10-Q 1 0001.txt QUARTERLY REPORT FOR THE QTR ENDED 6/30/00 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2000 OR [ ] 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 0-28294 SILICON GAMING, INC. (Exact Name of Registrant as Specified in Its Charter) California 77-0357939 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification Number) 2800 W. Bayshore Road Palo Alto, CA 94303 (Address of Principal Executive Offices) Telephone: (650) 842-9000 (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of Common Stock, as of the latest practicable date. 30,978,831 shares of Common Stock, $.001 par value, were outstanding as of July 31, 2000. SILICON GAMING, INC. QUARTERLY REPORT ON FORM 10-Q FOR THE PERIOD ENDED JUNE 30, 1999 INDEX Page ---- PART I FINANCIAL INFORMATION Item 1. Financial Statements: Consolidated Balance Sheets--June 30, 2000 and December 31, 1999 ........................................... 3 Consolidated Statements of Operations--Three months and six months ended June 30, 2000 and June 30, 1999............. 4 Consolidated Statements of Cash Flows--Six months ended June 30, 2000 and June 30, 1999............................ 5 Notes to Consolidated Financial Statements....................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........................................ 9 PART II OTHER INFORMATION Item 5. Other Information................................................ 20 Item 6. Exhibits and Reports on Form 8-K................................. 21 Signature........................................................ 21 PART I--FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS SILICON GAMING, INC. CONSOLIDATED BALANCE SHEETS (In thousands, except share data) JUNE 30, DECEMBER 31, 2000 1999 -------- -------- (Unaudited) ASSETS CURRENT ASSETS: Cash and equivalents ............................... $ 2,467 $ 877 Short-term investments ............................. -- 1,000 Accounts receivable (net of allowances of $1,091 in 2000 and $1,169 in 1999) ...................... 2,165 1,188 Inventories ........................................ 5,058 7,331 Prepaids and other ................................. 382 1,069 -------- -------- Total current assets .......................... 10,412 11,465 PROPERTY AND EQUIPMENT, NET .......................... 3,224 3,795 OTHER ASSETS, NET .................................... 382 321 -------- -------- $ 14,018 $ 15,581 ======== ======== LIABILITIES AND SHAREHOLDERS' DEFICIENCY CURRENT LIABILITIES: Accounts payable ................................... $ 1,814 $ 1,389 Accrued liabilities ................................ 1,592 1,655 Deferred revenue ................................... 233 240 Line of credit ..................................... 750 622 Current portion of long-term obligations ........... 997 1,165 -------- -------- Total current liabilities ..................... 5,386 5,071 OTHER LONG-TERM LIABILITIES .......................... 1,606 1,611 LONG-TERM OBLIGATIONS ................................ 13,548 10,428 LONG-TERM ACCRUED INTEREST ........................... 5,635 5,832 SHAREHOLDERS' DEFICIENCY Common Stock, $.001 par value; 750,000,000 shares authorized; shares outstanding: June 30, 2000-- 30,978,831; December 31, 1999-- 30,949,273 ................................ 64,123 64,123 Preferred stock, $.001 par value; 6,884,473 shares authorized; shares outstanding at June 30, 2000-- 39,750: (liquidation preference up to $39.75 million) ................ 20,000 20,000 Warrants ........................................... 5,576 5,542 Notes receivable from shareholders ................. (344) (345) Deferred stock compensation ...................... (4,065) (4,646) Accumulated deficit ................................ (97,447) (92,035) -------- -------- Total shareholders' deficiency ................ (12,157) (7,361) -------- -------- $ 14,018 $ 15,581 ======== ======== See notes to consolidated financial statements. 3 SILICON GAMING, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) (unaudited)
Three Months Ended Six Months Ended June 30, June 30, -------------------- ------------------ 2000 1999 2000 1999 -------- ------- ------- ------- REVENUE: Hardware ............................... $ 3,571 $ 3,609 $ 5,549 $ 7,322 Software ............................... 691 1,502 1,336 2,888 Participation and other ................ 562 616 1,042 1,178 -------- ------- ------- ------- Total revenue .......................... $ 4,824 $ 5,727 $ 7,927 $11,388 OPERATING EXPENSES: Cost of sales and related manufacturing expenses ............... 2,967 2,965 4,954 7,184 Research and development ............... 1,252 1,483 1,865 3,831 Selling, general and administrative ....................... 3,275 2,587 6,411 5,483 Restructuring charges .................. (35) 3,277 -------- ------- ------- ------- Total costs and expenses ............... 7,494 7,000 13,230 19,775 -------- ------- ------- ------- Loss from operations ................. 2,670 1,273 5,303 8,387 Interest expense, net .................. 13 1,926 109 3,852 -------- ------- ------- ------- NET LOSS ................................. $ 2,683 $ 3,199 $ 5,412 $12,239 ======== ======= ======= ======= Basic and diluted net loss per share...... $ 0.09 $ 0.22 $ 0.17 $ 0.86 ======== ======= ======= ======= Shares used in computation ............... 30,979 14,376 30,969 14,275 ======== ======= ======= =======
See notes to consolidated financial statements. 4 SILICON GAMING, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (unaudited)
Six Months Ended June 30, -------------------- 2000 1999 ------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss .................................................... $(5,412) $(12,239) Reconciliation to net cash used in operating activities: Depreciation and amortization ............................. 956 2,570 Accrued interest .......................................... (197) 2,251 Accretion of debt discount ................................ -- 1,207 Deferred rent ............................................. (5) (111) Restructuring charges ..................................... -- 3,277 Provision for bad debt .................................... -- (98) Deferred stock compensation ............................... 581 -- Loss on disposal of property ......................... 38 -- Changes in assets and liabilities: Accounts receivable ....................................... (977) 1,109 Inventories ............................................... 2,273 1,165 Prepaid and other ......................................... 319 (655) Participation units ....................................... (210) 1,628 Accounts payable .......................................... 425 (80) Accrued liabilities ....................................... (63) (1,808) Other liabilities ......................................... -- 177 Deferred revenue .......................................... (7) (737) ------- -------- Net cash used in operating activities ................... (2,279) (2,344) ------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of property and equipment ....................... (235) (221) Proceeds from disposal of property and equipment ............ 23 -- Sales and maturities of short-term investments .............. 1,000 -- Other assets, net ........................................... -- (39) ------- -------- Net cash provided by (used in) investing activities 788 (260) ------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Sales of Common Stock, net of notes receivable .............. -- 74 Collection of note receivable ............................... -- 13 Proceeds from Debt financing ............................. 3,500 -- Proceeds from term loans and line of credit ................. 750 -- Repayment of bank line of credit ............................ (622) (2,057) Repayment of term loans ..................................... (492) (478) Repayment of capital lease obligations ...................... (55) (153) ------- -------- Net cash provided by (used in) financing activities ..... 3,081 (2,601) ------- -------- NET DECREASE IN CASH AND EQUIVALENTS .......................... 1,590 (5,205) Beginning of period ......................................... 877 8,399 ------- -------- End of period ............................................... $ 2,467 $ 3,194 ======= ======== SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for interest .................... $ 175 $ 313 ======= ======== NONCASH INVESTING AND FINANCING ACTIVITIES: Conversion of preferred stock to Common Stock ............... $ -- $ 410 Issuance of Common Stock Warrants ........................... $ 34 $ -- ======= ========
