 

Trade receivables

 

$

34,502

 

 

$

18,148

 

 

Less: allowance for bad debts

 

(2,227

)

 

(283

)

 

 

 

$

32,275

 

 

$

17,865

 

 

 

 

 

April 30,
2006

 

October 31,
2005

 

Investment in sales-type leases and notes receivable, net:

 

 

 

 

 

 

 

Minimum sales-type lease payments

 

$

14,690

 

 

$

13,329

 

 

Notes receivable-table game licenses

 

9,680

 

 

10,269

 

 

Sub-total sales-type leases and notes receivable

 

24,370

 

 

23,598

 

 

Less: interest sales-type leases and notes receivable

 

(1,559

)

 

(1,579

)

 

Less: deferred service revenue

 

(2,644

)

 

(2,033

)

 

Investment in sales-type leases and notes receivable, net

 

20,167

 

 

19,986

 

 

Less: current portion sales-type leases, net

 

(4,069

)

 

(3,929

)

 

Less: current portion notes receivable-table games licenses, net

 

(4,661

)

 

(4,290

)

 

Less: allowance for bad debts

 

(600

)

 

(631

)

 

Long-term portion investment in sales-type leases and notes receivable, net

 

$

10,837

 

 

$

11,136

 

 

 

We maintain provisions for bad debts for estimated credit losses that result from the inability of our customers to make required payments. The provisions for bad debts are estimated based on historical experience and specific customer collection issues.

Sales-type leases and other notes receivables related to our financing for sales of our intellectual property products are interest-bearing at market interest rates, require monthly installment payments over periods ranging generally from 30 to 60 months and contain bargain purchase options.

8




 

 

 

April 30,
2006

 

October 31,
2005

 

Inventories:

 

 

 

 

 

 

 

Raw materials and component parts

 

$

10,386

 

 

$

5,482

 

 

Work-in-process

 

2,762

 

 

820

 

 

Finished goods

 

10,713

 

 

4,613

 

 

 

 

23,861

 

 

10,915

 

 

Less: allowance for inventory obsolescence

 

(3,110

)

 

(1,487

)

 

 

 

$

20,751

 

 

$

9,428

 

 

Products leased and held for lease, net:

 

 

 

 

 

 

 

Utility products

 

$

20,144

 

 

$

18,091

 

 

Entertainment products

 

4,153

 

 

3,183

 

 

 

 

24,297

 

 

21,274

 

 

Less: accumulated depreciation

 

(14,421

)

 

(12,111

)

 

 

 

$

9,876

 

 

$

9,163

 

 

 

4. INTANGIBLE ASSETS AND GOODWILL

Amortized intangible assets.   Substantially all of our recorded intangible assets are subject to amortization. Amortization expense was $2,382 and $1,556 for the three months ended April 30, 2006 and 2005, respectively, and $4,021 and $2,958 for the six months ended April 30, 2006 and 2005, respectively. Amortized intangible assets are comprised of the following:

 

 

Weighted Avg
Useful Life

 

April 30,
2006

 

October 31,
2005

 

Amortized intangible assets:

 

 

 

 

 

 

 

 

 

 

 

Patents, games and products

 

 

10 years

 

 

$

56,655

 

 

$

55,552

 

 

Less: accumulated amortization

 

 

 

 

 

(12,550

)

 

(9,478

)

 

 

 

 

 

 

 

44,105

 

 

46,074

 

 

Customer relationships

 

 

10 years

 

 

10,035

 

 

 

 

Less: accumulated amortization

 

 

 

 

 

(251

)

 

 

 

 

 

 

 

 

 

9,784

 

 

 

 

Licenses and other

 

 

6 years

 

 

2,846

 

 

3,053

 

 

Less: accumulated amortization

 

 

 

 

 

(1,517

)

 

(1,536

)

 

 

 

 

 

 

 

1,329

 

 

1,517

 

 

Developed technology

 

 

4 years

 

 

8,355

 

 

 

 

Less: accumulated amortization

 

 

 

 

 

(522

)

 

 

 

 

 

 

 

 

 

7,833

 

 

 

 

Total

 

 

 

 

 

$

63,051

 

 

$

47,591

 

 

 

Trademark.   Intangibles with an indefinite life consisting of the Stargames and CARD trademarks are not amortized. Changes in the carrying amount of our unamortized intangibles for the six months ended April 30, 2006, are as follows:

Balance at October 31, 2005

 

$

886

 

Stargames trademark

 

17,325

 

Foreign currency translation adjustment

 

49

 

Balance at April 30, 2006

 

$

18,260

 

 

9




Goodwill.   Changes in the carrying amount of goodwill for the six months ended April 30, 2006, are as follows:

Balance at October 31, 2005

 

$

36,017

 

Stargames goodwill

 

46,619

 

Foreign currency translation adjustment

 

1,765

 

Balance at April 30, 2006

 

$

84,401

 

 

All of our goodwill originated from the acquisitions of foreign subsidiaries. For foreign income tax purposes, a portion of this goodwill is amortized using the straight-line method and deducted over its statutory fifteen year life for US and foreign tax purposes. The remaining goodwill is non-deductible for tax purposes in its respective jurisdictions.

5.   NOTES PAYABLE AND OTHER INDEBTEDNESS

Notes payable and other indebtedness is summarized as follows:

 

 

April 30,
2006

 

October 31,
2005

 

Contingent convertible senior notes, fixed rate interest at 1.25%, due 2024

 

$

150,000

 

 

$

150,000

 

 

Bridge loan, due July 2006

 

100,000

 

 

 

 

Stargames credit facility

 

6,462

 

 

 

 

BTI acquisition contingent consideration

 

5,347

 

 

6,167

 

 

ENPAT note payable, non-interest bearing, due in installments through 2007

 

5,557

 

 

8,518

 

 

Bet the Set “21” contingent consideration

 

542

 

 

549

 

 

VIP note payable

 

323

 

 

318

 

 

Other

 

4,546

 

 

189

 

 

 

 

272,777

 

 

165,741

 

 

Less: current portion

 

(110,244

)

 

(3,082

)

 

 

 

$

162,533

 

 

$

162,659

 

 

 

Contingent convertible senior notes.   In April 2004, we issued $150,000 of contingent convertible senior notes due 2024 (the “Notes”) through a private placement under Rule 144A of the Securities Act of 1933. The Notes are unsecured and bear interest at a fixed rate of 1.25% per annum. Interest is payable semi-annually in arrears on April 15 and October 15 of each year, beginning October 15, 2004.

Holders may convert any outstanding Notes into cash and shares of our common stock at an initial conversion price per share of $28.07. This represents a conversion rate of approximately 35.6210 shares of common stock per $1,000 in principal amount of Notes. The value of the cash and shares of our common stock, if any, to be received by a holder converting $1,000 principal amount of the Notes will be determined based on the applicable Conversion Rate, Conversion Value, Principal Return, and other factors, each as defined in the indenture covering these Notes.

