10-Q/A 1 a06-19139_110qa.htm AMENDMENT TO QUARTERLY REPORT PURSUANT TO SECTIONS 13 OR 15(D)

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q/A


(Mark One)

 

x

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

For the quarterly period ended July 31, 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

 

(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 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 September 5, 2006, there were 34,934,695 shares of our $.01 par value common stock outstanding.

 




SHUFFLE MASTER, INC.
QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED JULY 31, 2006
TABLE OF CONTENTS

 

 

 

Page

 

 

PART I—FINANCIAL INFORMATION

 

 

Item 1.

 

Financial Statements (unaudited):

 

 

 

 

Condensed Consolidated Statements of Income
Three and Nine months ended July 31, 2006 and 2005

 

1

 

 

Condensed Consolidated Balance Sheets
July 31, 2006 and October 31, 2005

 

2

 

 

Condensed Consolidated Statements of Cash Flows
Nine months ended July 31, 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

 

26

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

55

Item 4.

 

Controls and Procedures

 

56

 

 

PART II—OTHER INFORMATION

 

 

Item 1.

 

Legal Proceedings

 

58

Item 1A.

 

Risk Factors

 

58

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

60

Item 6.

 

Exhibits

 

60

Signatures

 

61

 




PART I

ITEM 1.   FINANCIAL STATEMENTS

SHUFFLE MASTER, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited, in thousands, except per share amounts)

 

 

Three Months Ended
July 31,

 

Nine Months Ended
July 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

Revenue:

 

 

 

 

 

 

 

 

 

Utility products leases

 

$

5,936

 

$

6,252

 

$

18,029

 

$

17,437

 

Utility products sales and service

 

12,689

 

10,282

 

46,095

 

29,842

 

Entertainment products leases and royalties

 

6,532

 

6,266

 

19,262

 

18,557

 

Entertainment products sales and service

 

15,568

 

4,391

 

33,914

 

13,802

 

Other

 

12

 

81

 

58

 

132

 

Total revenue

 

40,737

 

27,272

 

117,358

 

79,770

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of leases and royalties

 

2,858

 

2,501

 

8,417

 

7,105

 

Cost of sales and service

 

10,491

 

4,496

 

29,308

 

12,527

 

Selling, general and administrative

 

14,851

 

6,474

 

38,211

 

22,253

 

Research and development

 

3,763

 

1,796

 

8,963

 

5,770

 

Gain on sale of patent

 

(4,566

)

 

(4,566

)

 

In-process research and development

 

 

 

19,145

 

 

Total costs and expenses

 

27,397

 

15,267

 

99,478

 

47,655

 

Equity method investment loss

 

(119

)

 

(275

)

 

Income from operations

 

13,221

 

12,005

 

17,605

 

32,115

 

Other expense

 

(1,873

)

(291

)

(4,699

)

(485

)

Income from continuing operations before tax

 

11,348

 

11,714

 

12,906

 

31,630

 

Provision for income taxes

 

3,905

 

3,663

 

10,876

 

10,671

 

Income from continuing operations

 

7,443

 

8,051

 

2,030

 

20,959

 

Discontinued operations, net of tax

 

(174

)

8

 

(127

)

67

 

Net income

 

$

7,269

 

$

8,059

 

$

1,903

 

$

21,026

 

Basic earnings per share:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

0.21

 

$

0.23

 

$

0.06

 

$

0.60

 

Discontinued operations

 

 

 

 

 

Net income

 

$

0.21

 

$

0.23

 

$

0.06

 

$

0.60

 

Diluted earnings per share:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

0.20

 

$

0.22

 

$

0.06

 

$

0.57

 

Discontinued operations

 

 

 

(0.01

)

 

Net income

 

$

0.20

 

$

0.22

 

$

0.05

 

$

0.57

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

34,746

 

35,048

 

34,596

 

35,093

 

Diluted

 

36,907

 

36,317

 

36,206

 

36,658

 

 

See notes to unaudited condensed consolidated financial statements

1




SHUFFLE MASTER, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except per share amounts)

 

 

July 31,

 

October 31,

 

 

 

2006

 

2005

 

ASSETS

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

23,361

 

 

$

13,279

 

 

Investments

 

41

 

 

20,809

 

 

Accounts receivable, net

 

26,164

 

 

17,865

 

 

Investment in sales-type leases and notes receivable, net

 

9,896

 

 

8,219

 

 

Inventories, net

 

24,471

 

 

9,428

 

 

Prepaid income taxes

 

1,398

 

 

 

 

Deferred income taxes

 

6,107

 

 

1,837

 

 

Other current assets

 

11,066

 

 

3,255

 

 

Total current assets

 

102,504

 

 

74,692

 

 

Investment in sales-type leases and notes receivable, net

 

12,000

 

 

11,136

 

 

Products leased and held for lease, net

 

10,099

 

 

9,163

 

 

Property and equipment, net

 

8,807

 

 

4,144

 

 

Deferred income taxes

 

3,303

 

 

2,400

 

 

Intangible assets, net

 

76,447

 

 

48,477

 

 

Goodwill

 

81,935

 

 

36,017

 

 

Other assets

 

10,550

 

 

7,088

 