See notes to consolidated financial statements. 5 SILICON GAMING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying consolidated balance sheet as of June 30, 2000, the consolidated statements of operations for the three and six months ended June 30, 2000 and 1999, and the consolidated statements of cash flows for the six months ended June 30, 2000 and 1999, are unaudited. In the opinion of management, these financial statements have been prepared on the same basis as the audited financial statements and include all adjustments, consisting only of normal recurring adjustments and accruals, necessary for the fair presentation of the financial position and operating results as of such dates and for such periods. The unaudited information should be read in conjunction with the audited consolidated financial statements of Silicon Gaming, Inc. ("Silicon Gaming" or the "Company") and the notes thereto for the year ended December 31, 1999 included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company has incurred operating losses every year since its inception and at June 30,2000, had an accumulated deficit of $97,447,000 and a shareholders' deficiency of $12,157,000. The Company has been required to obtain additional financing every year to be able to fund its ongoing operations. Based on historical levels of cash usage, the above factors raise substantial doubt about the Company's ability to continue as a going concern. In the fourth quarter of 1999 the Company completed a substantial restructuring of its capitalization whereby $39.75 million of Senior Discount Notes and approximately $8.3 million of accrued interest were converted into Preferred Stock, and the remaining terms of the Senior Discount Notes were modified to reduce the interest rate thereon and extend the payment terms. Concurrent with the restructuring, the Company borrowed $3 million under new Senior Discount Notes and established a facility whereby up to an additional $2 million of new Senior Discount Notes may be issued upon meeting certain financial and operational milestones. Management continues to review financing and other strategic alternatives available to the Company such as additional equity or debt offerings in the Company or certain of its subsidiaries, joint ventures, alternative distribution channels, direct investment by third parties into several of the Company's strategic business opportunities and sale of all or part of the Company's assets to improve the Company's liquidity position. Management believes that these steps, plus sales related to proposed new product introductions, will provide sufficient cash and working capital for the Company to meet its ongoing obligations and to allow it to continue operating as a going concern through at least March 31, 2001. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. 2. NET LOSS PER SHARE Basic earnings per share excludes dilution and is computed by dividing net income by the weighted average of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution that would occur if securities or other contracts to issue Common Stock were exercised or converted into Common Stock. Common share equivalents including stock options, warrants and Redeemable Convertible Preferred Stock have been excluded from all periods presented, as their effect would be antidilutive. 6 The following is a reconciliation of the numerators and denominators of the basic and diluted net loss per share computations (in thousands except per share amounts):
Three months ended Six months ended June 30, June 30 --------------------- --------------------- 2000 1999 2000 1999 -------- -------- -------- -------- Net Loss (Numerator): Net Loss, basic and diluted .............. $ (2,683) $ (3,199) $ (5,412) $(12,239) ======== ======== ======== ======== Shares (Denominator) Weighted average common shares outstanding 30,979 14,437 30,969 14,367 Weighted average common shares subject to repurchase ........................... (61) (92) -------- -------- Shares used in computation .............. 30,979 14,376 30,969 14,715 ======== ======== ======== ======== Net Loss Per Share, Basic and Diluted .... $ 0.09 $ 0.22 $ 0.17 $ 0.86 ======== ======== ======== ========
3. INVENTORIES Inventories are stated at lower of cost (first-in, first-out) or market and consist of the following (in thousands): JUNE 30, DECEMBER 31, 2000 1999 ------ ------ Raw materials ..................... $1,317 $ 849 Work in process ................... 747 111 Finished goods .................... 2,994 6,371 ------ ------ $5,058 $7,331 ====== ====== 4. CONCENTRATION OF CREDIT RISK Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents and trade accounts receivable. The Company invests only in high credit quality short-term debt with its surplus funds. The Company performs ongoing credit evaluations of its customers' financial condition and limits the amount of credit extended when deemed necessary but generally requires no collateral. The Company maintains reserves for estimated potential credit losses. As of June 30, 2000, three customers accounted for 15%, 9% and 9% of accounts receivable, respectively. As of December 31, 1999, one customer accounted for 19% of accounts receivable. For the three months ended June 30, 2000, two customers accounted for 17% and 10% of revenue and for the six months ended June 30, 2000, two customers accounted for 11% and 6% of revenue. For the three months ended June 30, 1999 two customers accounted for 27% and 13% of revenue and for the six months ended June 30, 1999, one customer accounted for 18% of revenue. 5. BORROWING ARRANGEMENTS In May 2000, the Company executed on a $2 million secured revolving line of credit agreement based on the Company's eligible accounts receivable which expires May 25, 2001. Borrowings bear interest at the Bank's prime rate (9.5% at June 30, 2000) plus 1.5%. As of June 30, 2000, the Company had $750,000 outstanding under this facility. This agreement requires the Company to maintain certain ratios of tangible net worth to total debt among other covenants (as defined in the agreement) and the Company was in non-compliance with the agreement as of June 30, 2000. The lender has given the company an informal notice of forbearance which is to expire on August 15, 2000. The company expects to cure this violation upon the closing of the Series A Convertible Preferred Stock as discussed in FOOTNOTE 7 below. 7 Borrowing arrangements consist of the following (in thousands): June 30, December 31, 2000 1999 -------- -------- Senior Discount Notes .............. $ 10,500 $ 9,500 Capital lease obligations .......... -- 55 Other long-term obligations ........ 1,545 2,038 Subsidiary's Series A Bridge Loans . 2,500 -- -------- -------- 14,545 11,593 Current obligation ................. (997) (1,165) -------- -------- Long-term obligation ............... $ 13,548 $ 10,428 ======== ======== On June 22, 2000, the company, on behalf of one of its wholly owned subsidiary companies, entered into a lease for commercial space in the city of San Francisco for the purpose of conducting the business of its subsidiary at this location. The lease covers a three year period with total consideration over the term of the lease to be approximately $875,000. The Company shall also be obligated for certain costs in operating said premises as well as certain buildout costs which are expected to be approximately $150,000. 6. OPERATING SEGMENTS During the second quarter, Silicon Gaming completed a realignment of its resources around market opportunities by creating a separate business unit to investigate market opportunities in the growing market for Internet gaming. The Company incurred expenses for its On-line division of approximately $663,000 for the three and six-month period ended June 30, 2000. 7. SUBSEQUENT EVENTS On April 13, 2000 and May 3, 2000, respectively, the company, through one its wholy owned subsidiaries, obtained bridge loan financing in the amount of $2.5 million dollars from two different parties. The terms of the financing contain an automatic conversion feature into a Series A Convertible Preferred Stock Share in the subsidiary company, which conversion feature occurs upon the completion of at least, an additional $3.5 million dollar financing under similar terms for the Series A Convertible Preferred Stock. The Series A Convertible Preferred Stock shall be convertible into one share of the common stock of the subsidiary upon the occurance of several factors, including, but not limited to either an initial public offering of the common stock of the subsidiary or a change in control of the subsidiary, as defined in the term sheet. The loans bear interest at the rate of 10%, and are due and payable in full on demand, on or after July 12, 2000, unless automatically converted as described above, in which case no interest will be due. The holders of the Series A Preferred Stock shall be entitled to a liquidation preference in the subsidiary equal to the amount paid per share (currently assumed to be $1 per share), as well as certain other information rights and participation rights in subsequent equity offerings of the subsidiary. As of July 31, 2000, additional funding in the amount of $2 million dollars, has been received as part of the total financing of this Series A Convertible round, and is currently being held in escrow pending the receipt of the additional funding from other investors. As of August 21, 2000, the initial funding investors have agreed not to demand payment in full, as per the bridge loan agreement, pending the anticipated close of this round. 