The Notes are convertible, at the holders’ option, into cash and shares of our common stock, under any of the following circumstances:

·       during any fiscal quarter commencing after the date of original issuance of the Notes, if the closing sale price of our common stock over a specified number of trading days during the previous quarter is more than 120% of the conversion price of the Notes on the last trading day of the previous quarter;

·       if we have called the Notes for redemption and the redemption has not yet occurred;

10




·       during the five trading day period immediately after any five consecutive trading day period in which the trading price of the Notes per $1,000 principal amount for each day of such period was less than 95% of the product of the closing sale price of our common stock on such day multiplied by the number of shares of our common stock issuable upon conversion of $1,000 in principal amount of the Notes, provided that, if on the date of any conversion pursuant to this trading price condition, our common stock price on such date is greater than the conversion price but less than 120% of the conversion price, then the holder will be entitled to receive Conversion Value (as defined in the indenture covering these Notes) equal to the principal amount of the Notes, plus accrued and unpaid interest including liquidated damages, if any; or

·       upon the occurrence of specified corporate transactions.

We may call some or all of the Notes at any time on or after April 21, 2009, at a redemption price, payable in cash, of 100% of the principal amount of the Notes, plus accrued and unpaid interest and including liquidated damages, if any, up to but not including the date of redemption. In addition, the holders may require us to repurchase all or a portion of their Notes on April 15, 2009, 2014 and 2019, at 100% of the principal amount of the Notes, plus accrued and unpaid interest and including liquidated damages, if any, up to but not including the date of repurchase, payable in cash. Upon a change in control, as defined in the indenture governing the Notes, holders may require us to repurchase all or a portion of their Notes, payable in cash equal to 100% of the principal amount of the Notes plus accrued and unpaid interest and liquidated damages, if any, up to but not including the date of repurchase.

Bridge loan.   On January 25, 2006, we entered into a Credit Agreement with Deutsche Bank AG Cayman Islands Branch, as a Lender, Deutsche Bank AG New York Branch, as Administrative Agent, and Deutsche Bank Securities Inc., as Sole Arranger and Book Manager (the “Credit Agreement”), pursuant to which we obtained a bridge loan (the “Bridge Loan”) in the amount of $115,000, in order to finance the acquisition of Stargames. On April 24, 2006, we entered into Amendment No. 1 (the “Amendment”) to the Credit Agreement. The Amendment extended the maturity date for the Bridge Loan to July 24, 2006 and we have agreed to use our commercially reasonable efforts to secure the loan extended under the Credit Agreement. The interest rate under the Credit Agreement is based on the sum of the relevant Base Rate or Eurodollar Rate plus the Applicable Margin, as defined, each as in effect from time to time. The Bridge Loan is currently unsecured. The obligations under the Bridge Loan are guaranteed by each wholly-owned domestic subsidiary of ours that is not an immaterial subsidiary and each wholly-owned domestic subsidiary that is not an immaterial subsidiary of the Company established, created or acquired after January 25, 2006, if any. The Credit Agreement contains customary affirmative and negative covenants for transactions of this nature, including but not limited to restrictions and limitations on the following:

·       Incurrence of indebtedness;

·       Granting or incurrence of liens;

·       Pay dividends and make other distributions in respect of our equity securities;

·       Acquire assets and make investments;

·       Sales of assets;

·       Transactions with affiliates;

·       Mergers; and

·       Agreements to restrict dividends and other payments from subsidiaries.

As of April 30, 2006, we were in compliance with all of the affirmative and negative covenants pursuant to the Credit Agreement. Additional information on these covenants may be found in Section 7 and Section 8 of the Credit Agreement included in our Current Report on Form 8-K, dated January 25, 2006. The current outstanding principal balance on the Bridge Loan as of April 30, 2006 was $100,000.

11




Management intends and believes it has the ability, to refinance the Bridge Loan on a long-term basis. Financing options currently under consideration include, but are not limited to, (i) an extension of the existing Credit Agreement, (ii) a senior secured bank credit facility or (iii) convertible or other debt to be issued by private placement pursuant to Rule 144A under the Securities Act of 1933.

Total debt issuance costs incurred with the issuance of long-term debt and the Bridge Loan are capitalized and amortized as interest expense using the effective interest method. Amortization of debt issuance costs were $634 and $240 for the three months ended April 30, 2006 and 2005, respectively, and $892 and $482 for the six months ended April 30, 2006, and 2005, respectively. Unamortized debt issuance costs of $2,848 as of April 30, 2006, are included in other assets on the condensed consolidated balance sheets.

Stargames credit facility.   Stargames has banking facilities with the Australia and New Zealand Banking Group (“ANZ”).  The facilities have a borrowing capacity of AU $12,700; amounts outstanding as of April 30, 2006 were AU $8,514 or US $6,472. The banking facilities are comprised of two main components; a flexible bank overdraft that acts as a working capital facility and a bank loan facility which is an interchangeable facility comprised of commercial bills, overdrafts and advances.  There were no amounts outstanding on the bank overdraft facility as of April 30, 2006 which amounts, if borrowed, would be based on the reference rate, as defined, plus 0.25%. The US $6,472 amount outstanding is under the bank loan facility which carries a weighted average interest rate of 5.98% as of April 30, 2006.  Interest rates are based on the bank bill swap yield, as defined, plus a margin.

The facilities are secured by a cross guarantee and indemnity between all the operating entities of the Stargames group.  The agreements provide for collateralization of all the assets and operations of all members of the Stargames group as well as the operating facilities of Stargames based in Milperra, NSW Australia.

The facilities include certain financial covenants which are tested annually by ANZ at the end of each financial year.  These financial covenants include a minimum working capital ratio, a minimum ratio of net profit, as defined, to interest expense and minimum liabilities to equity ratio. As of June 30, 2005, the most recent date of review, Stargames was in compliance with all financial covenants. The facilities are subject to the next compliance assessment as of October 31, 2006.

BTI liabilities.   In connection with our acquisition of certain assets from BTI, we recorded an initial estimated liability of $7,616 for contingent installment payments computed as the excess fair value of the acquired assets over the fixed installments and other direct costs. Beginning November 2004, we pay monthly note installments based on a percentage of certain revenue from BTI games for a period of up to ten years, not to exceed $12,000. The balance of this liability as of April 30, 2006, was $5,347.

ENPAT note payable.   In December 2004, we purchased two RFID technology patents from ENPAT for $12,500. The purchase price was comprised of an initial payment of $2,400 followed by a $1,100 payment in January 2005 and non-interest bearing annual installments through December 2007. The balance as of April 30, 2006, of $5,557 represents the discounted present value of the future payments, including imputed interest of approximately $118. The remaining principal and interest payments of $3,000 each are due in December 2006 and 2007.