 

Total assets

 

$

305,645

 

 

$

193,117

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Accounts payable

 

$

6,472

 

 

$

3,540

 

 

Accrued liabilities

 

13,520

 

 

6,547

 

 

Customer deposits and unearned revenue

 

4,972

 

 

3,518

 

 

Income taxes payable

 

 

 

371

 

 

Note payable and current portion of long-term liabilities

 

89,867

 

 

3,082

 

 

Total current liabilities

 

114,831

 

 

17,058

 

 

Long-term liabilities, net of current portion

 

159,317

 

 

162,659

 

 

Deferred income taxes

 

1,057

 

 

 

 

Total liabilities

 

275,205

 

 

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; 34,975 and 34,527 shares issued and outstanding

 

350

 

 

345

 

 

Additional paid-in capital

 

3,551

 

 

 

 

Deferred compensation

 

 

 

(5,788

)

 

Retained earnings

 

19,201

 

 

17,298

 

 

Accumulated other comprehensive income

 

7,338

 

 

1,545

 

 

Total shareholders’ equity

 

30,440

 

 

13,400

 

 

Total liabilities and shareholders’ equity

 

$

305,645

 

 

$

193,117

 

 

 

See notes to unaudited condensed consolidated financial statements

2




SHUFFLE MASTER, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)

 

 

Nine Months Ended

 

 

 

July 31,

 

 

 

2006

 

2005

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

1,903

 

$

21,026

 

Adjustments to reconcile net income to cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

13,251

 

8,901

 

Share-based compensation

 

4,036

 

486

 

In-process research and development

 

19,145

 

 

Gain on sale of patent

 

(4,566

)

 

Provision for bad debts

 

(360

)

167

 

Provision for inventory obsolescence

 

391

 

(165

)

Tax benefit from stock option exercises

 

125

 

4,773

 

Excess tax benefit from stock option exercises

 

(2,650

)

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

3,640

 

(2,629

)

Investment in sales-type leases and notes receivable

 

(2,511

)

(7,615

)

Inventories

 

(3,024

)

(2,496

)

Other assets

 

(2,444

)

(1,719

)

Accounts payable and accrued liabilities

 

(1,620

)

1,910

 

Customer deposits and unearned revenue

 

924

 

81

 

Prepaid income taxes

 

213

 

8,479

 

Income taxes, net of stock option exercises

 

1,283

 

 

Deferred income taxes

 

918

 

(2,123

)

Net cash provided by operating activities

 

28,654

 

29,076

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of investments

 

(15,523

)

(7,311

)

Proceeds from sale and maturities of investments

 

32,288

 

6,822

 

Proceeds from sale of leased assets

 

1,320

 

 

Payments for products leased and held for lease

 

(6,099

)

(6,212

)

Purchases of property and equipment

 

(1,359

)

(2,110

)

Purchases of intangible assets

 

 

(4,413

)

Acquisition of Stargames, net of cash acquired

 

(114,337

)

 

Net proceeds from patent sale

 

3,000

 

9,039

 

Other

 

 

(3,402

)

Net cash used by investing activities

 

(100,710

)

(7,587

)

Cash flows from financing activities:

 

 

 

 

 

Proceeds from acquisition financing

 

115,000

 

 

Proceeds from other borrowings

 

2,385

 

 

Repurchases of common stock

 

(3,532

)

(20,821

)

Debt issuance costs

 

(281

)

 

Proceeds from issuances of common stock, net

 

6,065

 

5,954

 

Excess tax benefit from stock option exercises

 

2,650

 

 

Payments on acquisition financing

 

(30,000

)

 

Payments on notes payable and other liabilities

 

(9,011

)

(2,091

)

Net cash provided (used) by financing activities

 

83,276

 

(16,958

)

Effect of exchange rate changes on cash

 

(1,138

)

 

Net increase in cash and cash equivalents

 

10,082

 

4,531

 

Cash and cash equivalents, beginning of period

 

13,279

 

20,580

 

Cash and cash equivalents, end of period

 

$

23,361

 

$

25,111

 

Cash paid for:

 

 

 

 

 

Income taxes, net of refunds

 

$

7,406

 

$

(675

)

Interest

 

4,347

 

1,002

 

Non-cash transactions:

 

 

 

 

 

Unrealized gain on investments, net of tax

 

$

165

 

$

 

Equity method loss, net of tax

 

(174

)

 

Note payable for patent purchase

 

 

9,666

 

Note payable and contingent consideration issued in connection with the acquisition of a business or assets

 

 

560

 

 

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.   We develop, manufacture and market technology and entertainment-based products for the gaming industry for placement on the casino floor. Our products primarily relate to our casino customers’ table game activities and focus on either increasing their profitability, productivity and security or expanding their gaming entertainment offerings.

Our Utility Products include a full line of automatic card shufflers for use with the vast majority of card table games as well as chip sorting machines for use on roulette tables. We also have acquired and/or are developing other products that automatically gather data to enable casinos to track table game play, such as Table iD™ (formerly known as Intelligent Table System™), currently in development with International Game Technology (“IGT”) and Progressive Gaming International Corporation (“PGIC”).