8. NEW ACCOUNTING PRONOUNCEMENTS In December 1999, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 101, "Revenue Recognition in Financial Statements," which provided the SEC staff's views on selected revenue recognition issues. The guidance in SAB 101 must be adopted during the fourth quarter of fiscal 2000 and the effects, if any, are required to be recorded through a retroactive, cumulative-effect adjustment as of the beginning of the fiscal year, with a restatement of all prior interim quarters in the year. Our management has not completed its evaluation of the effects, if any, that SAB 101 will have on the Company's income statement presentation, operating results or financial position. 8 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THIS DISCUSSION INCLUDES A NUMBER OF FORWARD-LOOKING STATEMENTS WHICH REFLECT THE COMPANY'S CURRENT VIEWS WITH RESPECT TO FUTURE EVENTS AND FINANCIAL PERFORMANCE. THESE FORWARD-LOOKING STATEMENTS ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES, INCLUDING THOSE REFERRED TO IN THE RISK FACTORS SECTION BELOW AND ELSEWHERE HEREIN AND CONTAINED IN THE COMPANY'S PREVIOUSLY FILED ANNUAL REPORT ON FORM 10-K, THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM HISTORICAL RESULTS OR THOSE ANTICIPATED. IN THIS DISCUSSION, THE WORDS "ANTICIPATES," "BELIEVES," "EXPECTS," "INTENDS," "FUTURE" AND SIMILAR EXPRESSIONS IDENTIFY FORWARD-LOOKING STATEMENTS. READERS ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH SPEAK ONLY AS OF THE DATE HEREOF. THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO INCLUDED IN PART I--ITEM 1 OF THIS REPORT AND THE AUDITED CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO INCLUDED IN THE COMPANY'S ANNUAL REPORT ON FORM 10-K FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. OVERVIEW The Company was incorporated on July 27, 1993 with a charter to design, develop, manufacture and distribute a new breed of interactive gaming machines. It was the Company's strategy to implement a new product paradigm in which software-based gaming platforms would displace the traditional fixed-application slot machines. Through early 1997, the Company focussed on executing it's product development plans while at the same time preparing to initiate operations. Substantial investments were made in the infrastructure required to sell, build, fulfill, and ultimately service machines in each of the major U.S. gaming markets. In the third quarter of 1997, the Company introduced the Odyssey gaming platform and it's suite of six gambling applications. The marketing strategy called for a conservative, focussed roll-out in which the initial units were installed in a limited number of Southern Nevada casinos. After an initial evaluation period the product was refined and ultimately distributed into nearly every major US market, as well as select international markets. Since that time the Company has rolled out ODYSSEY into other jurisdictions including Connecticut, Illinois, Indiana, Iowa, Kansas, Louisiana, Michigan, Minnesota, Mississippi, Missouri, New Jersey, New Mexico, certain Canadian provinces, certain international cruise line routes and Uruguay. Since the Company's initial product launch, it has developed and distributed nearly 40 different game applications and achieved an installed base of over 4,500 gaming platforms. The Company's products feature high-resolution video presented across the full surface of a large touchscreen display. The games feature high-quality animation, video clips, digital sound and a level of visual appeal and interactivity that the Company believes is unattainable by the current generation of slot machines. The Company is attempting to maximize the entertainment value offered on the video screen by providing multiple levels of achievement within certain games so that, through successful play over a period of time, a player may advance to a bonusing sequence and win additional jackpots. SGI believes that by utilizing these features, it will encourage longer and more frequent periods of play by existing slot machine customers and attract new gaming customers who are seeking greater entertainment value than that offered by the current generation of slot machines. The Company has designed its machines with a number of unique player features, such as play stoppage entertainment(TM). In addition, the product's modular components and Machine Management System(TM) software provide easy-to-use diagnostics designed to minimize player inconvenience and machine down time. The Company currently offers several products including ODYSSEY(TM), a multi-game machine that can play up to six different games on the same machine, and QUEST, a single-game machine. 9 The Company's initial business model was dependent on the proliferation of its gaming platforms. However, management believes that due to a number of factors including price resistance, stagnant market growth, increased competition, and a slower rate of adoption, the Company was unable to achieve its projected sales volumes. As such the market for high-margin replacement software never materialized. In the Spring of '99 the Company re-formulated it's business strategy and implemented a new plan. The strategy called for the company to more fully leverage it's development capabilities while minimizing the expenses related to maintaining it's distribution channel. The result was a 35% reduction in operating expenses, and the formation of three distinct business units, the Wagering Content Studio, Product Sales, and WagerWorks.com. The Wagering Content Studio is focussed on creating new game experiences that can be distributed off-line into the domestic casino markets through the Product Sales division, and on-line both domestically and internationally through it's Internet division. The Company spent much of the second quarter, ending June 30, 2000, executing it's three-tier business plan. The Wagering Content Studio completed The Family Feud product suite, which was launched in Las Vegas in partnership with MGM MIRAGE, Inc. This new gambling experience consists of an enhanced platform, new package design, three different game applications, a highly interactive bonus event, and a 3,500 square foot boutique casino venue. All of these elements have been combined to create what the Company believes is the industry's first Wagering Attraction, a gambling experience that has the ability to drive new business. The Product Sales division continued to place and sell gaming platforms along with new game applications created by our Content Studio. The Company capitalized on the opening of the California market with sales into each of the major tribal casinos. In addition, the Company formalized its Internet strategy and initiated the business development and product development aspects of it's plan. Through June 30, 2000, the Company has installed 4,572 ODYSSEY, QUEST and FAMILY FEUD machines in approximately 208 properties throughout Connecticut, Iowa, Indiana, Louisiana, Michigan, Minnesota, Mississippi, Missouri, Nevada, New Mexico, certain Canadian provinces, certain international cruise line routes and Uruguay. Of these machines, 4,322 have been sold outright or placed on a revenue-sharing basis. After returns, 250 machines remain installed on a trial basis and the casino operators are required to purchase the machine outright, participate in SGI's revenue sharing plan or return the machine to the Company within a defined trial period. This compares to a restated installed base of 4,157 machines at March 31, 2000, of which, 256 machines were installed on a trial basis. At June 30, 2000 the Company had cash and equivalents of $2,467,000. The Company has incurred operating losses each year since inception and as of June 30, 2000 had an accumulated deficit of $97,447,000 and a deficiency of shareholders' equity of $12,157,000. The Company has been required to obtain additional financing each year to be able to fund its ongoing operations. Based on historical levels of cash usage, the above factors raise substantial doubt about the Company's ability to continue as a going concern. In late 1998 and early 1999 the Company took steps to reduce the level of operating expenses and made a number of management decisions which resulted in total reductions of the Company's work force by approximately 70% and made significant cuts in