Bet the Set “21” contingent consideration.   In connection with our acquisition of Bet the Set “21”, we recorded contingent consideration of $560. The contingent consideration consists of quarterly payments of 22.5% of “adjusted gross revenues,” as defined, attributed to the Bet the Set “21” side bet table games up to a maximum of $560. The balance of this liability as of April 30, 2006, was $542.

VIP note payable.   In connection with our acquisition of VIP in August 2005, we recorded a note payable with annual installments due each July through 2010. The balance of this liability as of April 30, 2005 was $323.

12




6.   SHAREHOLDERS’ EQUITY

The following table reconciles the changes in our shareholders’ equity during the six months ended April 30, 2006:

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

Total

 

 

 

 

 

 

 

Additional

 

Deferred

 

 

 

Other

 

Share-

 

 

 

Common Stock

 

Paid-in

 

Compen-

 

Retained

 

Comprehensive

 

holders’

 

 

 

Shares

 

Amount

 

Capital

 

sation

 

Earnings

 

Income

 

Equity

 

Balance, October 31, 2005 

 

34,527

 

 

$

345

 

 

 

$

 

 

$

(5,788

)

$

17,298

 

 

$

1,545

 

 

$

13,400

 

Reclassification of deferred compensation to APIC

 

 

 

 

 

 

(5,788

)

 

5,788

 

 

 

 

 

 

Comprehensive income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

 

 

 

 

(5,367

)

 

 

 

(5,367

)

Currency translation

 

 

 

 

 

 

 

 

 

 

 

4,495

 

 

4,495

 

Unrealized gain on investments

 

 

 

 

 

 

 

 

 

 

 

126

 

 

126

 

Total comprehensive income (loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(746

)

Options exercised

 

490

 

 

5

 

 

 

5,701

 

 

 

 

 

 

 

5,706

 

Share-based compensation expense

 

 

 

 

 

 

1,810

 

 

 

 

 

 

 

1,810

 

Tax benefit from stock options

 

 

 

 

 

 

2,487

 

 

 

 

 

 

 

2,487

 

Issuance of restricted stock 

 

60

 

 

1

 

 

 

 

 

 

 

 

 

 

1

 

Amortization of deferred compensation

 

 

 

 

 

 

734

 

 

 

 

 

 

 

734

 

Balance, April 30, 2006

 

35,077

 

 

$

351

 

 

 

$

4,944

 

 

$

 

$

11,931

 

 

$

6,166

 

 

$

23,392

 

 

Stock splits.   In December 2004, our board of directors approved a three-for-two common stock split, with new shares distributed in the form of a dividend on January 14, 2005, to shareholders of record on January 3, 2005 (the “January 2005 Split”). Share and per share amounts have been adjusted for all periods presented herein to reflect the January 2005 Split. In connection with the January 2005 Split, we paid cash of $68 for fractional shares and reclassified to common stock the par value of $0.01 per newly issued share.

In March 2004, our board of directors approved a three-for-two common stock split, with new shares distributed in the form of a dividend on April 16, 2004, to shareholders of record on April 5, 2004 (the “April 2004 Split”). Share and per share amounts have been adjusted for all periods presented herein to reflect the April 2004 Split. In connection with the April 2004 Split, we paid cash of $138 for fractional shares and reclassified to common stock the par value of $0.01 per newly issued share.

Common stock repurchases.   Our board of directors periodically authorizes us to repurchase shares of our common stock. Under our existing board authorizations, during the six months ended April 30, 2006, no shares of our common stock were repurchased compared to 558 shares of our common stock repurchased for a total cost of $15,256 at an average price of $27.36 for the same prior year period. As of April 30, 2006, $8,831 remained outstanding under our board authorizations. We cancel shares that we repurchase.

Tax benefit from stock option exercises.   During the six months ended April 30, 2006 and 2005, we realized income tax benefits of $2,487 and $4,310, respectively, related to deductions for employee stock

13




option exercises. These tax benefits, which reduced income taxes payable and additional paid-in capital by an equal amount, had no affect on our provision for income taxes.

Preferred stock purchase rights.   In February 2005, we amended our Shareholder Rights Agreement, dated June 26, 1998 (the “Rights Agreement”). As more fully described therein, and subject to the terms thereof, the Rights Agreement, as amended, generally gives holders of our common stock rights to acquire shares of our preferred stock upon the occurrence of specified events.  The amendment (a) eliminated all requirements in the Rights Agreement that actions, approvals and determinations to be taken or made by our board of directors be taken or made by a majority of the “Continuing Directors,” and (b) reflects the change of the name of our stock transfer agent to Wells Fargo Bank, N.A. The amendment eliminated from the Rights Agreement those provisions commonly referred to as “dead hand” provisions.

7.   SHARE-BASED COMPENSATION

Adoption of SFAS 123R.   Effective November 1, 2005, we account for stock-based compensation in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004) (“SFAS 123R”), “Share-Based Payment”, and SEC Staff Accounting Bulletin No. 107 (“SAB 107”), “Share-Based Payment”, requiring the measurement and recognition of all share-based compensation under the fair value method. We previously accounted for stock-based compensation in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, and the Financial Accounting Standards Board’s Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25”, and disclosed supplemental information in accordance with Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation.”  Under these standards, we did not incur compensation expense for employee stock options when the exercise price was at least 100% of the market value of our common stock on the date of grant. SFAS 123R requires that all stock-based compensation, including shares and share-based awards to employees, be valued at fair value. We measure the fair value of share-based awards using the Black-Scholes model.

Under SFAS 123R, compensation is attributed to the periods of associated service. For awards granted prior to November 1, 2005, such expense is being recognized on an accelerated basis since that is the method that we previously applied in our supplemental disclosures. Beginning with awards granted on November 1, 2005, such expense is being recognized on a straight-line basis over the vesting period of the awards. Forfeitures are estimated at the time of grant, with such estimate updated periodically and with actual forfeitures recognized currently to the extent they differ from the estimate.

We adopted SFAS 123R by applying the modified-prospective transition method and adjusted previously recorded deferred compensation back to additional paid-in capital. Under this method, we began applying the valuation and other criteria of SFAS 123R on November 1, 2005, and began recognizing expense for the unvested portion of previously issued grants at the same time, based on the valuation and attribution methods originally used to calculate the disclosures.

The impact of adopting SFAS 123R was as follows, due to the incremental compensation cost recognized for employee stock options and restricted stock :

 

 

Three Months Ended

 

Six Months Ended

 

 

 

April 30, 2006

 

April 30, 2006

 

Incremental stock-based compensation under SFAS 123R

 

 

$

1,235

 

 

 

$

2,546

 

 

Tax benefit

 

 

(362

)

 

 

(745

)

 

Reduction of net income

 

 

$

873

 

 

 

$

1,801

 

 

Reduction in basic earnings per share

 

 

$

0.03

 

 

 

$

0.05

 

 

Reduction in diluted earnings per share

 

 

$

0.03

 

 

 

$

0.05

 

 

 

14




In addition, SFAS 123R requires the excess tax benefit from stock-option exercises—tax deductions in excess of compensation cost recognized—to be classified as a financing activity. Previously, all tax benefits from stock option exercises were classified as operating activities. We have evaluated the provisions of SFAS 123R-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards” and have elected the alternative method for establishing the APIC pool. Accordingly, the excess tax benefits are classified as an operating cash outflow and a financing cash inflow.