Our Entertainment Products include our portfolio of live proprietary poker, blackjack, baccarat, and pai gow poker-based table games and side bets as well as several electronic content delivery system platforms including Table Master™, Vegas Star®, Rapid Table Games™ and wireless Casino On Demand™.

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

In January 2006, we entered into a licensing and distribution agreement with Sona Mobile Holdings Corp. (“Sona”) to license, develop, distribute and market “in-casino” wireless handheld gaming content and delivery systems to casinos and through other legal gaming modes 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 and 1,200 warrants to purchase shares of Sona’s common stock at a discount to the grant date fair value. On June 30, 2006, we purchased approximately 1,667 additional shares of Sona’s common stock at the price of $0.60 per share for approximately $1,000. These shares were purchased through a private equity investment along with other accredited investors. As part of the second private equity investment, we also received an additional 833 warrants to purchase shares of Sona’s common stock at prices as specified in the agreement. The investment in Sona is accounted for under the equity method of accounting and is included in Other long-term assets in our condensed consolidated balance sheet as of July 31, 2006. Accordingly, we recognized Equity method investment losses of $119 and $275, for the three and nine months ended July 31, 2006, respectively, which represents our pro rata share of Sona’s net loss for the comparable periods.

On February 1, 2006, we substantially completed our acquisition of Australian-based Stargames Limited (“Stargames”), a gaming company that develops, manufactures and distributes a wide range of

4




innovative electronic entertainment gaming products to worldwide markets. Accordingly, the results of Stargames have been included in our condensed consolidated financial statements beginning February 1, 2006. Stargames product offerings are classified as Entertainment Products and include Rapid Table Games and Vegas Star multi-terminal gaming machines, and a broad line of traditional video slot machines designed for the Australian and Asian gaming markets. The Rapid series of games, which we previously distributed 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 currently 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.

Basis of presentation.   The condensed consolidated financial statements of Shuffle Master, Inc. as of July 31, 2006, and for the three and nine months ended July 31, 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 nine months ended July 31, 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.

Recently Issued Accounting Standards.   In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109. FIN 48 prescribes the recognition threshold and measurement criteria for determining the tax benefit amounts to recognize in financial statements. This interpretation is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of this standard on the condensed consolidated financial statements.

2. ACQUISITIONS, DISPOSITIONS AND OTHER SIGNIFICANT TRANSACTIONS

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

Consideration to Stargames consisted of an Australian-denominated cash payment of AU $148,441 or US $112,147. In addition, we incurred total direct acquisition costs, consisting primarily of legal and due diligence fees, of approximately US $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

 

 

5




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

Accounts receivable

 

$

10,940

 

Inventory

 

12,133

 

Other current assets (including cash of $98)

 

4,554

 

Other long-term assets

 

6,558

 

Assumed liabilities

 

(18,255

)

Developed technology, average life of 4 years

 

8,338

 

Customer relationships, average life of 10 years

 

10,015

 

Tradename

 

17,291

 

Goodwill

 

44,301

 

In-process research and development

 

19,145

 

PVS disposal liability

 

(683

)

 

 

$

114,337

 

 

This acquisition enhances the products in our Entertainment Products segment as well as providing for additional electronic platforms for our branded content. Additionally, we acquired a strong brand name as well as an experienced and talented management team. These factors result in the recognition of certain intangible assets, discussed below, and significant goodwill. Developed technology is being amortized on a straight-line basis over its useful life and is charged to cost of sales and service, a component of gross margin. Customer relationships are being amortized on a straight-line basis over their useful life and is reflected in selling, general and administrative expenses in the condensed consolidated statement of operations.

A project-by-project valuation using the guidance in FASB Statement of Financial Accounting Standard No. 141, “Business Combinations” and the American Institute of Certified Public Accountants (“AICPA”) Practice Aid “Assets Acquired in a Business Combination to Be Used In Research and Development Activities: A Focus on Software, Electronic Devices and Pharmaceutical Industries” is in the process of being performed by us, with the assistance of an 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 is determined using the multi-period excess earnings approach on a project-by-project basis. This method is based on the present value of earnings attributable to the asset or costs avoided as a result of owning the assets and after a contributory charge on assets. This method includes risk factors, which include applying an appropriate discount rate that reflects the 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;

6




·       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 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 IPR&D of $19,145 was immediately expensed in the quarter ended April 30, 2006.

As a part of the Stargames acquisition, we acquired Professional Vending Services Pty Ltd (“PVS”), a wholly-owned subsidiary of Stargames. PVS designs, develops and manufactures automatic vending machines. PVS offers exclusive equipment in all main vending segments including snacks, cold drinks, food (hot and cold), coffee and cigarettes. We have determined that the operations of PVS are non-core to our Entertainment Products and Utility Products segments. Accordingly, we have entered into an agreement to sell Stargames’ equity interests in PVS including settlement of all existing liabilities of PVS. The estimated liabilities exceed assets in the amount of approximately $683. The fair value of PVS’ working capital has been valued at zero in our preliminary purchase price allocation. The results of operations for PVS are included in Discontinued Operations until the disposition is complete. It is anticipated that the transaction will close in September 2006. See Note 13 for more information.