expenditures across the Company. Management also announced the relocation of its manufacturing to its Las Vegas, Nevada facility and the closure of its Mountain View, California manufacturing facility. In November 1999, the Company, with the consent of the holders of its Senior Discount Notes, was able to convert approximately $40 million principal amount of debt plus $8.3 million in accrued interest into a 57% equity stake in the Company, and to obtain commitments for additional financing from the debt holders. The aforementioned actions resulted in the Company reducing its operating expenses by approximately 40%, its interest obligations by approximately 80%, and reduced the cash used in operations by approximately 80% from the levels of the prior year. Management has recently obtained a line of credit with a new bank on more favorable terms so that this financing source remains available to the Company. Management is also reviewing financing alternatives available to the Company such as additional share or debt offerings in the Company or certain of its subsidiaries, joint ventures, alternative distribution channels and sale of a 10 portion of the Company's assets, to improve the Company's liquidity position. Management believes that these steps, plus sales related to new product introductions will provide sufficient cash and working capital for the Company to meet its ongoing obligations and to allow it to continue operating as a going concern through at least March 31, 2001. Silicon Gaming is headquartered in Palo Alto, California and has sales offices in Reno and Las Vegas, Nevada, and in Gulfport, Mississippi. The Company's products are now manufactured at the Company's location in Las Vegas, Nevada. At June 30, 2000 the Company had 86 employees. REVENUE The Company generates hardware revenue from the sale of its products and related parts and accessories. All products are sold with licensed software and customers have the choice of either a paid-up or renewable annual license. The Company places products in casinos under a participation program where it receives 20% of the net win generated by the product as revenue. Total revenue units include machines sold outright as well as machines placed under the participation programs. The Company generated revenues as follows:
Three Months Ended June 30, Six Months Ended June 30, -------------------------------------- -------------------------------------- 2000 1999 2000 1999 ----------------- ----------------- ----------------- ----------------- (in $'000 except for machine numbers) Hardware sales $ 3,571 74% $ 3,609 63% $ 5,549 70% $ 7,322 64% Software sales 691 14% 1,502 26% 1,336 17% 2,888 25% Participation revenue 562 12% 616 11% 1,042 13% 1,178 11% ------- ------- ------- ------- ------- ------- ------- ------- Total revenue $ 4,824 100% $ 5,727 100% $ 7,927 100% $11,388 100% ======= ======= ======= ======= Total revenue units 755 468 977 895 ======= ======= ======= =======
Total revenue units consist of machines sold outright to customers as well machines owned by the Company placed in casinos under a participation program. For the three months ended June 30, 2000, revenue units consisted of 378 machines sold outright, and 377 machines on casino floors under a participation program. For the six month period ended June 30, 2000, revenue units consisted of 600 machines sold outright and 377 machines on casino floors under a participation program. Revenue for the quarter ended June 30, 2000 was $4,824,000, a decrease of $903,000, or 16%, from $5,727,000 for the quarter ended June 30, 1999. This also represents an increase of $1,721,000, or 55%, from the $3,103,000 recorded in the three-month period ended March 31, 2000. The change in sales mix reflects an increase in direct sales relative to sales on a participation basis as a result of introducing the Family Feud game in June, and the benefit of sales to the new jurisdiction of California. The average selling price on hardware sales increased to $9,773 in the quarter ended June 30, 2000 compared to $7,771 in the quarter ended June 30, 1999,. This reflected the effect of the higher priced Family Feud game and a lower level of discounts given to strategic corporate customers compared to the prior year period, offset slightly by some lower selling prices due to the Company selling used equipment to certain customers during 2000. The decrease in software revenues for the three months ended June 30, 2000 of $811,000, or 54%, compared to the same period in 1999 is a direct result of the lower number of Odyssey units sold outright, the lower selling prices of used equipment in the current year and the impact of focussing on and delivering the Family Feud Suite of games in the current period. Participation revenues decreased by $54,000, or 9%, compared to the comparable period in 1999 due largely to a reduction in the number of machines on participation programs as customers have either purchased those machines outright or returned them to the Company. 11 Revenue for the six months ended June 30, 2000 was $7,927,000, a decrease of $3,461,000, or 30%, from $11,388,000 for the six months ended June 30, 1999. For the six month period ended June 30, 2000 total software sales decreased by $1,552,000, or 54%, compared to the same period in 1999 reflecting a shift in the company's model for software sales as a percentage of total revenue. Total participation revenues decreased by $136,000, or 12%, due to the reductions in the number of machines on participation as the Company has converted these units to sales or were returned to the Company by its customers. During the three-month period ended June 30, 2000, two different customers accounted for 17% and 10% of revenue. In the three-month period ended June 30, 1999, two different customers accounted for 27% and 13% of revenue. For the six month period ended June 30, 2000, two different customers accounted for 11% and 6% of revenue and in the six-months ended June 30, 1999, one customer represented 18% of revenue. The Company expects that a significant portion of its revenues will remain consolidated within a limited number of strategic customers within the gaming industry due to the increasing consolidation that is taking place among casino operators. As an equipment vendor to the gaming industry, the Company sells infrequently to many customers and the volume of sales to any particular customer may vary significantly from period to period. As a result, there can be no assurance that the above strategic customers will continue to account for a significant percentage of the Company's revenue in the future. The loss of any strategic customer would adversely affect the Company's business and results of operations. The Company believes the revenue generated from sales will increase in the current year over the first half year's results, as the Company's base of installed units continues to increase, and the Company believes participation revenue will increase as a percentage of total revenue and in absolute dollars. Anticipated increases in revenue, however, are subject to a number of risks and uncertainties. See "Factors Affecting Future Results - Management of Changing Business; "Liquidity", "Customer Retention" , "Changing Legislative Environment", "Intellectual Property Rights", and "Rapidly Changing Technology". COST OF SALES Cost of sales includes the direct costs of product sales as well as the unabsorbed costs of the Company's manufacturing operations. Cost of sales also includes license fees and royalties paid to third parties as well as depreciation on machines placed on the participation programs. Cost of sales was $2,967,000, or 62% of revenue, as compared to $2,965,000, or 52% of revenue, for the quarters ended June 30, 2000 and 1999, respectively. Cost of sales was $4,954,000, or 62% of revenue, as compared to $7,184,000, or 63% of revenue, for the six months ended June 30, 2000 and 1999, respectively. The increase in cost of sales as a percentage of revenue for the three month period is a reflection of several factors. The introduction of the Family Feud suite of games, a unique, fully integrated specialty product, had the effect of raising per unit costs on that portion of cost of sales that represented the cost of this product. This was offset slightly by lower manufacturing overhead costs associated with the refurbishing and reselling of used machines taken back by the company, benefits derived from the tooling of certain of its hardware components, and from some cost reductions in some of the components included in its machines other than the Family Feud suite of games. Due to significant levels of finished goods inventory, the Company manufactured minimal new product outside of the new Family Feud games during the quarter ended June 30, 2000, and this has prevented it from obtaining further cost reductions in its products. The Company does not anticipate that cost reduction will continue into future periods. The Company believes that as it introduces more unique, fully integrated specialty products, per-unit costs may increase in future periods. 