Share-based award plans.   In February 2004, our board of directors adopted and, in March 2004, our shareholders approved the Shuffle Master, Inc. 2004 Equity Incentive Plan (the “2004 Plan”) and the Shuffle Master, Inc. 2004 Equity Incentive Plan for Non-Employee Directors (the “2004 Directors’ Plan”). These approved plans replaced our prior plans and no further options may be granted from the prior plans. Both the 2004 Plan and the 2004 Directors’ Plan provide for the grant of stock options, stock appreciation rights (none issued), and restricted stock, individually or in any combination (collectively referred to as “Awards”). Stock options may not be granted at an exercise price less than the market value of our common stock on the date of grant and may not be subsequently repriced. Options granted under the 2004 Plan generally vest in equal increments over four years and expire in ten years. Options granted under the 2004 Directors’ Plan generally vest immediately and expire in ten years.

The 2004 Plan provides for the grants of Awards to our officers, other employees and contractors.  The maximum number of Awards which may be granted is 2,700 of which no more than 1,890 may be granted as restricted stock. The 2004 Directors’ Plan provides for the grants of Awards to our non-employee directors. The maximum number of Awards which may be granted is 1,125 of which no more than 788 may be granted as restricted stock.

As of April 30, 2006, 1,127 and 903 shares are available for grant under the 2004 Plan and 2004 Directors’ Plan, respectively. A summary of activity under our share-based payment plans for the six months ended April 30, 2006 is presented below:

 

 

Shares

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
Contractual
Term

 

Aggregate
Intrinsic
Value 

 

Outstanding at October 31, 2005

 

 

3,822

 

 

 

$

17.01

 

 

 

 

 

 

 

 

 

 

Granted

 

 

113

 

 

 

33.36

 

 

 

 

 

 

 

 

 

 

Exercised

 

 

(490

)

 

 

11.65

 

 

 

 

 

 

 

 

 

 

Forfeited or expired

 

 

(119

)

 

 

12.26

 

 

 

 

 

 

 

 

 

 

Outstanding at April 30, 2006

 

 

3,326

 

 

 

$

18.53

 

 

 

7.7

 

 

 

$

60,680

 

 

Exercisable at April 30, 2006

 

 

2,064

 

 

 

$

17.80

 

 

 

7.4

 

 

 

$

36,743

 

 

 

The total intrinsic value of stock options exercised during the six months ended April 30, 2006 and 2005 was $9,177 and $16,672, respectively. The total income tax benefits from stock option exercises during the six months ended April 30, 2006 and 2005 were $2,487 and $4,310, respectively. As of April 30, 2006, there was a total of $7,385 of unamortized compensation related to stock options, which expense is expected to be recognized over a weighted-average period of 2.3 years. As noted earlier, we are recognizing expense for awards granted prior to November 1, 2005 on an accelerated basis, so a disproportionate amount of unamortized expense will be recognized in the first 12 months of this weighted-average period.

15




Recognition of compensation expense.   The following table shows information about compensation costs recognized:

 

 

Three
Months Ended

 

Six Months Ended

 

 

 

April 30,

 

April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Compensation expense:

 

 

 

 

 

 

 

 

 

Stock options

 

$

816

 

$

60

 

$

1,811

 

$

60

 

Restricted stock

 

419

 

161

 

735

 

305

 

Total compensation expense

 

1,235

 

221

 

2,546

 

365

 

Less: Related tax benefit

 

(362

)

(81

)

(745

)

(134

)

Total compensation expense, net of tax benefit

 

$

873

 

$

140

 

$

1,801

 

$

231

 

 

Reported share-based compensation expense was classified as follows:

 

 

Three
Months Ended

 

Six Months Ended

 

 

 

April 30,

 

April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Gross margin

 

$

16

 

$

 

$

46

 

$

 

Selling, general and administrative

 

1,145

 

221

 

2,348

 

365

 

Research and development

 

74

 

 

152

 

 

Total share-based compensation expense

 

$

1,235

 

$

221

 

$

2,546

 

$

365

 

Tax benefit

 

(362

)

(81

)

(745

)

(134

)

Total share-based compensation expense, net of tax

 

$

873

 

$

140

 

$

1,801

 

$

231

 

 

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 (assumptions in 2005 were used to compute the pro forma compensation for disclosure purposes only). Option valuation models require the input of highly subjective assumptions, and changes in assumptions used can materially affect the fair value estimate. Expected volatility and dividends are based on historical factors related to our common stock. Expected term represents the estimated weighted-average time between grant and employee exercise. Risk free interest rate is based on U.S. Treasury rates appropriate for the expected term.

 

 

Three Months
Ended

 

Six Months
Ended

 

 

 

April 30,

 

April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Option valuation assumptions:

 

 

 

 

 

 

 

 

 

Expected dividend yield

 

 

 

 

 

Expected volatility

 

36.5

%

53.6

%

36.5

%

54.8

%

Risk-free interest rate

 

4.7

%

4.2

%

4.7

%

3.0

%

Expected term of options

 

4.4

 

5.5

 

4.4

 

5.5

 

 

16




Pro forma disclosures.   Had we accounted for these plans during 2005 under the fair value method allowed by SFAS 123, our net income and earnings per share would have been reduced to recognize the fair value of employee options, as follows:

 

 

Three Months Ended

 

Six Months Ended

 

 

 

April 30, 2005

 

April 30, 2005

 

Net income

 

 

 

 

 

 

 

 

 

As reported

 

 

$

6,845

 

 

 

$

12,967

 

 

Incremental stock-based compensation under SFAS 123,
net of tax benefit

 

 

(7,273

)

 

 

(8,724

)

 

Pro forma

 

 

$

(428

)

 

 

$

4,243

 

 

Basic (loss) earnings per share

 

 

 

 

 

 

 

 

 

As reported

 

 

$

0.19

 

 

 

$

0.37

 

 

Pro forma

 

 

(0.01

)

 

 

0.12

 

 

Diluted earnings (loss) per share

 

 

 

 

 

 

 

 

 

As reported

 

 

$

0.19

 

 

 

$

0.35

 

 

Pro forma

 

 

(0.01

)

 

 

0.12

 

 

 

Restricted stock.   During the six months ended April 30, 2006 and 2005, we issued 60 and 50 shares of restricted stock, respectively, with an aggregate fair value of $2,018 and $1,353, respectively. 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. Net income, as reported, for the three months ended April 30, 2006 and 2005, reflects $296 and $104 respectively, net of tax, and $520 and $198 for the six months ended April 30, 2006 and 2005, respectively, of amortization of restricted stock compensation.