The operating results for Stargames are included in the accompanying condensed consolidated statements of operations from the date of the acquisition. The following unaudited pro forma condensed consolidated financial information has been prepared assuming the Stargames acquisition had occurred on November 1, 2005, May 1, 2005, and November 1, 2004, respectively, and is as follows:

 

 

 

Nine Months Ended
July 31, 2006

 

Three Months Ended
July 31, 2005

 

Nine Months Ended
July 31, 2005

 

Revenue

 

 

$

127,001

 

 

 

$

39,670

 

 

 

$

115,440

 

 

Operating income

 

 

26,206

 

 

 

10,715

 

 

 

26,865

 

 

Discontinued operations

 

 

(214

)

 

 

(84

)

 

 

(87

)

 

Net income

 

 

17,164

 

 

 

7,240

 

 

 

17,519

 

 

Basic earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

$

0.50

 

 

 

$

0.21

 

 

 

$

0.50

 

 

Diluted earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

$

0.47

 

 

 

$

0.20

 

 

 

$

0.48

 

 

 

The unaudited pro forma condensed combined financial statements have been prepared based upon currently available information and assumptions that are deemed appropriate by management. The pro forma information is for informational purposes only and is not intended to be indicative of the actual consolidated financial position or consolidated results that would have been reported had the transactions occurred on the dates indicated, nor does this information represent a forecast of the consolidated financial position at any future date or the combined financial results for any future period.

Historical financial information for Stargames for the three months ended January 31, 2006 includes certain non-recurring expenses of approximately $2,000 included in selling, general, and administrative expenses. These expenses include a success fee related to the ultimate sale of Stargames and the expense related to a potential Australian Goods and Services Tax liability associated with export sales in the period December 2001 through November 2005. The three month period ended January 31 has historically been a seasonally slower period for Stargames. The expense for IPR&D for the nine months ended July 31, 2006,

7




has not been included in the unaudited pro forma results since such expense is non-recurring in nature. Also excluded from the pro forma results is the reduction in interest expense related to the $35,000 in principal payments made on the Stargames bridge financing since the date of acquisition.

IGT Agreement.   On July 31, 2006 (the “Effective Date”), we entered into an agreement with IGT whereby we sold to IGT our remaining 50% ownership in the ENPAT patents. This agreement rescinded certain provisions of the April Agreement (“April Agreement”) whereby we assigned, transferred, and conveyed to IGT our 50% share of the first $3,000 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 consideration for the remaining 50% ownership of the ENPAT patents was the $3,000 previously received from IGT pursuant to the April Agreement between us and IGT, plus a payment of an additional $4,500. This payment was in lieu of the $4,875 that would have been due, at IGT’s discretion, under the patent purchase agreement entered into on June 13, 2005 between us and IGT. As a result, IGT shall receive 100% of the future royalties on the ENPAT patents until IGT has earned a total of $17,400 in gross royalties; thereafter IGT will pay us 17 ½% of any gross royalties. The transaction has been reflected in the accompanying condensed consolidated statements of income by recording a gain on sale of patent of $4,566.

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 slot operations consisted of the following:

 

 

Three Months 
Ended
July 31,

 

Nine Months 
Ended
July 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

Revenues

 

$

13

 

 

$

31

 

 

$

52

 

$

191

 

Income (loss) from operations before tax

 

$

(20

)

 

$

12

 

 

$

(5

)

$

100

 

Income tax benefit (expense)

 

16

 

 

(4

)

 

21

 

(34

)

Net income (loss) from operations

 

(4

)

 

8

 

 

16

 

66

 

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

 

$

(4

)

 

$

8

 

 

$

150

 

$

67

 

 

As discussed above, the results of PVS for the three and nine months ended July 31, 2006 included in discontinued operations are as follows:

 

 

Three Months Ended
July 31, 2006

 

Nine Months Ended
July 31, 2006

 

Revenues

 

 

$

818

 

 

 

$

1,511

 

 

Loss from operations before tax

 

 

$

(243

)

 

 

$

(393

)

 

Income tax benefit

 

 

73

 

 

 

116

 

 

Discontinued operations, net

 

 

$

(170

)

 

 

$

(277

)

 

 

8




3. CURRENT AND LONG-TERM ASSETS

 

 

July 31,
2006

 

October 31,
2005

 

Accounts receivable, net:

 

 

 

 

 

 

 

Trade receivables

 

$27,129

 

 

$

18,148

 

 

Less: allowance for bad debts

 

(965

)

 

(283

)

 

Total accounts receivable, net

 

$

26,164

 

 

$

17,865

 

 

 

 

 

July 31,
 2006

 

October 31,
 2005

 

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

 

 

 

 

 

 

 

Minimum sales-type lease payments

 

$

15,505

 

 

$

13,329

 

 

Notes receivable-table game licenses

 

11,567

 

 

10,269

 

 

Sub-total sales-type leases and notes receivable

 

27,072

 

 

23,598

 

 

Less: interest sales-type leases and notes receivable

 

(1,682

)

 

(1,579

)

 

Less: deferred service revenue

 

(2,822

)

 

(2,033

)

 

Investment in sales-type leases and notes receivable, net

 

22,568

 

 

19,986

 

 

Less: current portion sales-type leases, net

 

(4,380

)

 

(3,929

)

 

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

 

(5,516

)

 

(4,290

)

 

Less: allowance for bad debts

 

(672

)

 

(631

)

 

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

 

$

12,000

 

 

$

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, in the case of sales-type leases, contain bargain purchase options.