12 Cost of sales and manufacturing expenses are expected to increase in absolute terms through 2000 as the Company increases sales volume for its product, while gross margins are expected to remain volatile due to the products' sensitivity to volume levels. The Company believes that it will be able to continue seeing some benefits of decreased aggregate manufacturing costs due to the relocation of its manufacturing activities to its Las Vegas, Nevada location. The anticipated manufacturing expenses are subject to a number of risks and uncertainties. RESEARCH AND DEVELOPMENT Research and development ("R&D") expenses include payroll and related costs of employees engaged in ongoing design and development activities of the Company and its subsidiary companies, costs paid to outside contractors and specialists, prototype development expenses, overhead costs, equipment depreciation and costs of supplies. To date, the Company has expensed all costs associated with the research, design and development of its product. R&D expenses were $1,252,000, or 26% of revenue, as compared to $1,483,000, or 26% of revenue, for the quarters ended June 30, 2000 and 1999, respectively. R&D expenses were $1,865,000, or 24% of revenue, as compared to $3,831,000, or 34% of revenue for the six months ended June 30, 2000 and 1999, respectively. Of the $1,252,000 in R&D expenses incurred in the second quarter period, $391,000 or 31% was incurred in launching the activity of the Company's new wholly owned subsidiary, Wager Works Inc., which did not contribute any revenue to the company. The decrease in R&D expenses are largely the result of one of the Company's new strategies involving strategic partnering, where a portion of the Company's expenses incurred for the Wagering Content Studio were subsidized by an outside strategic partner/customer, as well as lower personnel costs attributable to the Company's reductions in its workforce and lower use of engineering consultants, offset by higher license fees and similar costs associated with the acquisition of outside technologies. Since the comparable period in 1999, the focus of the Company's R&D activities has changed to emphasize new game development, the introduction of new product platforms, and the introduction of new game types. The Company is focussed on offering additional features in its products that will fully utilize the underlying technology used as well as continuing to procure new strategic partner relationships to help subsidize a portion of this effort.. This is expected to require a continued investment in R&D resources to continue the development of the product platform and new platforms to facilitate the elaborate requirements of the game development process in future periods. With the continuing efforts to successfully launch the business of its new subsidiary company, Wager Works, Inc., management believes the absolute level of R&D expenses may increase in future periods. SELLING, GENERAL AND ADMINISTRATIVE Selling, general and administrative ("SG&A") expenses include payroll and related costs for administrative and executive personnel, sales and customer-support organization personnel, marketing and licensing personnel, overhead costs, legal and associated costs, costs associated with obtaining and retaining corporate and product licenses in various jurisdictions and fees for professional services. SG&A expenses were $3,275,000, or 68% of revenue, as compared to $2,587,000, or 45% of revenue for the quarters ended June 30, 2000 and 1999, respectively. SG&A expenses were $6,411,000, or 81% of revenue, as compared to $5,483,000, or 48% of revenue for the six months ended June 30, 2000 and 1999, respectively. For the six months ended June 30, 2000 and 1999, respectively, approximately 47% of 2000 expenses and 59% of 1999 expenses were headcount related. The increase in SG&A expenses in 2000 reflects higher legal fees in connection with ongoing patent infringement cases that the Company was party to during 1999 and a suit by a Company distributor in South Carolina, costs associated with applying for corporate and product licenses as the Company began selling product into new jurisdictions during the first two quarters of 2000, as well as costs incurred in launching the activity of its new wholly owned 13 subsidiary, Wager Works, Inc.. The Company intends to restrict the growth in SG&A expenses as much as possible in future periods and believes SG&A expenses in absolute dollars may increase and may decline as a percentage of total revenue. INTEREST INCOME AND EXPENSE Net interest expense was $13,000 for the quarter ended June 30, 2000, as compared to $1,926,000 for the quarter ended June 30, 1999. Net interest expense was $109,000 for the six months ended June 30, 2000, as compared to $3,852,000 for the six months ended June 30, 1999. Included in these totals was interest income of $17,000 and $22,000 for the quarter ended June 30, 2000 and 1999, respectively, and $27,000 and $75,000 for the six months ended June 30, 2000 and 1999, respectively. Changes in interest income over these periods are directly attributable fluctuations in the level of average cash and investment balances that the Company holds. The timing of share offerings, issuance of Senior Discount Notes, and the rate of spending on operations have impacted the average level of cash and investments. Interest expense was $30,000 and $1,948,000 for the quarters ended June 30, 2000 and 1999, respectively, and $136,000 and $3,927,000 for the six months ended June 30, 2000 and 1999, respectively. The decrease in interest expense over these periods is substantially due to the restructuring the Company underwent in the November of 1999. The holders of the Senior Discount Notes exchanged $39.75 million principal notes and accrued interest of $8.3 million for Preferred Stock that is convertible into a 57% voting interest in the Company. Concurrent with this conversion, the holders of the Senior Discount Notes invested an additional $2 million of New Senior Discount Notes in the Company. The company also paid off it revolving line of credit with its former bank in the first quarter of 2000, did not complete it new bank arrangement until the second quarter of 2000 and didn't begin to use its line of credit until the end of May 2000. The company also reduced its amount of equipment financing in 2000 as well as reducing the principal due on capital leases and other equipment related borrowings in the second quarter of 2000. INCOME TAXES The Company has not been required to pay income taxes due to the fact that it has had net operating losses in each period since the Company's inception. The Tax Reform Act of 1986 and the California Act of 1987 impose restrictions on the utilization of net operating loss and tax credit carryforwards in the event of an "ownership change" as defined by the Internal Revenue Code. The Company's ability to utilize its net operating loss and tax credit carryforwards is subject to limitation pursuant to these restrictions. The Company underwent an ownership change as of the date of the debt restructuring in November, 1999. As a result, the Company lost the potential tax benefits of the net operating loss carryforwards and the tax credit carryforwards that existed at that time. A valuation allowance has been recorded for any deferred tax assets due to uncertainty regarding the ultimate realization of these assets resulting from the lack of earnings history of the Company. LIQUIDITY AND CAPITAL RESOURCES The Company's financial condition has continued to stabilize since June of 1999. Cash and equivalents had increased to $2,467,000 at June 30, 2000 compared to $877,000 at December 31, 1999 and decreased compared to $3,194,000 at June 30, 1999. The increase in cash in the current period as compared to December 31, 1999 is due primarily to new financing obtained from additional borrowings on the Senior Discount Notes, the securing of Bridge Loan financing for the Company's wholly owned subsidiary, Wager Works, Inc., and the Company's continuing successful efforts to convert inventory into cash, offset by losses from ongoing operations. 