A summary of activity related to restricted stock for the six months ended April 30, 2006 is presented below:

 

 

 

 

Weighted

 

 

 

 

 

Average

 

 

 

 

 

Grant-Date

 

 

 

Shares

 

Fair Value

 

Nonvested at October 31, 2005

 

276,750

 

 

$

24.35

 

 

Granted

 

60,500

 

 

33.36

 

 

Exercised

 

 

 

 

 

Forfeited

 

 

 

 

 

Nonvested at April 30, 2006

 

337,250

 

 

$

25.96

 

 

 

No shares vested during the three months ended April 30, 2006. As of April 30, 2006, there was $7,071 of unamortized compensation expense related to restricted stock, which expense is expected to be recognized over a weighted-average period of 2.5 years.

8.   INCOME TAXES

Our effective income tax rate for continuing operations for the three and six months ended April 30, 2006 was (34.5%) and 447.6%, respectively. Excluding the impact of the one-time IPR&D charge in relation to the Stargames acquisition, which is non-deductible for tax purposes, the effective tax rate for the three and six months ended April 30, 2006 would have been 33.2% and 33.7%, respectively.

17




9.   EARNINGS PER SHARE

Shares used to compute basic and diluted earnings per share from continuing operations are as follows:

 

 

Three Months Ended

 

Six Months Ended

 

 

 

April 30,

 

April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Income (loss) from continuing operations

 

$

(12,632

)

$

6,829

 

$

(5,414

)

$

12,908

 

Basic:

 

 

 

 

 

 

 

 

 

Weighted average shares

 

34,555

 

35,301

 

34,522

 

35,116

 

Diluted:

 

 

 

 

 

 

 

 

 

Weighted average shares, basic

 

34,555

 

35,301

 

34,522

 

35,116

 

Dilutive effect of options and restricted stock

 

 

1,321

 

 

1,493

 

Dilutive effect of contingent convertible notes

 

 

194

 

 

222

 

Weighted average shares, diluted

 

34,555

 

36,816

 

34,522

 

36,831

 

Basic earnings (loss) per share

 

$

(0.37

)

$

0.19

 

$

(0.16

)

$

0.37

 

Diluted earnings (loss) per share

 

$

(0.37

)

$

0.19

 

$

(0.16

)

$

0.35

 

 

We account for our contingent convertible notes in accordance with EITF 04-08, “The Effect of Contingently Convertible Debt on Diluted Earnings Per Share” which requires us to include the dilutive effect of our outstanding Notes shares in our diluted earnings per share calculation, regardless of whether the market price trigger or other contingent conversion feature has been met. Because our Notes include a mandatory cash settlement feature for the principal payment, we applied the treasury stock method. This method results in incremental dilutive shares when the average fair value of our common stock for a reporting period exceeds the initial conversion price per share of $28.07. For the six months ended April 30, 2006 and 2005, the average fair value of our common stock did exceed $28.07, resulting in additional dilutive shares. For the three and six months ended April 30, 2006, the dilution related to our options, restricted stock and contingent convertible notes have not been included in the diluted earnings (loss) per share computation as their inclusion would be anti-dilutive.

10.   OTHER INCOME (EXPENSE)

Other income (expense) is comprised of the following:

 

 

Three
Months Ended

 

Six Months Ended

 

 

 

April 30,

 

April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Interest income

 

$

561

 

$

945

 

$

1,070

 

$

1,334

 

Interest expense

 

(2,287

)

(586

)

(2,950

)

(1,096

)

Amortization of debt issue costs

 

(634

)

(240

)

(892

)

(482

)

Foreign currency (loss) gain

 

22

 

18

 

(103

)

51

 

Other

 

1

 

4

 

48

 

(1

)

Total other income (expense)

 

$

(2,337

)

$

141

 

$

(2,827

)

$

(194

)

 

Interest expense is primarily related to the $150,000 of Notes due in April 2024 and the $115,000 Bridge Loan due July 2006.

11.   OPERATING SEGMENTS

We have two reportable segments which are classified as continuing operations, Utility Products and Entertainment Products. Utility Products includes our Shufflers, Chip Sorting Machines and ITS product

18




lines. Entertainment Products includes our Proprietary Table Games, Table Master products, Shuffle Up and the products developed, manufactured and distributed by Stargames. The Stargames product offerings include Rapid Table Games, Vegas Star, multi-terminal gaming machines and a broad line of traditional video slot machines designed most specifically for the Australian and Asian gaming markets. Each segment’s activities include the design, development, acquisition, manufacture, marketing, distribution, installation and servicing of its product lines. All periods presented have been reclassified to conform to our current reportable segments.

Segment revenues include sale, lease or licensing of products within each reportable segment. Segment operating income includes revenues and expenses directly and indirectly associated with the product lines included in each segment. Direct expenses primarily include depreciation of leased assets, amortization of intangible assets, cost of products sold, shipping, installation, commissions, product approval costs, research and development and product related litigation. Indirect expenses include an activity-based allocation of other general product-related costs, the most significant of which are service and selling expenses, including stock option expense, and manufacturing overhead. Corporate general and administrative expenses are not allocated to segments.  Capital expenditures include amounts reported in our condensed consolidated statements of cash flows for purchases of leased products, property and equipment, and intangible assets plus the financed or non-cash portion of these purchases which is excluded from cash flows.

As discussed in Note 2, we recognized a one-time charge related to IPR&D of $19,145 related to the acquisition of Stargames. All of the products acquired from Stargames have been classified as Entertainment products and accordingly, the Entertainment segment results for the six months ended April 30, 2006, include the impact of the IPR&D charge of $19,145.

The following provides financial information concerning our reportable segments of our continuing operations:

 

 

Three Months Ended
April 30,

 

Six Months Ended
April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Revenue:

 

 

 

 

 

 

 

 

 

Utility Products

 

$

23,615

 

$

17,384

 

$

45,499

 

$

30,745

 

Entertainment Products

 

19,653

 

9,742

 

31,076

 

21,702

 

Corporate

 

35

 

2

 

45

 

51

 

 

 

$

43,303

 

$

27,128

 

$

76,620

 

$

52,498

 

Operating Income (Loss):

 

 

 

 

 

 

 

 

 

Utility Products

 

$

12,756

 

$

7,687

 

$

23,471

 

$

12,544

 

Entertainment Products

 

(9,489

)

7,532

 

(1,501

)

17,156

 

Corporate

 

(10,321

)

(4,797

)

(17,586

)

(9,590

)

 

 

$

(7,054

)

$

10,422

 

$

4,384

 

$

20,110

 

Depreciation and Amortization:

 

 

 

 

 

 

 

 

 

Utility Products

 

$

2,179

 

$

1,806

 

$

4,274

 

$

3,692

 

Entertainment Products

 

1,659

 

533

 

2,425

 

1,183

 

Corporate

 

1,075

 

402

 

1,801

 

882

 

 

 

$

4,913

 

$

2,741

 

$

8,500

 

$

5,757

 

Capital Expenditures:

 

 

 

 

 

 

 

 

 

Utility Products

 

$

1,428

 

$

1,651

 

$

2,983

 

$

15,568

 

Entertainment Products

 

469

 

496

 

980

 

763

 

Corporate

 

705

 

385

 

929

 

1,138

 

 

 

$

2,602

 

$

2,532

 

$

4,892

 

$

17,469

 

 

19




12. COMMITMENTS AND CONTINGENCIES

Purchase commitments.   From time to time, we enter into commitments with our vendors to purchase inventory at fixed prices or in guaranteed quantities. As of April 30, 2006, our significant inventory purchase commitments totaled $9,250 which are primarily related to our Table Master products, one2six shufflers, and the Easy Chipper roulette chip sorter machine.