 

 

July 31,

 

October 31,

 

 

 

2006

 

2005

 

Inventories:

 

 

 

 

 

 

 

Raw materials and component parts

 

$

5,871

 

 

$

5,482

 

 

Work-in-process

 

1,006

 

 

820

 

 

Finished goods

 

18,812

 

 

4,613

 

 

 

 

25,689

 

 

10,915

 

 

Less: allowance for inventory obsolescence

 

(1,218

)

 

(1,487

)

 

 

 

$

24,471

 

 

$

9,428

 

 

 

 

 

July 31,

 

October 31,

 

 

 

2006

 

2005

 

Other current assets:

 

 

 

 

 

 

 

Receivable related to IGT patent sale (See Note 2)

 

$

4,505

 

 

$

 

 

GST tax receivable

 

1,221

 

 

 

 

Prepaid legal fees

 

1,002

 

 

 

 

Other

 

4,338

 

 

3,255

 

 

 

 

$

11,066

 

 

$

3,255

 

 

 

 

9




 

 

July 31,

 

October 31,

 

 

 

2006

 

2005

 

Products leased and held for lease, net:

 

 

 

 

 

 

 

Utility products

 

$

20,132

 

 

$

18,091

 

 

Entertainment products

 

5,012

 

 

3,183

 

 

 

 

25,144

 

 

21,274

 

 

Less: accumulated depreciation

 

(15,045

)

 

(12,111

)

 

 

 

$

10,099

 

 

$

9,163

 

 

 

 

 

July 31,

 

October 31,

 

 

 

2006

 

2005

 

Other long-term assets:

 

 

 

 

 

 

 

Equity investment in Sona (See Note 1)

 

$

3,728

 

 

$

 

 

Injunction bond (See Note 12)

 

3,000

 

 

3,000

 

 

Debt issuance costs

 

2,609

 

 

3,328

 

 

Other

 

1,213

 

 

760

 

 

 

 

$

10,550

 

 

$

7,088

 

 

 

4. INTANGIBLE ASSETS AND GOODWILL

Amortized intangible assets.   Substantially all of our recorded intangible assets are subject to amortization. Amortization expense was $2,471 and $1,514 for the three months ended July 31, 2006 and 2005, respectively, and $6,492 and $4,472 for the nine months ended July 31, 2006 and 2005, respectively. Amortized intangible assets are comprised of the following:

 

 

Weighted Avg

 

July 31,

 

October 31,

 

 

 

Useful Life

 

2006

 

2005

 

Amortized intangible assets:

 

 

 

 

 

 

 

 

 

 

 

Patents, games and products

 

 

10 years

 

 

$

53,461

 

 

$

55,552

 

 

Less: accumulated amortization

 

 

 

 

 

(13,653

)

 

(9,478

)

 

 

 

 

 

 

 

39,808

 

 

46,074

 

 

Customer relationships

 

 

10 years

 

 

10,120

 

 

 

 

Less: accumulated amortization

 

 

 

 

 

(506

)

 

 

 

 

 

 

 

 

 

9,614

 

 

 

 

Licenses and other

 

 

6 years

 

 

2,868

 

 

3,053

 

 

Less: accumulated amortization

 

 

 

 

 

(1,635

)

 

(1,536

)

 

 

 

 

 

 

 

1,233

 

 

1,517

 

 

Developed technology

 

 

4 years

 

 

8,426

 

 

 

 

Less: accumulated amortization

 

 

 

 

 

(1,053

)

 

 

 

 

 

 

 

 

 

7,373

 

 

 

 

Total

 

 

 

 

 

$

58,028

 

 

$

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 nine months ended July 31, 2006, are as follows:

Balance at October 31, 2005

 

$

886

 

Stargames trademark

 

17,291

 

Foreign currency translation adjustment

 

242

 

Balance at July 31, 2006

 

$

18,419

 

 

10




Goodwill.   Changes in the carrying amount of goodwill for the nine months ended July 31, 2006, are as follows:

Balance at October 31, 2005

 

$

36,017

 

Stargames goodwill

 

44,301

 

Foreign currency translation adjustment

 

1,617

 

Balance at July 31, 2006

 

$

81,935

 

 

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:

 

 

July 31,

 

October 31,

 

 

 

2006

 

2005

 

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

 

$

150,000

 

 

$

150,000

 

 

Bridge loan, due September 2006

 

80,000

 

 

 

 

Stargames credit facility

 

6,900

 

 

 

 

BTI acquisition contingent consideration

 

4,917

 

 

6,167

 

 

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

 

5,749

 

 

8,518

 

 

Bet the Set “21” contingent consideration

 

534

 

 

549

 

 

VIP note payable

 

326

 

 

318

 

 

Other

 

758

 

 

189

 

 

 

 

249,184

 

 

165,741

 

 

Less: current portion

 

(89,867

)

 

(3,082

)

 

 

 

$

159,317

 

 

$

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;

11




·       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.