14 As of June 30, 2000 the Company had an accumulated deficit of $97,447,000 and a shareholder's deficiency of $12,157,000 and has had operating losses every year since its inception. The Company has been required to obtain additional financing each year to be able to fund its ongoing operations. In the fourth quarter of 1999 the Company completed a substantial restructuring of its capitalization whereby $39.75 million of Senior Discount Notes and approximately $8.3 million of accrued interest were converted into Preferred Stock, and the remaining terms of the Senior Discount Notes were modified to reduce the interest rate thereon and extend the payment terms. Concurrent with the restructuring, the Company borrowed $2 million under new Senior Discount Notes and established a facility whereby up to an additional $3 million of new Senior Discount Notes may be issued upon meeting certain financial and operational milestones. In the quarter ended June 30, 2000, the Company met one of the operational milestones identified and established as part if it's November 1999 restructuring plan. The company borrowed an additional $1 million of Senior Discount Notes, and an additional $2 million of new Senior Discount Notes may be issued in the future depending upon the Company's ability to meet certain other financial and operational milestones. Management continues to review financing and other strategic alternatives available to the Company such as additional equity or debt offerings in the Company or certain of its subsidiaries, joint ventures, alternative distribution channels, direct investment by third parties into several of the Company's strategic business opportunities and sale of all or part of the Company's assets to improve the Company's liquidity position. Management believes that these steps, plus sales related to proposed new product introductions, will provide sufficient cash and working capital for the Company to meet its ongoing obligations and to allow it to continue operating as a going concern through at least the end of March 31, 2001. The Company's net cash used in operating activities was $2,279,000 and $2,344,000 for the six months ended June 30, 2000 and 1999, respectively. This modest decrease in cash used in operating activities reflects the amount of non-cash items such as depreciation and amortization and deferred stock compensation. The Company was able to reduce its investments in inventory and increase its level of payables, offset by an increase in its level of receivables, as it has improved its asset management and focussed on converting its existing assets into cash to improve its liquidity situation. For the six month period ended June 30, 1999, the company experienced a significantly higher loss from operations, which was mainly offset by substantial non cash charges to that period for restructuring charges, accrued interest on a higher level of debt, and accretion of debt discount. These items were not a factor in the Company's current six month period for 2000 due to the restructuring of the Company's balance sheet as a result of the old Senior Note restructuring that occurred in November of 1999. Net cash provided by investing activities was $788,000 for the six months ended June 30, 2000 compared to net cash used for investing activities of $260,000 for the six months ended June 30, 1999. The change was primarily due to the sale of property and equipment and the sale and maturity of short-term investments as the Company's available cash balances decreased. Net cash provided by financing activities was $3,081,000 for the six months ended June 30, 2000 compared to net cash used in financing activities of $2,601,000 for the six months ended June 30, 1999. The increase is related primarily to the additional debt funding the Company obtained through exercising some of its Senior Discount Note funding it was entitled to through its restructuring agreement in November of 1999 and the Series A Preferred Bridge Loan Financing it obtained for its subsidiary, Wager Works, Inc. in the current period. The period covering the six months of 2000 also included the conversion of its old line of credit from one banking facility into another, as compared to the period ending June 30, 1999, which included a substantial net reduction in its line of credit. In March 2000, the Company entered into a secured revolving line of credit with a new bank based upon eligible accounts receivable. Under the terms of this borrowing arrangement, which will expire in May 2001 (and subject to automatic renewal provisions), the Company may borrow up to $2 million. Borrowings bear interest at the bank's prime rate (9.50% at June 30, 2000) plus 1.5%. The Company has issued the bank warrants to acquire $35,000 worth of shares of Common Stock at a per share price not to exceed $.35 (35 cents) per share, which may be exercised over a five-year period. The exercise price of the warrants adjust to the fair market value of the underlying common stock, at the date of exercise, with a maximum cumulative exercise value of $35,000. In May 2000, the Company finalized its contract involving this revolving line of credit, and borrowed $750,000, which is the outstanding amount due as of June 30, 2000. 15 In March 2000 the Company was served papers in connection with a patent infringement lawsuit filed against it and one other slot machine manufacturer by International Game Technology, Inc. (IGT). As disclosed in November 1999, IGT is alleging infringement of a patent issued to IGT in September 1999 entitled "Game Machine and Method Using Touch Screen". The Company has not yet responded to the lawsuit and the Company's management denies the assertions of infringement. The Company is presently unable to determine the financial impact, if any, of this litigation. The costs of defending this lawsuit may be substantial and may require significant amounts of senior management time. Any adverse result from such litigation could materially and adversely affect the Company's liquidity and capital resources. In March 2000, a former distributor of the Company's products, filed suit against the Company in the United States District Court for the District of South Carolina. The distributor seeks repayment of $1 million, plus damages, in connection with machines previously shipped to the distributor in 1998. The Company is in the process of seeking arbitration as required by the Distribution Agreement, seeking to recover outstanding receivables from the distributor. The distributor filed in South Carolina an action to stay the arbitration portion of the agreement between the Company and the distributor and was granted such a stay. The company filed a motion on August 14th,2000 appealing the decision to the United States Court of Appeals for the Fourth Circuit. The Company is currently awaiting a decision from the Court of Appeals. The costs of responding to and/or defending this lawsuit may be substantial and may require significant amounts of senior management time. Any adverse result from such litigation could materially and adversely affect the Company's liquidity and capital resources. OUTLOOK This outlook section and other sections in this Quarterly Report on Form 10-Q contain a number of forward-looking statements that reflect the Company's current views with respect to future events and future financial performances. Because they relate to future activities, there is a high degree of risk that such events will not materialize and readers should not place undue reliance upon them as actual results may differ materially. To date the Company has focused many of its resources on creating a business based on the high-volume manufacturing and sale of slot machines. The Company has historically emphasized the selling of its hardware platforms but has relied on frequent releases of new game software to drive market penetration. The Company has struggled in its endeavors against many competitors who are significantly larger and who have much greater resources than the Company. In addition, there have been certain changes in the competitive landscape since the Company was formed. These changes have led the Company to develop and implement a new, three-pronged business strategy. The Company has established separate, internal business units that will focus on what the Company believes are its most promising opportunities, given the current market conditions and the Company's core competencies. The business units are: Product Sales, the Wagering Content Studio, and On-Line. The Company remains committed to supporting and growing its installed base of slot machines. To date, the Company has sold or placed on a participation basis over 4572 units. The Company's sales and support team is, once again, fully staffed and new products are in development for both the slant-top and the upright platform. The Company intends to change its focus from one of frequent game releases to one that emphasizes the quality and feature content of new game titles. It will also offer product extensions and variations of existing successful game titles. The most recently released games are performing at or near the top of the market for their respective categories and denominations. These titles include: Banana-Rama Deluxe, Cash Cruise, Hot Reels - a proprietary game type, Silver Belle Express and Hitsville. 