Employment agreements.   We have entered into employment contracts with our Corporate Officers and certain other key employees with durations ranging typically from one to three years. Significant contract provisions include minimum annual base salaries, healthcare benefits, bonus compensation if performance measures are achieved, and non-compete provisions. These contracts are primarily “at will” employment agreements, under which the employee or we may terminate employment. If we terminate any of these employees without cause, then we are obligated to pay the employee severance benefits as specified in their individual contract. As of April 30, 2006, minimum aggregate severance benefits totaled $5,018.

Legal proceedings.   Our current material litigation and our current assessments are described below. Litigation is inherently unpredictable. Our assessment of each matter may change based on future unknown or unexpected events. Subject to the foregoing, we believe we will prevail in each of the material litigation actions described below. If any litigation were to have an adverse result that we did not expect, there could be a material impact on our results of operations or financial position. We believe costs associated with litigation will not have a material impact on our financial position or liquidity, but may be material to the results of operations in any given period. We assume no obligation to update the status of pending litigation, except as may be required by applicable law, statute or regulation.

Certain of our litigation relate to products or patents associated with our discontinued slot products operations. Legal expenses and settlement proceeds or payments associated with these matters, if any, are included in the Discontinued Operations caption on our condensed consolidated statements of income.

Continuing operations—

VendingData I—On July 12, 2005, we settled our litigation (known as VendingData I) with VendingData Corporation (“VendingData”) over VendingData’s Random Ejection shuffler. Under the terms of the settlement, VendingData was required to pay us $800, one-half of which was received on July 14, 2005, and the other half of which was paid in May 2006. We granted VendingData a conditional Covenant Not to Sue concerning our U.S. patents 6,028,258 and 6,325,373 (except for claims 6 and 7 of the 6,325,373 patent), which were the patents at issue in the VendingData I litigation. Each party has completely and fully released the other for any acts or omissions committed prior to July 12, 2005, except that, these releases have no effect with respect to our patent infringement claims against VendingData’s PokerOneTM shuffler in the VendingData II litigation. The VendingData I settlement does not restrict either party’s ability to bring new actions for any wrongful acts or acts of infringement committed after July 12, 2005.

VendingData II—In October 2004, we filed a second patent infringement lawsuit against VendingData Corporation (“VendingData II”). This second suit alleges that the use, importation and offering for sale of VendingData’s PokerOneTM shuffler infringes another patent owned by us (a different patent than the patents that were the subject of the VendingData I case mentioned above). VendingData II was filed in the U.S. District Court for the District of Nevada (the “Court”) in Las Vegas, Nevada. The complaint seeks an unspecified amount of damages against VendingData and a preliminary and permanent injunction against VendingData’s infringing conduct. VendingData has denied infringement and has also filed a counterclaim for a declaratory judgment of non-infringement.

20




On November 29, 2004, the Court granted our motion for a preliminary injunction (the “Injunction”). The Injunction became effective upon our posting of a $3,000 cash security with the Court on November 30, 2004. This security deposit is included in other assets on our consolidated balance sheet and included in cash flows from investing activities in our consolidated statement of cash flows. On December 17, 2004, the Court denied VendingData’s two emergency motions to modify the Injunction.

In March 2005, the Court of Appeals for the Federal Circuit (the “Federal Circuit”) stayed the Injunction based on a technical defect in the Court’s process in granting the Injunction, and not on its merits. In May 2005, the Court held a Markman hearing for construction of the claims. On September 26, 2005, U.S. Magistrate Judge Lawrence R. Leavitt for the District of Nevada issued his Claim Construction Report and Recommendation in the Markman hearing concerning VendingData’s PokerOneTM shuffler. The Magistrate Judge’s findings were limited to his interpretation of certain words in the patent claim asserted by us, and he agreed with the interpretation put forth by VendingData. The Magistrate Judge’s Recommendation is not a determination of whether the PokerOneTM infringes the asserted patent, nor does it speak to the validity of our claims. We have filed a written objection with the Court to the Magistrate Judge’s ruling. This objection is now pending.

On December 27, 2005, the Federal Circuit vacated the Injunction and ordered the Court to perform a more complete claim construction analysis in order to deal with any future motions on whether or not to reinstate the Injunction. Two of the three judges on the Federal Circuit panel stated that they did not believe that infringement exists under VendingData’s claim construction. We continue to believe that infringement exists under either our claim construction or VendingData’s claim construction, and we continue to believe that our claim construction is the proper one. The Federal Circuit did not rule on whether our claim construction or VendingData’s claim construction is the proper one. There can be no guarantee that the Court or, upon any further appeal, the Federal Circuit will agree with our claim construction. We intend to continue to enforce our intellectual property rights by moving the litigation forward to resolve our patent infringement claim. However, in June 2006, we agreed with VendingData to a 90 day standstill in the litigation in order to pursue settlement negotiations.

VendingData III—On March 31, 2006, VendingData filed a suit alleging that we have infringed and are currently infringing United States Patent No. 6,726,206 through the use or offering for sale of the MD2 shuffler in the United States. On May 1, 2006, VendingData filed a Notice of Voluntary Dismissal.

TCS—On July 15, 2005, we executed a settlement agreement with Technical Casino Supplies, Ltd. (“TCS”). As part of the settlement agreement, each party has completely and fully released the other for any acts or omissions committed prior to June 27, 2005. Under the terms of the settlement agreement, we paid TCS a one-time payment of $215 in settlement of disputed invoices and commissions relating to the previously terminated International Distribution Agreement with TCS (the “TCS Agreement”). The TCS Agreement had been terminated by the Arbitrator on December 22, 2004.

GEI—In July 2004, we filed a patent infringement lawsuit against Gaming Entertainment, Inc. (“GEI”) in the U.S. District Court for the District of Nevada, in Las Vegas, Nevada. The lawsuit alleges that GEI’s 3-5-7 PokerTM game infringes one of our Three Card Poker® patents. We are seeking a permanent injunction and an as yet undetermined amount of damages against GEI. GEI has answered our complaint, denying infringement, and also seeking a ruling that the patent is invalid.  The case is presently in the discovery phase. In November 2005, the Court held a Markman hearing for construction of the claims. The Markman decision is now pending.