We account for our contingent convertible notes in accordance with FASB Emerging Issues Task Force Issue No. 04-8 (“EITF 04-8”), “The Effect of Contingently Convertible Debt on Diluted Earnings Per Share” which requires us to include the dilutive effect of our outstanding Notes shares in our diluted earnings per share calculation, regardless of whether the market price trigger or other contingent conversion feature has been met. Because our Notes include a mandatory cash settlement feature for the principal payment, we apply the treasury stock method. This method results in incremental dilutive shares when the average fair value of our common stock for a reporting period exceeds the initial conversion price per share of $28.07. For the three and nine months ended July 31, 2006, the average fair value of our common stock did exceed $28.07, resulting in additional dilutive shares of 891 and 387, respectively.

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 agreed to use commercially reasonable efforts to secure the loan extended under the Credit Agreement. On July 24, 2006, we entered into Amendment No. 2 (“Amendment No. 2”) to the Credit Agreement. Amendment No. 2 extended the maturity date for the Bridge Loan to September 30, 2006. On July 31, 2006, we entered into a security agreement, as required by Amendment No. 2, with Deutsche Bank AG New York Branch, as collateral agent to secure the Bridge Loan to comply with the requirements of the Amendment. 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 obligations under the Bridge Loan are guaranteed by each of our current and future material wholly-owned domestic subsidiaries. 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;

12




·       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 July 31, 2006, we were in compliance with all of the affirmative and negative covenants pursuant to the Credit Agreement. These covenants are contained in Section 7 and Section 8 of the Credit Agreement, furnished in our Current Report on Form 8-K, dated January 25, 2006. The principal balance on the Bridge Loan as of July 31, 2006 was $80,000.

We are currently in the process of obtaining a senior secured credit facility of approximately $100,000. We believe that the facility will be closed and funded by October 31, 2006. We intend and believe that we have the ability to extend the maturity of the existing Bridge Loan until the funding of the senior secured credit facility. We currently intend to repay the balance on the Bridge Loan with the proceeds of the new senior secured credit facility.

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 $240 and $239 for the three months ended July 31, 2006 and 2005, respectively, and $1,132 and $721 for the nine months ended July 31, 2006 and 2005, respectively. Unamortized debt issuance costs of $2,609 as of July 31, 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 July 31, 2006 were AU $9,162 or US $7,024. 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. Amounts outstanding on the bank overdraft facility was AU $162 or US $124 as of July 31, 2006 at a weighted average rate of 9.85%. This overdraft is reflected in the condensed consolidated balance sheets as a current liability. Amounts outstanding under the bank loan facility is AU $9,000 or US $6,900 as of July 31, 2006 at a weighted average interest rate of 6.36%. Interest rates are based on the bank bill swap yield, as defined, plus a margin.

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

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 Bet Technology, Inc. (“BTI”) in February 2004, we recorded an initial estimated liability of $7,616 for contingent installment payments computed as the excess fair value of the acquired assets over the fixed installments and other direct costs. Beginning November 2004, we pay monthly note installments based on a percentage of certain revenue

13




from BTI games for a period of up to ten years, not to exceed $12,000. The balance of this liability as of July 31, 2006, was $4,917.

ENPAT note payable.   In December 2004, we purchased two Radio Frequency Identification (“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 July 31, 2006, of $5,749 represents the discounted present value of the future payments, including imputed interest of approximately $192. 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” in June 2005, we recorded contingent consideration of $560. The contingent consideration consists of quarterly payments of 22.5% of “adjusted gross revenues,” as defined, attributed to the Bet the Set “21” side bet table games up to a maximum of $560. The balance of this liability as of July 31, 2006, was $534.

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 July 31, 2006 was $326.

6. SHAREHOLDERS’ EQUITY

The following table reconciles the changes in our shareholders’ equity during the nine months ended July 31, 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

 

Comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

 

 

 

1,903

 

 

 

 

1,903

 

Currency translation

 

 

 

 

 

 

 

 

 

 

 

5,628

 

 

5,628

 

Unrealized gain on investments

 

 

 

 

 

 

 

 

 

 

 

165

 

 

165

 

Total comprehensive
income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

7,696

 

Stock repurchased

 

(125

)

 

(1

)

 

 

(3,531

)

 

 

 

 

 

 

(3,532

)

Options exercised

 

509

 

 

5

 

 

 

6,060

 

 

 

 

 

 

 

6,065

 

Share-based compensation expense

 

 

 

 

 

 

2,675

 

 

 

 

 

 

 

2,675

 

Tax benefit from stock option exercises

 

 

 

 

 

 

2,775

 

 

 

 

 

 

 

2,775

 

Issuance of restricted
stock

 

64

 

 

1

 

 

 

2,018

 

 

(2,018

)

 

 

 

 

1

 

Amortization of deferred compensation

 

 

 

 

 

 

626

 

 

734

 

 

 

 

 

1,360

 

Reclass deferred compensation to APIC

 

 

 

 

 

 

(7,072

)

 

7,072

 

 

 

 

 

 

Balance, July 31, 2006

 

34,975

 

 

$

350

 

 

 

$

3,551

 

 

$

 

$

19,201

 

 

$

7,338

 

 

$

30,440

 

 

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

14




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 three and nine months ended July 31, 2006, we repurchased 125 shares of our common stock for a total cost of $3,532 at an average price of $28.22. During the three and nine months ended July 31, 2005, we repurchased 200 shares of our common stock for a total cost of $5,565 at an average price of $27.83 and 758 shares for a total cost of $20,821 at an average price of $27.49. As of July 31, 2006, $5,300 remained outstanding under our board authorizations. Through September 7, 2006, we repurchased an additional 91 shares for a total cost of $2,592 at an average price of $28.35. We cancel shares that we repurchase.