16 In addition to the continued sale of slot machines, the Company's Wagering Content Studio will develop and bring to market a new class of brand-based, wagering attraction. These attractions represent a more complete environmental experience and call for a minimum level of marketing and promotional support. The Wagering Content Studio is an outgrowth of the Company's need to more fully exploit the technology inherent in its game platforms and the creative capabilities of its development organization. The Company is also seeking to develop proprietary versions of its wagering attractions for a limited number of customers/partners, and has already entered into one such development relationship. The result of this relationship between the Company and MGM Grand, Inc. premiered on June 2 in the MGM Grand Hotel and Casino in Las Vegas, Nevada. The Company is currently in negotiation with additional casino operators, other slot manufacturers, and other intellectual property and brand-based content holders. By partnering with outside parties the Company believes it can offset its development risk and costs, achieve higher revenues and increase the likelihood of product success. With respect to the On-Line business unit, Wager Works, Inc., the Company is exploring the varying opportunities that the Internet represents through applications on the World Wide Web. The Company also intends to continue its program of improving and solidifying its financial position. The Company is considering raising additional capital in either the parent company or directly into certain of its subsidiaries, in order to fund new product and system development. Management also intends to simplify the business and focus resources so that it can continue to minimize the level of cash usage as the Company transitions to a business model that takes advantage of revenue-sharing opportunities. The Company's future results of operations and the other forward-looking statements contained in this outlook - in particular the statements regarding potential partnerships with casino operators or other third parties, and the possible raising of additional capital - involve a number of risks and uncertainties. In addition to the factors discussed above, the following could also cause actual results to differ materially: the success of the Company's game titles, changes in customer order patterns, competitive factors such as new competitor products or game introductions or changes in pricing strategies, reluctance of casino operators to use participation-based products or to partner with the Company in product development, the Company's level of financial resources and adequate cash flows, the stability of the Company's management team and workforce, and the ability of the Company to meet all initial and ongoing licensing requirements of the jurisdictions in which it sells products. The Company believes that it has the product offerings, facilities, personnel, and competitive resources needed for business success, but future revenue, costs, margins, and profits are all influenced by a number of factors, including those discussed above and the need for the Company to raise additional funds, all of which are inherently difficult to predict. FACTORS AFFECTING FUTURE RESULTS MANAGEMENT OF CHANGING BUSINESS - The Company has spent part of the last year as well as all of the first helf of the year 2000, trying to shift its business strategy from one of high-volume manufacturing and placement of slot machines with a goal of capturing market share, to a strategy that emphasizes the quality and feature content of new game titles and takes advantage of revenue-sharing opportunities. The Company plans on offering product extensions and variations of successful existing games in 2000, however the emphasis will shift from volume-based to one of providing a unique, fully-integrated gaming experience. This transition represents a significant challenge for the Company and its management and employees, and places increased demand on its systems and controls. The Company's ability to manage this change will require the Company to continue to change, expand and improve its operational, management and financial systems and controls to manage any outsourcing or relocation of existing activities. Key to effecting this change in business is the ability of the Company to sell its existing inventory of ODYSSEY and QUEST products in a 17 timely manner and to resolve outstanding collections issues with customers to provide sufficient working capital during this transition process. If the Company is not able to generate adequate funds from its working capital in a timely manner, the Company's business, operating results and financial condition will be materially and adversely affected. LIQUIDITY - The Company has funded its operations to date primarily through private and public offerings of its equity securities, the issuance of Senior Discount Notes, term and equipment loans and from bank borrowings. At June 30, 2000, the Company had an accumulated deficit of $97,447,000 and a deficiency of shareholders' equity of $12,157,000. The Company has repaid all amounts due under the former line of credit and has negotiated a new line of credit with a different financial institution on better terms. Management is also reviewing financing alternatives available to the Company such as additional share or debt offerings in the Company or certain of its subsidiaries, joint ventures, alternative distribution channels and sale of all or a portion of the Company's assets. If the plans that management has undertaken to improve the Company's liquidity position are not successfully completed in a timely manner it is probable that insufficient funds will exist to satisfy the Company's operating requirements. The Company will be required to make adjustments to its operating activities to operate within the restrictions of its liquidity and this could have a material adverse affect upon the Company's business, operating results and financial condition. To the extent that the Company sells additional shares or issues any convertible debt securities, this could result in additional dilution to existing shareholders. There can be no assurance that the Company will be able to raise additional funds when and if needed. VOLATILITY OF STOCK - The market price of the Company's stock has been highly volatile and subject to large fluctuations. The Company's stock price may be affected by factors such as actual or unanticipated fluctuations in the Company's results of operations, new product or technical introductions by the Company or any of its competitors, developments with respect to patents, copyrights or proprietary rights, conditions or trends in the gaming industry, changes in or failure by the Company to meet securities analysts' expectations, general market conditions and other factors. The Company's stock now trades on the Over The Counter (OTC) Bulletin Board. This may affect the level of trading activity in the Company's stock, result in higher bid/ask spreads, and increase the cost of raising additional equity for the Company, as well as result in higher levels of volatility in the price of the Company's stock. RETENTION OF PERSONNEL - The operations of the Company depend to a great extent on the management efforts of its officers and other key personnel, and on the ability to attract new key personnel and retain existing key personnel. The Company has experienced some turnover among its senior management during 1999 and the half year ended June 30, 2000. In February 1999, the Company announced the appointment of a new Chief Executive Officer. The Company also reduced its workforce by approximately 20% in December 1998 and by a further 40% in March 1999. These factors, combined with the Company's poor operating results and the significant decrease in the price of the Company's Common Stock may have an adverse affect on the Company's ability to retain and motivate its key employees. Competition is intense for highly skilled product development employees in particular. In addition, the Company's officers and key employees are not bound by non-competition agreements that extend beyond their employment at the Company, and there can be no assurance that employees will leave the Company or compete against the Company. The Company's failure to attract additional qualified employees or to retain its existing employees could have a material adverse affect on the Company's operating results and financial condition.. CUSTOMER RETENTION - The Company's ability to sell product may be hampered due to the financial position of the Company which presents risks to customers that the Company may not be able to fulfill its obligations under license agreements or be available to provide warranty, repair or upgrade services on products that it has already sold. The Company experienced negative reaction from customers who held these views during 1999 and, to a lesser extent, in the first half of the year 2000. These customers have indicated that they may not purchase additional product from the Company. Completion of the Company's debt restructuring in November 1999 mitigates these risks, however, the Company continues to experience some negative sentiments from its customers. Certain of the Company's competitors who have significantly greater financial and marketing resources than the Company are also trying to take advantage of the Company's financial position and are fueling the speculation about the Company's financial position. To the extent that this results in the loss of any of the Company's strategic customers or results in a loss of sales opportunities, the Company's business, operating results and financial condition may be adversely affected. 18 INTELLECTUAL PROPERTY RIGHTS - The Company regards its product as proprietary and relies primarily on a combination of patent, trademark, copyright and trade secret laws and employee and third-party nondisclosure agreements to protect its proprietary rights. Defense of intellectual property rights can be costly, and there can be no assurance that the Company will be able to effectively protect its technology from misappropriation by competitors. As the number of software products in the gaming industry increases and the functionality of these products further overlap, software developers and publishers or competitors may increasingly become subject to infringement claims. The Company may also become subject to infringement claims, with or without merit, that are brought by competitors who are motivated with a desire to disrupt the Company's business. The Company and three of its competitors were notified by one of its competitors, IGT, of a potential infringement claim during November 1999. This required senior management to work with the other defendants to provide information to IGT that it believes repudiates the claims alleged by IGT. In March 2000, the Company and one other slot machine manufacturer were notified by one of its competitors, IGT, of a patent infringement lawsuit filed against it. The company has not yet presently responded to this latest lawsuit. Any such claims or litigation can be costly and result in a diversion of management's attention, which could have a material adverse effect on the Company's business and financial condition. Any settlement of such claims or adverse determinations in such litigation could also have a material adverse effect on the Company's business, operating results and financial condition. CHANGING LEGISLATIVE ENVIRONMENT -The opening of new casinos, including casinos in jurisdictions where gaming has recently been legalized historically has driven growth for demand in slot machines. However, in recent years, the legalization of gaming in new jurisdictions has been reduced; therefore demand based on new openings may be largely limited to new projects in existing markets. Certain markets, which currently permit gaming, are contemplating legislation to limit, reduce or eliminate gaming. If successful such legislation could limit growth opportunities for the Company. As a result of these factors, there can be no assurance that the slot machine market will sustain the rate of growth that was possible in the first half of this decade. RAPIDLY CHANGING TECHNOLOGY - The Company's products utilize hardware components that have been developed primarily for the personal computer and multimedia industries. These industries are characterized by rapid technological change and product enhancements. The Company's ability to remain competitive and retain any technological lead may depend in part upon its ability to continually develop new slot machine games that take full advantage of the technological possibilities of state-of-the-art hardware. The Company has not updated its product offering to take advantage of enhanced hardware components since 1998. Should any current or potential competitor of the Company succeed in developing a competing software-based gaming platform, such competitor could be in a position to outperform the Company in its ability to exploit developments in microprocessor, video or other multimedia technology. The emergence of a suite of slot machine games that is superior to the Company's in any respect could substantially diminish the Company's product sales and thereby have a material adverse effect on the Company's operating results. DEPENDENCE ON SINGLE-SOURCE SUPPLIERS - The Company currently obtains certain systems components from single-source suppliers. In particular the touchscreen and picture tube that comprise the video display are supplied by MircoTouch Systems, Inc. and Philips Display Components Company, respectively. The Company does not have long-term supply contracts with these suppliers but rather obtains these components on a purchase order basis. Although the design of these components is not unique or proprietary and the Company believes that it could identify alternative sources of supply, if necessary, there can be no assurance that the Company would be able to procure, substitute or produce such components without a significant interruption in its assembly process in the event that these single sources were unable to supply these components. Even where the Company has multiple sources of supply for a component, industry-wide component shortages, such as those that have occurred with various computer components, could significantly delay productivity, increase costs or both. The Company is also considering exclusive outsourcing arrangements whereby a single third party contract manufacturer will assemble all or a significant portion of 19 new products that the Company is planning to introduce. The failure or delay by any supplier to furnish the Company with the required components or products would have a material adverse effect on the Company's business, financial condition and results of operations. ITEM 7A Market Risk Disclosures: The following discussion about the Company's market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The Company is exposed to market risk related to changes in interest rates and equity security price risk. The Company does not have derivative financial instruments for speculative or trading purposes. The Company has fixed rate long-term debt of approximately $10.5 million outstanding at June 30, 2000 and a hypothetical ten percent increase or decrease in interest rates would not have a material impact on the fair market value of this debt. The fair value of the Company's Senior Discount Notes may be lower than the recorded value, but the Company is unable to estimate the fair value at this time. The Company does not hedge any interest rate exposures. PART II--OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In March 2000, a former distributor of the Company's products, filed suit against the Company in the United States District Court for the District of South Carolina. The distributor seeks repayment of $1 million, plus damages, in connection with machines previously shipped to the distributor in December of 1998. The Company responded to the complaint requesting that the proceeding be stayed while the parties went through arbitration in accordance with the Distribution Agreement pursuant to which the machines were shipped. The distributor filed a response requesting the court to reject the stay. The court ruled in favor of the Distributor and the Company appealed the decision to the United States Court of Appeals for the Fourth Circuit on August 14, 2000. The Company is awaiting a decision from the Court of Appeals. 20 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. Number Exhibit Description ------ ------------------- 27.1 Financial Data Schedule (b) Reports on Form 8-K. A Current Report on Form 8-K was filed on April 25, 2000 announcing the commencement of an exchange offer by the Company whereby the Company offered to exchange a unit consisting of one share of common stock and a warrant to purchase 3.59662 shares of common stock for each share of common stock outstanding. A Current Report on Form 8-K was filed announcing an extension of the exchange offer from May 19, 2000 to June 23, 2000. The exchange offer terminated on June 30, 2000. The Company's exchange agent received 541 election notices representing 11,585,457 shares of common stock participating in the exchange offer. Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SILICON GAMING, INC. By /s/ ANDREW S. PASCAL ------------------------------------- Andrew S. Pascal President, Chief Executive Officer, Acting Chief Financial Officer (Principal Financial and Chief Accounting Officer) Date: August 21, 2000 21