21




Awada—On April 25 and April 26, 2005, our rescission trial was held in the District Court in Clark County, Nevada in the Awada and Gaming Entertainment, Inc. case against us and our CEO, Mark Yoseloff. At the conclusion of the trial, the court granted our rescission motion, ordering that the subject contract, called the “Game Option Agreement”, be rescinded and/or void. On May 18, 2005, the Court entered Findings of Fact/Conclusions of Law confirming the Court’s rescission ruling. Among the findings, the Court found that the actions of plaintiffs Yehia Awada and Gaming Entertainment, Inc. demonstrated that the plaintiffs never had any intention of conveying to us the exclusive license to the 3-Way Action game, as they had agreed and were required to do under the Game Option Agreement. The Court further found that we had established by a preponderance of the evidence that the plaintiffs had materially failed to perform their obligations under the Game Option Agreement and that we were entitled to the remedy of rescission. On May 5, 2005, the Court ruled on the parties’ damages requests in connection with the case and as required under Nevada law. Plaintiffs were seeking approximately $13,000 in damages. The Court ordered that the total damages under Nevada law due to the successful rescission of the Game Option Agreement was $130, including all interest. We had fully reserved for this amount. On June 1, 2005, the Court dismissed with prejudice all other claims asserted by plaintiffs.

Plaintiffs have appealed the Court’s order granting the rescission of the “Game Option Agreement” to the Nevada Supreme Court.

Awada II—On September 12, 2005, we filed a new lawsuit against defendants Awada and Gaming Entertainment, Inc. The lawsuit alleges that our Four Card Poker® game is being infringed and illegally copied by the defendants’ Play Four Poker game. The lawsuit claims that the defendants are violating the federal Lanham Act by infringing the trademark/trade dress of our Four Card Poker® game layout, and that the defendants are committing acts of unfair competition, interference with prospective business advantage and conversion. Our action seeks appropriate injunctive relief against defendants’ Play Four Poker game layout, as well as unspecified monetary damages. On September 15, 2005, the U.S. District Court for the District of Nevada issued a temporary restraining order prohibiting the defendants from displaying or advertising the infringing layout.

On or about December 6, 2005, the defendants answered our complaint and denied all liability. They also filed counterclaims for alleged patent misuse, anti-trust violations based on said patent misuse, patent invalidity, unfair competition, unfair trade practices, and other related claims. The counterclaims seek an unspecified amount of damages, disgorgement of our profits as a result of our alleged unfair trade practices, and preliminary and permanent injunctive relief against our alleged unfair trade practices. The defendants filed these counterclaims against both us and our CEO. We completely and uncategorically deny the defendants’ counterclaims, and intend to vigorously oppose them. On January 9, 2006, we filed a motion to dismiss all of defendants’ counterclaims. On January 24, 2006, defendants filed an opposition to our motion to dismiss. On March 27, 2006, the Court granted our motion for a preliminary injunction and dismissed four of defendants’ seven counterclaims.

MP Games I—In July 2004, we filed a complaint against MP Games LLC and certain other defendants in the U.S. District Court for the District of Nevada, in Las Vegas, Nevada. The complaint alleges that the defendants’ MP21 System infringes two patents owned by us. The complaint also alleges misappropriation of trade secrets against certain, but not all, of the defendants, and also includes claims for correction of named inventor on certain related patents held in the name of certain of the defendants. We are seeking a permanent injunction and an as yet undetermined amount of damages against all of the defendants. The defendants have answered our complaint denying infringement and also claiming that the two patents are invalid. The defendants have also counterclaimed against us, claiming that we infringe several of their patents, and that we misappropriated certain of their trade secrets, and are seeking damages against us. We deny any

22




infringement, misappropriation or wrongdoing. In May 2005, the Court dismissed defendants’ breach of contract counterclaim. The case is currently in the discovery phase. In the recent Two-Party Agreement transaction with IGT, IGT purchased a 50% ownership interest in the two patents which are the subject of this lawsuit, and IGT has been added as a named plaintiff in this lawsuit. In June 2005, the defendants filed the same, previously dismissed, breach of contract claim, and several other related claims as a new lawsuit in the U.S. District Court for the Western District of Washington, as explained below. On December 20, 2005, the Court entered its Markman order, construing the disputed claims in the various patents-in-suit. The Court ruled in our favor on a number of disputed terms and in the defendants’ favor on others. Some or all of these rulings may be overturned on appeal. Litigation will continue on all claims in the case.

MP Games II (Washington)—In June 2005, MP Games LLC, Alliance Gaming and Bally Gaming, which are among the defendants in MP Games I, filed a complaint against us in the U.S. District Court for the Western District of Washington, in Seattle, Washington. The complaint includes the breach of contract claim which had been dismissed from the MP Games Nevada litigation, discussed above, as well as related claims of misappropriation of trade secrets and patent infringement. The complaint seeks a permanent injunction against our MD2 shuffler with card recognition, an unspecified amount of damages and other relief. We deny the plaintiffs’ allegations. We filed a motion to dismiss and/or stay some of the plaintiffs’ allegations. On February 22, 2006, the Court denied our motion to dismiss the trade secret claim and granted our motion to stay the trade secrets and breach of contract claims pending further order of the Court. A scheduling conference was held on March 21, 2006 and discovery is ongoing. We will vigorously contest and deny any liability.

Discontinued operations—

IGCA—In April 2001, we were sued by Innovative Gaming Corporation of America (“IGCA”), a Minnesota corporation. The suit was filed in the Second Judicial District Court of the State of Nevada, in Washoe County, Nevada. The defendants are us and Joseph J. Lahti, our former Chairman. The complaint alleges breach of contract, negligence, misrepresentation and related theories of liability, all relating to a confidentiality agreement with respect to what the plaintiff claims to be its intellectual property. The complaint seeks an unspecified amount of damages. We have answered the complaint by denying any liability and raising various affirmative defenses. We deny the plaintiff’s claims. In 2004, IGCA filed for bankruptcy and a trustee was appointed. In December 2005, we entered into a settlement agreement with the trustee to settle all of IGCA’s claims for $150. On January 25, 2006, the Bankruptcy Court approved the settlement agreement and we paid the $150 settlement on February 14, 2006. A written order has been issued and the time for appeal, if any, has not yet run.

FleetwoodIn January 2004, the Company sold its then slot operating system (the “System”) to IGT. Prior to the sale, the Company had been negotiating with Fleetwood Manufacturing, Inc. (“Fleetwood”) about a sale of the System, but no agreement was reached and the negotiations were terminated. After the termination of the negotiations, however, the Company came to believe that Fleetwood was claiming that the Company had an obligation to continue to negotiate with Fleetwood regarding the System. Accordingly, in January 2004, the Company filed a complaint for declaratory relief in the District Court in Clark County, Nevada seeking a judicial ruling that the negotiations with Fleetwood had terminated and that the Company had the legal right to negotiate with third parties, including IGT, regarding a sale of the System.