On September 5, 2006, our board of directors voted a new authorization to repurchase shares of our common stock by an additional $30,000.

Tax benefit from stock option exercises.   During the nine months ended July 31, 2006 and 2005, we realized income tax benefits of $2,775 and $4,773, respectively, related to deductions for employee stock option exercises.

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 (“APB 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.

15




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 reclassified previously recorded deferred compensation 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.

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 $2,650 of 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 July 31, 2006, 1,116 and 883 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 nine months ended July 31, 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

 

 

143

 

 

 

32.96

 

 

 

 

 

 

 

 

 

 

Exercised

 

 

(509

)

 

 

11.89

 

 

 

 

 

 

 

 

 

 

Forfeited or expired

 

 

(122

)

 

 

12.49

 

 

 

 

 

 

 

 

 

 

Outstanding at July 31, 2006

 

 

3,334

 

 

 

$

18.64

 

 

 

7.5

 

 

 

$

61,205

 

 

Exercisable at July 31, 2006

 

 

2,066

 

 

 

$

17.82

 

 

 

7.2

 

 

 

$

36,818

 

 

 

16




The total intrinsic value of stock options exercised during the nine months ended July 31, 2006 and 2005 was $9,584 and $17,663, respectively. The total income tax benefits from stock option exercises during the nine months ended July 31, 2006 and 2005 were $2,775 and $4,773, respectively. As of July 31, 2006, there was a total of $6,787 of unamortized compensation related to stock options, which expense is expected to be recognized over a weighted-average period of 2.5 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.

During the nine months ended July 31, 2006 and 2005, we issued 64 and 73 shares of restricted stock, respectively, with an aggregate fair value of $2,112 and $1,978, 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 July 31, 2006 and 2005, reflects $396 and $124 respectively, net of tax, and $862 and $322, net of tax, for the nine months ended July 31, 2006 and 2005, respectively, of amortization of restricted stock compensation.

A summary of activity related to restricted stock for the nine months ended July 31, 2006 is presented below:

 

 

Shares

 

Weighted 
 Average 
 Grant-Date 
 Fair Value

 

Nonvested at October 31, 2005

 

276

 

 

$

19.11

 

 

Granted

 

64

 

 

33.27

 

 

Exercised

 

 

 

 

 

Forfeited

 

 

 

 

 

Nonvested at July 31, 2006

 

340

 

 

$

22.35

 

 

 

No shares vested during the three months ended July 31, 2006. As of July 31, 2006, there was $6,539 of unamortized compensation expense related to restricted stock, which expense is expected to be recognized over a weighted-average period of 2.6 years.

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

 

 

Three 
Months Ended

 

Nine
Months Ended

 

 

 

July 31,

 

July 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

Compensation costs:

 

 

 

 

 

 

 

 

 

Stock options

 

$

864

 

$

 

$

2,675

 

$

60

 

Restricted stock

 

626

 

180

 

1,361

 

485

 

Total compensation cost

 

1,490

 

180

 

4,036

 

545

 

Less: Related tax benefit

 

(456

)

(66

)

(1,201

)

(199

)

Total compensation expense, net of tax benefit

 

$

1,034

 

$

114

 

$

2,835

 

$

346

 

Reduction in basic earnings per share

 

$

0.03

 

$

0.00

 

$

0.08

 

$

0.01

 

Reduction in diluted earnings per share

 

$

0.03

 

$

0.00

 

$

0.08

 

$

0.01

 

 

17




Reported share-based compensation expense was classified as follows:

 

 

Three 
Months Ended

 

Nine
Months Ended

 

 

 

July 31,

 

July 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

Gross margin

 

$

29

 

$

 

$

74

 

$

 

Selling, general and administrative

 

1,392

 

180

 

3,740

 

545

 

Research and development

 

69

 

 

222

 

 

Total share-based compensation

 

$

1,490

 

$

180

 

$

4,036

 

$

545

 

Tax benefit

 

(456

)

(66

)

(1,201

)

(199

)

Total share-based compensation, net of tax

 

$

1,034

 

$

114

 

$

2,835

 

$

346

 

Impact on:

 

 

 

 

 

 

 

 

 

Gross margin

 

0.1

%

0.0

%

0.1

%

0.0

%

Selling, general and administrative expenses
as a % of revenue

 

3.4

%

0.7

%

3.2

%

0.7

%

Research and development as a % of revenue

 

0.2

%

0.0

%

0.2

%

0.0

%

 

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

 

Nine Months 
Ended

 

 

 

July 31,

 

July 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

Option valuation assumptions:

 

 

 

 

 

 

 

 