Fleetwood disagreed with the Company’s position and filed an Answer denying the Company’s claimed right for declaratory relief. Fleetwood also filed a counterclaim alleging that the Company breached its obligations to negotiate in good faith with Fleetwood. Fleetwood claimed that its damages were in excess of $10.

23




Prior to June, 2006, Fleetwood never put forth the damages, or any proof relating thereto, that were allegedly caused by the Company’s alleged breaches. In June 2006, Fleetwood, for the first time, produced an expert report which opined that Fleetwood’s business had suffered in the last two years and that the cause of its losses was the Company’s failure to sell the System to Fleetwood. Fleetwood has alleged that its losses are approximately $12,000.

The Company completely rejects Fleetwood’s arguments and positions, and believes that Fleetwood’s claims and theory of damages have no support either in fact or law. The Company believes that it committed no wrongful acts against Fleetwood and caused it no damages. The Company is continuing to vigorously oppose Fleetwood’s claims and believes that it will prevail in this lawsuit. A trial is scheduled for October 2006.

This litigation is now being disclosed due to the newly alleged amount of damages, and not because the Company believes that Fleetwood’s claims have any validity. The Company strongly believes that Fleetwood’s claims and allegations of damages completely lack merit.

In the ordinary course of conducting our business, we are, from time to time, involved in other litigation, administrative proceedings and regulatory government investigations. We believe that the final disposition of any of these or other matters will not have a material adverse effect on our financial position, results of operations or liquidity.

ITEM 2.                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

BUSINESS OVERVIEW
(In thousands, except units)

We develop, manufacture and market technology-based products for the gaming industry for placement on the casino floor. Our products primarily relate to our casino customers’ table game activities and are focused on increasing their profitability, productivity and security. Our Utility Products include a full line of automatic card shufflers for use with the vast majority of card table games and chip sorting machines for roulette. In addition, we have acquired or are developing other products to automatically gather data and to enable casinos to track table game play, such as our Bloodhound® and Intelligent Table System™ products. Our Entertainment Products include our line of live proprietary poker, blackjack, baccarat, and pai gow poker-based table games and our Table Master™ product that delivers our popular branded table game content on a multi-player video platform. In January 2005, we formed Shuffle Up ProductionsTM, Inc. (“Shuffle Up”) to leverage our intellectual property and develop live and broadcast tournament events as well as merchandise based on our extremely popular gaming offerings. In November 2005, we hosted the finals of our Three Card Poker National ChampionshipTM with a grand prize of $1,000. In February 2006, we acquired Stargames Limited (“Stargames”). Stargames product offerings are classified as Entertainment Products and include Rapid Table GamesTM, Vegas Star® multi-terminal gaming machines, and a broad line of traditional video slot machines designed most specifically for the Australian and Asian gaming markets. The Rapid series of games, which we already distribute in the Americas and the Caribbean, combines a live dealer with multi-terminal electronic wagering. Current offerings include Rapid Roulette®, Rapid Sic-Bo® and Rapid Big Wheel®. Vegas Star® multi-terminal gaming machines feature animated dealers and a selection of public domain table games. The Vegas Star® Nova line utilizes Stargames existing slot cabinet to extend the number of wagering terminals for a Vegas Star game, while minimizing the footprint required on the gaming floor. All of our product lines compete or will compete with other gaming products, such as slot machines, blackjack tables, keno, craps, and roulette, for space on the casino floor.

We sell, lease or license our products. When we sell our products, we offer our customers a choice between a sale, a longer-term sales-type lease or other long-term financing. When we lease or license our

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products, we generally negotiate a month-to-month operating lease. We offer our products worldwide in markets that are significantly regulated. We manufacture the majority of our products at our headquarters and manufacturing facility in Las Vegas, Nevada. In addition, we outsource the manufacturing of certain of our products in the United States, Europe and Asia Pacific.

Our internet address is www.shufflemaster.com. Through the “Investor Relations” page on our internet website, our annual report on Form 10-K, proxy statement, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act are available free of charge, as soon as reasonably practical after such information has been filed or furnished to the Securities and Exchange Commission. Additional information regarding Shuffle Up can be accessed at www.shuffleupproductions.com.

Management’s Discussion and Analysis contains forward-looking statements. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in “Forward Looking Statements” elsewhere in this quarterly report.

SHARE-BASED COMPENSATION

On November 1, 2005, we adopted the provisions of Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard No. 123 (revised 2004) (“SFAS 123R”), “Share-Based Payment”, and SEC Staff Accounting Bulletin No. 107 (“SAB 107”), “Share-Based Payment”, requiring the measurement and recognition of all share-based compensation under the fair value method. Under the fair value recognition provisions of this statement, share-based compensation cost is estimated at the grant date based on the value of the award and is recognized as expense over the vesting period. Option valuation models require the input of highly subjective assumptions, and changes in the assumptions used can materially affect the fair value estimate. Additionally, judgment is required in estimating stock price volatility, expected dividends, and expected term for options that remain outstanding. Actual results, and future estimates, may differ substantially from our current estimates. See Note 7 of our condensed consolidated financial statements for additional information regarding the adoption of SFAS 123R.

ACQUISITIONS, DISPOSITIONS AND OTHER SIGNIFICANT TRANSACTIONS

Stargames.   As discussed elsewhere, on February 1, 2006, we had substantially completed our acquisition of Stargames by purchasing 95% of the outstanding Stargames shares for AU$1.55 per share. Effective March 8, 2006, we had acquired 100% of the outstanding Stargames shares.  Consideration to Stargames consisted of an Australian-denominated cash payment of $148,441 AUD or $112,147 USD denominated. In addition, we estimate that our total direct acquisition costs, consisting primarily of legal and due diligence fees, to be approximately $2,190.  The shares purchase was funded by temporary bridge financing which has a maturity date of July 24, 2006. We expect to secure permanent financing through i) an extension of the existing Credit Agreement, ii) a senior secured bank credit facility or iii) convertible or other debt to be issued by private placement pursuant to Rule 144A under the Securities Act of 1933. For additional information on the bridge financing see Note 5 to our condensed consolidated financial statements.

The acquisition enhances the products in our Entertainment segment as well as provides for additional electronic platforms for the Company’s branded content. Additionally, the Company acquired a strong brand name as well as an experienced and talented management team. These factors result in the recognition of certain intangible assets, discussed below, and significant goodwill.

The transaction was accounted for as a purchase and, accordingly, the preliminary purchase price was allocated to the underlying assets acquired and liabilities assumed based upon their estimated fair values at the date of the acquisition. The preliminary fair values have been prepared