 

Expected dividend yield

 

 

 

 

 

Expected volatility

 

39.5

%

40.3

%

37.1

%

52.6

%

Risk-free interest rate

 

5.1

%

3.7

%

4.7

%

3.1

%

Expected term

 

4.4

 

6.8

 

4.4

 

5.7

 

 

18




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

 

Nine Months Ended

 

 

 

July 31, 2005

 

July 31, 2005

 

Net income

 

 

 

 

 

 

 

 

 

As reported

 

 

$

8,059

 

 

 

$

21,026

 

 

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

 

 

(1,136

)

 

 

(9,905

)

 

Pro forma

 

 

$

6,923

 

 

 

$

11,121

 

 

Basic earnings per share

 

 

 

 

 

 

 

 

 

As reported

 

 

$

0.23

 

 

 

$

0.60

 

 

Pro forma

 

 

0.20

 

 

 

0.32

 

 

Diluted earnings per share

 

 

 

 

 

 

 

 

 

As reported

 

 

$

0.22

 

 

 

$

0.57

 

 

Pro forma

 

 

0.19

 

 

 

0.30

 

 

 

8. INCOME TAXES

Our effective income tax rate for continuing operations for the three and nine months ended July 31, 2006 was 34.4% and 84.3%, 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 nine months ended July 31, 2006 would have been 33.9%.

9. EARNINGS PER SHARE

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

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

July 31,

 

July 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

Income from continuing operations

 

$

7,443

 

$

8,051

 

$

2,030

 

$

20,959

 

Basic:

 

 

 

 

 

 

 

 

 

Weighted average shares

 

34,746

 

35,048

 

34,596

 

35,093

 

Diluted:

 

 

 

 

 

 

 

 

 

Weighted average shares, basic

 

34,746

 

35,048

 

34,596

 

35,093

 

Dilutive effect of options and restricted stock

 

1,270

 

1,269

 

1,223

 

1,417

 

Dilutive effect of contingent convertible notes

 

891

 

 

387

 

148

 

Weighted average shares, diluted

 

36,907

 

36,317

 

36,206

 

36,658

 

Basic earnings per share

 

$

0.21

 

$

0.23

 

$

0.06

 

$

0.60

 

Diluted earnings per share

 

$

0.20

 

$

0.22

 

$

0.06

 

$

0.57

 

 

19




10. OTHER INCOME (EXPENSE)

Other income (expense) is comprised of the following:

 

 

Three 
Months Ended

 

Nine
Months Ended

 

 

 

July 31,

 

July 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

Interest income

 

$

463

 

$

512

 

$

1,533

 

$

1,846

 

Interest expense

 

(2,075

)

(664

)

(5,025

)

(1,761

)

Amortization of debt issue costs

 

(240

)

(239

)

(1,132

)

(721

)

Foreign currency (loss) gain

 

(34

)

138

 

(136

)

190

 

Other

 

13

 

(38

)

61

 

(39

)

Total Other expense

 

$

(1,873

)

$

(291

)

$

(4,699

)

$

(485

)

 

Interest income decreased primarily as a result of a reduction in our investment portfolio. Proceeds of matured investments were not re-invested, but were used to pay down the bridge financing associated with the acquisition of Stargames and stock repurchases. This decrease was partially offset by an increase in interest income attributable to increased interest bearing sales-type leases and notes receivable as of July 31, 2006.

Interest expense is primarily related to the $150,000 of Notes due in April 2024 and the Bridge Loan which matures in September 2006. For the three and nine months ended July 31, 2006, interest income related to our investment in sales-type leases and notes receivable was $296 and $881, respectively.

11. OPERATING SEGMENTS

We have two reportable segments which are classified as continuing operations, Utility Products and Entertainment Products. Utility Products include our Shufflers, Chip Sorting Machines and ITS product lines. Entertainment Products include our Proprietary Table Games, Table Master products, Shuffle Up Productions and the products developed, manufactured and distributed by Stargames. The Stargames product offerings include Rapid Table Games and Vegas Star multi-terminal gaming machines and a broad line of traditional video slot machines designed more specifically for the Australian and Asian gaming markets. Each 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 for 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 Products segment results for the nine months ended July 31, 2006 include the impact of the IPR&D charge of $19,145.

20




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

 

 

Three Months Ended 
July 31,

 

Nine Months Ended 
July 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

Revenue:

 

 

 

 

 

 

 

 

 

Utility Products

 

$

18,625

 

$

16,534

 

$

64,124

 

$

47,279

 

Entertainment Products

 

22,100

 

10,657

 

53,176

 

32,359

 

Corporate

 

12

 

81

 

58

 

132

 

 

 

$

40,737

 

$

27,272

 

$

117,358

 

$

79,770

 

Operating Income (Loss):

 

 

 

 

 

 

 

 

 

Utility Products

 

$

8,165

 

$

9,358

 

$

31,636

 

$

21,902

 

Entertainment Products

 

10,835

 

8,101

 

9,334

 

25,257

 

Corporate

 

(5,779

)

(5,454

)

(23,365

)

(15,044

)

 

 

$

13,221

 

$

12,005

 

$

17,605

 

$

32,115

 

Depreciation and Amortization: