-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Vs3PXfD3nbURv7HokkYSsfavkJJzpyUO4EMfg8hh/lCuC5iYJ5Id161iy6m3o/Yo eaS4k7Y1+3PJVaJH3BRd1Q== 0000950144-99-003738.txt : 19990402 0000950144-99-003738.hdr.sgml : 19990402 ACCESSION NUMBER: 0000950144-99-003738 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: INTERLOTT TECHNOLOGIES INC CENTRAL INDEX KEY: 0000873998 STANDARD INDUSTRIAL CLASSIFICATION: REFRIGERATION & SERVICE INDUSTRY MACHINERY [3580] IRS NUMBER: 311297916 STATE OF INCORPORATION: OH FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 001-12986 FILM NUMBER: 99581442 BUSINESS ADDRESS: STREET 1: 10830 MILLINGTON CT CITY: CINCINNATI STATE: OH ZIP: 45242 BUSINESS PHONE: (513)792-7000 MAIL ADDRESS: STREET 1: 6655 CREEK ROAD CITY: CINCINNATI STATE: OH ZIP: 45242 FORMER COMPANY: FORMER CONFORMED NAME: INTERNATIONAL LOTTERY INC DATE OF NAME CHANGE: 19940203 10-K405 1 INTERLOTT TECHNOLOGIES, INC. 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31,1998 [ ] 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 001-12986 INTERLOTT TECHNOLOGIES, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 31-1297916 (State of incorporation) (IRS Employer Identification Number) 10830 MILLINGTON COURT, CINCINNATI, OHIO 45242 (Address of principal executive offices, including zip code) (513) 792-7000 (Registrant's telephone number, including area code) SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED Common Stock, $.01 Par Value American Stock Exchange SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: NONE 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 by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of the Registrant's outstanding Common Stock held by non-affiliates of the Registrant on March 22, 1999 was $9,630,000. There were 3,210,000 shares of Common Stock outstanding as of March 22, 1999. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's 1998 Annual Report are incorporated by reference in Part II hereof. Portions of the Registrant's Proxy Statement for the 1999 Annual Meeting of Stockholders to be held on May 6, 1999 are incorporated by reference in Part III hereof. 2 INTERLOTT TECHNOLOGIES, INC. ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 TABLE OF CONTENTS
ITEM PAGE NUMBER NUMBER - ------ ------ PART I............................................................................................................3 1. Business...............................................................................................3 2. Properties............................................................................................20 3. Legal Proceedings.....................................................................................20 4. Submission of Matters to a Vote of Security Holders...................................................21 4(A). Executive Officers of the Registrant..................................................................21 PART II..........................................................................................................22 5. Market for the Registrant's Common Stock and Related Stockholder Matters..............................22 6. Selected Financial Data...............................................................................22 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.................22 7(A). Quantitative and Qualitative Disclosures About Market Risk............................................27 8. Financial Statements and Supplementary Data...........................................................27 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure..................27 PART III.........................................................................................................28 10. Directors and Executive Officers of the Registrant....................................................28 11. Executive Compensation................................................................................28 12. Security Ownership of Certain Beneficial Owners and Management........................................28 13. Certain Relationships and Related Transactions........................................................28 PART IV..........................................................................................................28 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K......................................28 SIGNATURES............................................................................................32 INDEX OF FINANCIAL STATEMENT SCHEDULES.................................................................1 INDEX OF EXHIBITS......................................................................................1
3 PART I ITEM 1. BUSINESS Interlott Technologies, Inc. (the "Company" or "Interlott") is engaged primarily in the design, manufacture, sale, lease and service of instant winner lottery ticket vending machines ("ITVMs"). ITVMs are used by public lotteries operated by states and international public entities to dispense instant winner lottery tickets primarily in retail locations such as supermarkets and convenience stores. An instant lottery commonly is played by players scratching off a latex coating from a pre-printed ticket or tearing pull-tabs from a pre-printed ticket to determine the outcome of the game. The Company's ITVMs dispense instant lottery tickets without the assistance of an employee of the lottery instant ticket retailer or agent, thereby permitting the retailer or agent to sell tickets without disrupting the normal duties of its employees. The Company's ITVMs dispense scratch-off instant lottery tickets using a dispensing process that incorporates the Company's patented "burster technology." The Company believes that this burster technology is superior to any other ITVM scratch-off dispensing technology on the market and considers it to be a key to its marketing efforts and the ITVM procurement decisions of the various lotteries. The Company is unaware of any competitor that incorporates a substantially equivalent or superior scratch-off dispensing mechanism in its ITVMs. To dispense pull-tab instant lottery tickets, the Company has developed an ITVM that incorporates a patented dispensing technology which is different than the burster technology but that is also believed by the Company to be superior to any other currently available pull-tab dispensing technology. ITVMs that dispense pull-tab tickets are sometimes referred to herein as "pull tab vending machines" or "PTVMs." The term "ITVM" includes both scratch-off vending machines and PTVMs unless the context indicates otherwise. As of December 31, 1998, the Company had sold or leased 15,045 ITVMs under agreements with 23 different state lotteries and seven international jurisdictions, or their licensees or contractors. The Company was awarded four of the six contracts that were awarded to the industry in 1998. Additionally, lotteries in four states and five international jurisdictions currently are testing the Company's products and services or have requested the Company to provide ITVMs for testing. The Company continually seeks to enhance its existing product lines and develop new products. In 1998, the Company introduced its Modular Vending Platform to increase over-the-counter instant ticket sales and reduce ticket shrinkage. Also in 1998, the Company introduced the Automated Communication System, which significantly increases and enhances the flow of information between the ITVMs in the field and the lotteries. Taking advantage of its expertise in dispensing technology, the Company introduced a prepaid phone card dispensing machine ("PCDM") in 1995 that enables providers of long distance telephone service to dispense prepaid telephone calling cards in retail locations without the assistance of an employee of the retailer. The dispensing process used in the Company's PCDM incorporates the same patented technology used in the Company's PTVM, and the Company believes that this dispensing technology is superior to any other PCDM dispensing technology on the market. Sales of the Company's PCDMs began in the latter part of 1995, and as of December 31, 1998, the Company had sold or leased a total of 851 PCDMs. PCDM revenues in 1998 represented 2.3% of total revenues. The Company was incorporated on February 20, 1990 under the laws of Ohio and was reincorporated under the laws of Delaware on March 18, 1994. In April 1994, the Company completed an initial public offering of Common Stock, and the Company's Common Stock now trades on the American Stock Exchange under the symbol "ILI." -3- 4 INDUSTRY OVERVIEW ITVMs The popularity and success of lotteries has increased worldwide in recent years, and the popularity of instant lotteries has increased at a rate that is greater than that of lotteries generally. Currently, 37 states and the District of Columbia operate lotteries as compared to 29 states as of June 30, 1989, and 37 states and the District of Columbia currently operate instant lotteries as compared to 28 states as of June 30, 1989. The Company believes that factors contributing to the rapid growth in the popularity and success of instant ticket games, which now comprise 45% of total lottery sales in the United States as compared to 24% in 1989, include more sophisticated marketing techniques, the introduction of new state instant ticket lotteries, a broader appeal among lottery consumers and increased technological advances in the distribution of instant tickets. ITVMs were first deployed to serve the instant lottery market in 1991, and the market for ITVMs has grown rapidly in subsequent years. The number of installed ITVMs has increased from approximately 900 in two states in 1991 to approximately 25,000 in 31 states, the District of Columbia and eight international jurisdictions as of December 31, 1998. Four states and five international jurisdictions currently are testing or preparing to test ITVMs in the field, and the Company believes that several other states and international jurisdictions are considering the use of ITVMs. Additionally, because states that utilize ITVMs typically introduce the ITVMs into the instant ticket distribution system in stages (preferring to test retail reception to a limited initial deployment of ITVMs before fully committing funds to the deployment of a significantly larger number of ITVMs), the Company believes that states currently utilizing ITVMs represent a growing market for the Company's ITVMs. PCDMs Like instant lottery tickets, the use of prepaid telephone calling cards also has grown significantly in the past few years. Prepaid telephone calling cards enable callers to make long distance calls at rates that typically are lower than the rates ordinarily charged for credit card or collect long distance telephone calls. This factor, together with the usage control that results from the pre-established value of the card, is perceived as a distinct value of the card and is believed to be responsible for the popularity of prepaid telephone calling cards. The use of PCDMs as a method of distribution of prepaid telephone calling cards has paralleled the market acceptance of the card. PCDMs are now being used successfully to sell prepaid telephone calling cards in truck stops, military bases, convenience stores, airports, and numerous other types of retail locations. The Company believes that the sale of prepaid long distance telephone calling cards and the use of PCDMs are in the very early stages of market development in the United States and anticipates the continued development of the market. BUSINESS STRATEGY The Company's business strategy involves the following elements: - Expansion of the Company's ITVM into new domestic and international markets. Lotteries are becoming increasingly aware of the success of ITVMs in increasing instant ticket revenues, and many domestic and international jurisdictions are currently testing and evaluating ITVMs. In the United States, the Company currently is testing or preparing for testing of ITVMs for four state lotteries. Internationally, the Company currently is testing or preparing for testing of ITVMs for lotteries in five countries. The Company plans to expand further into new and existing lottery jurisdictions by expanding its marketing efforts and lowering the cost associated with the procurement of its ITVMs. The Company also intends to continue to aggressively market its ITVM products and services to its existing customers to encourage expanded use of ITVMs in existing distribution systems. -4- 5 - PCDM market penetration. The Company has made only an initial and limited penetration of the PCDM market to date, but the Company is actively seeking to become a significant presence in the PCDM market in the United States. The Company believes that its ITVM has a reputation for quality, performance and reliability, and the Company intends to capitalize on this reputation in marketing its PCDM to providers of long distance telephone services. The Company also intends to demonstrate to such providers the advantages which its PCDM affords to the retailers that sell prepaid telephone calling cards, which in turn should lead to increased sales of prepaid telephone calling cards by such providers. The Company intends to aggressively market its PCDM products to its existing customers and to expand its marketing efforts to both the providers and resellers of long distance telephone services, as well as to market its PCDMs to retailers of prepaid telephone calling cards. - Continued product innovation and technological advances. Management believes that the Company's products are more technologically advanced than the products of its competitors and that the technological superiority of the Company's ITVM is a principal reason for its success to date. To further expand the Company's market opportunities, the Company continually seeks to enhance its existing products and develop complementary products that offer the superior operating performance of its ITVMs and PCDMs. For example, the Company has developed a new Modular Vending Platform ("MVP") for use in convenience stores and grocery check-out lanes which should increase sales and reduce ticket shrinkage. The Company also has enhanced its software to interact with currency acceptors of international currency and display messages in several languages. Finally, the Company has improved its on-line communications system through the new Automated Communication System that significantly increases and enhances the flow of information between the ITVMs in the field and the lotteries. - Manufacturing efficiencies. The Company continually seeks to enhance its manufacturing operations to improve its gross margins and overall profitability. The Company believes that through design refinements and continued higher production volumes, it will continue to achieve lower manufacturing costs by receiving more favorable terms from vendors. - Develop dispensing devices for other markets. The Company intends to expand its existing product lines by developing new dispensing devices for markets other than lotteries and prepaid telephone calling cards. For example, the Company has developed a device which dispenses stored value "smart" cards for possible use by the financial services industry to the extent that consumer use of smart cards develops in the future. PRODUCTS The ITVM In 1987, Edmund F. Turek, who currently serves as a director of and consultant to the Company, developed the technology for what the Company believes to be the first automated ITVM. The burster dispensing technology is a key component of the Company's ITVM for scratch-off instant lottery tickets and is protected by a patent that the Company acquired from Mr. Turek's family-owned corporation. See "Patents, Trademarks and Copyrights" below. The Company's ITVMs automatically dispense instant lottery tickets upon payment from the user. Unlike the products of some of the Company's competitors, the burster technology in the Company's ITVMs automatically separates one scratch-off instant ticket from another along the perforations between tickets to help prevent tearing of the tickets or scarring of the latex on the tickets. The Company's burster technology, which the Company believes to be the most technologically advanced scratch-off dispensing system in the ITVM industry, also enables the Company's ITVMs to dispense and account for virtually any known type of scratch-off instant lottery ticket, allowing the use of a wide range of sizes, shapes, paper stocks or perforations, without the intervention of a lottery -5- 6 retailer or agent. This feature allows lotteries to purchase virtually any known type of scratch-off instant ticket from their instant ticket manufacturer without having to request from the manufacturer major alterations in the ticket perforations. For example, the Company's ITVM, unlike the products of the Company's competitors, can dispense recyclable scratch-off tickets without tearing or scarring the tickets. The Company believes that lotteries will increasingly require the use of recyclable tickets in their ITVMs. This feature also is particularly beneficial to international lottery jurisdictions that may use non-standard sizes, shapes and paper stocks. In addition, the ITVM for scratch-off tickets is faster than manual sales of scratch-off tickets as the ITVM's entire dispensing process is completed in less than 1.5 seconds once the ticket selector button has been pushed. The Company's ITVMs for scratch-off tickets have a proven record of reliability. Based on an analysis of actual field service data regarding the dispensing of approximately 55 million scratch-off instant tickets by the Company's ITVMs during a 48-week period, the Company determined that the Mean Time Between Failure of these ITVMs is approximately 3.78 years and that the Mean Time to Repair is approximately 15 minutes. The data indicated that these ITVMs dispense an average of 392,800 scratch-off instant tickets between failures. The Company believes that it has developed an ITVM that has proven to be reliable and that requires less maintenance than the products of its competitors. The Company believes that the reliability of its ITVMs and the lower maintenance requirements distinguish the Company's ITVMs for scratch-off tickets from those of its competitors. See "Competition" below. The Company's ITVM for scratch-off tickets has the capacity to dispense tickets from one to 16 different bins. Because each bin can dispense tickets of different sizes, paper stocks and price levels, lotteries can sell scratch-off tickets for up to 16 different instant-winner games with a single ITVM. The ITVM can accommodate up to 16,000 tickets in the 16-game unit and can dispense all tickets in the bin without manual intervention. When all of the tickets in a bin have been dispensed, tickets can be easily reloaded by an employee of the retailer or agent. This is in contrast to the products of the Company's competitors, which the Company believes require the retailer or other agent to tape the last few tickets in each bin to the next pack of tickets provided by the retailer or other agent. The ability of the Company's ITVM to dispense every ticket in each bin not only facilitates the ticket reloading process but also enhances the accuracy of the inventory and accounting functions. All of the Company's ITVMs accept bills in $1, $2, $5, $10 and $20 denominations and, in some applications, accept international currency. The size of the Company's ITVM for scratch-off tickets varies from 69 inches tall, 28 inches wide and 24 inches deep for a 16-game unit to 19.75 inches tall, 15.5 inches wide and 20.5 inches deep for a countertop unit. All models are anchored to the floor or counter. The ITVMs typically are custom designed to meet any color and other appearance specifications that a lottery may desire. All models are Underwriters Laboratory ("UL((R))") listed and Federal Communications Commission ("FCC") approved, which ensures that the ITVM has passed nationally recognized safety standards and stringent requirements designed to preclude machine damage and personal injury due to non-approved components, devices, installation or application. The Company was the first manufacturer of ITVMs to obtain UL((R)) listing and FCC approval for its ITVMs. Each ITVM is standardized with an information display that provides the player with easy-to-read instructions on how to use the machine and gives the lottery retailer or agent the ability to read sales reports without printing the report. The ITVM can be ordered with a "BETA BRITE((R))" mulTi-color LED sign mounted on the top of the ITVM which is intended to increase attention to the machine and thereby increase ticket sales. The BETA BRITE((R)) sign is programmed at the Company's manufacturing facility and can display any message the lottery may desire. The BETA BRITE((R)) also may be programmed by the retailer or agent or can be programmed from the lottery headquarters by utilizing the Company's optional modem communications system. The Company currently is utilizing the BETA BRITE((R)) on ITVMs installed in approximately 15 states. For security and durability purposes, each of the Company's ITVM cabinets is manufactured with 16 gauge and 11 gauge steel. The surface of the ITVM is coated with durable and fade resistant paints. The display windows are fabricated from a flame resistant, high impact polycarbonate sheet material. This material is shatter -6- 7 resistant, and to date to the knowledge of the Company, none of the Company's installed ITVMs has had a polycarbonate window broken or shattered. Additionally, to the knowledge of the Company, the cabinets have not had any fading, marring, scratching, chipping or rusting. All of the Company's ITVMs are manufactured with high security locks which are coded to prevent unauthorized duplication, and each ITVM is keyed separately, except for ITVMs deployed in Maryland where the Lottery desired a master key system. For further security, each of the Company's bill acceptor units must be accessed with a key unique to the particular acceptor unit. All of the Company's ITVMs for scratch-off tickets utilize copyrighted software that can supply up to 11 different reports for accounting and inventory purposes. These reports can provide to the lottery and its retailers or agents a complete summary of daily sales, weekly sales, total sales, sales by game, current status of the machine, inventory of the product currently in the ITVM, the last three transactions of the ITVM and other types of information. The software system allows for a simple diagnostic test to identify any malfunction of the ITVM. The diagnostic mode communicates various information such as ticket size setting, status of electronics, status of each game and other information concerning the system software. The Company's ITVM software system may be programmed to the detail specifications of the specific lottery. The Company incorporates a common electronic system in all of its equipment. This enables the Company to efficiently develop common software and to realize cost efficiencies in acquiring electronic components. To dispense pull-tab instant lottery tickets, the Company's PTVM uses the same technology, design and specifications as are incorporated in the Company's PCDM. The Company's PCDM is described in detail below. The PCDM Like the Company's ITVM for scratch-off tickets, the key component of the Company's PCDM is the dispensing technology. The Company has the exclusive right to the use of this patented dispensing technology, which it acquired from a company owned by Kazmier J. Kasper, a director of the Company. See "Item 13. Certain Relationships and Related Transactions." Similar to the Company's ITVM for scratch-off tickets, the Company's PCDM automatically dispenses prepaid telephone calling cards upon payment from the user. Unlike the products of some of the Company's competitors, the dispensing technology in the Company's PCDM automatically pulls one prepaid telephone calling card from the bottom of the stack of cards without the jamming that is associated with other dispensing processes. The Company's dispensing technology, which the Company believes to be the most technologically advanced dispensing system in the PCDM industry, also enables the Company's PCDM to dispense and account for virtually any known thickness of calling card without the intervention of the retailer. In addition, the PCDM is faster than manual sales of prepaid telephone calling cards as the PCDM's entire dispensing process is completed in less than three seconds once the selector button has been pushed. The Company's PCDMs have the capacity to dispense cards from two to six different bins. The PCDM can accommodate up to 3,600 cards in the six-bin unit and can dispense all prepaid telephone calling cards in the bin without manual intervention. When all of the cards in a bin have been dispensed, cards easily can be reloaded by an employee of the retailer. The ability of the Company's PCDM to dispense every card in each bin not only facilitates the card reloading process but also enhances the accuracy of the inventory and accounting functions. All of the Company's PCDMs accept bills in $1, $2, $5, $10 and $20 denominations and, in some applications, accept international currency. The size of the Company's PCDMs varies from 66 inches tall, 26 inches wide and 19 inches deep for a six-bin dispenser unit to 22 inches tall, 14 inches wide and 10 inches deep for a countertop unit. All models are anchored to the floor or counter, except that the two bin model may be mounted on an optional pedestal. All models are UL((R)) listed and FCC approved. Each PCDM is standardized with an information display that provides the user with EASY-to-read instructions on how to use the machine and gives the retailer the ability to read sales reports without printing the report. -7- 8 For security and durability purposes, each of the Company's PCDM cabinets is manufactured with 16 gauge and 11 gauge steel. The surface of the PCDM is coated with durable and fade resistant paints. The display windows are fabricated from a flame resistant, high impact polycarbonate sheet material. To the knowledge of the Company, the cabinets have not had any fading, marring, scratching, chipping or rusting. All of the Company's PCDMs are manufactured with high security locks that are coded to prevent unauthorized duplication, and each PCDM is keyed separately. For further security, each of the Company's bill acceptor units must be accessed with a key unique to the particular acceptor unit. All of the Company's PCDMs utilize copyrighted software that can supply up to nine different reports for accounting and inventory purposes. These reports can provide retailers a complete summary of daily sales, weekly sales, total sales, sales by bin, current status of the machine, inventory of the product currently in the PCDM, the last three transactions of the PCDM and other types of information. The software system allows for a simple diagnostic test to identify any malfunction of the PCDM. MARKETING AND SALES ITVMs The Company markets its ITVMs to both domestic and international lotteries and their licensees or prime contractors. The Company attends lottery and gaming trade shows, maintains personal contact with lottery officials through its sales force of five employees and advertises in trade publications to increase its presence in the lottery industry. The focus of the Company's marketing strategy is on the superior performance and reliability of its ITVMs, as well as continued competitive pricing. Information developed through actual field use and product field tests demonstrates that a significant factor in increasing instant ticket sales is the reliability of the ITVM. Increased maintenance visits impair the ITVM "uptime," which in turn reduce ticket sales. The Company believes that its ITVMs, based on actual field performance and product testing, are the most reliable and technologically superior in the industry. Management believes that actual field demonstrations comparing the Company's ITVMs with those of its competitors are the Company's best method of marketing. The Company has been awarded contracts to provide ITVMs for 13 of the last 17 state lotteries that have requested bid proposals and 4 of the 6 domestic ITVM contracts that were awarded in 1998. The Company's ITVMs require preventive maintenance only twice a year. The ITVM "downtime" resulting from this semi-annual preventive maintenance averages approximately 20 minutes. To further increase the likelihood of receiving ITVM orders from lotteries, the Company intends to offer additional and more flexible financing alternatives to the lotteries. The Company believes that many state lotteries, due to budget considerations, cannot afford the high capital costs required to purchase ITVMs. However, if the Company can provide attractive variations of its standard and percentage lease financing options for the lotteries, the lotteries can more affordably deploy ITVMs. The Company believes that these types of financing alternatives will prove to be increasingly popular. The Company's ability to generate additional revenues and earnings from deployments of its ITVMs will depend upon continued market acceptance of ITVMs. The Company intends to expand its marketing presence with the retail grocers associations, convenience store operators associations, retail stores at both the corporate and store levels, and other types of corporate or association member entities to familiarize these groups with the Company's ITVM. These retailers are the lotteries' distribution system for all scratch-off and pull-tab lottery tickets, and management believes that increased exposure to lottery retailers will be a significant factor in the Company's ability to expand the market for its lottery products. As the distribution system for all lottery products, lottery retailers may advise the lotteries with regard to such matters as new lottery products, improved marketing strategy and improved product distribution. In many lottery jurisdictions, retailer advisory boards provide input to the lotteries on various issues affecting the lottery. While the lotteries must abide by the established procurement -8- 9 laws of their respective jurisdictions in selecting an ITVM manufacturer, the lotteries may solicit the opinions of the lottery retailers concerning the ITVMs under consideration by the lottery because the retailers are directly affected by the selection decision. The Company believes that retailers' opinions may be a significant factor in a customer's decision regarding which manufacturer's ITVM to deploy in its instant ticket distribution system. The Company will continue to participate in cooperative service arrangements with other lottery suppliers as the lotteries increasingly rely on these types of arrangements. These arrangements allow lotteries to reduce their operating costs while increasing lottery revenues. Additionally, these arrangements allow for a more efficient means for contracting products and services. The Company's ITVMs are deployed in Georgia and West Virginia pursuant to cooperative service arrangements between the Company and Scientific Games, Inc., which is a primary contractor for the Georgia and West Virginia Lotteries, and were deployed in New Jersey pursuant to a purchase agreement between the Company and GTECH Corporation, which is the on-line supplier to the New Jersey Lottery. Under these arrangements, the Company supplies ITVMs to Scientific Games, Inc. for use in Georgia and West Virginia and supplies ITVMs to GTECH Corporation for use in New Jersey. The Company is responsible for installing, servicing and maintaining the ITVMs in Georgia but is not required to provide preventive maintenance or servicing for the ITVMs supplied for use in West Virginia and New Jersey. Management believes that the deployment of the Company's ITVMs in Georgia, West Virginia and New Jersey resulted in part from the Company's cooperative service arrangements with Scientific Games, Inc. and GTECH Corporation and that such cooperative service arrangements will prove to be increasingly attractive to both domestic and international lotteries in the future. PCDMs The Company has been marketing its PCDMs since late 1995 and to date has employed a marketing strategy that is similar to the strategy that it has used successfully to market its ITVMs. The focus of the Company's marketing strategy is on the superior performance and reliability of its PCDMs as well as on competitive pricing. The Company markets its PCDMs to both domestic and international providers of long distance telephone service. The Company attends telecommunications trade shows, maintains personal contact with telecommunications companies through its sales force of two employees and advertises in trade publications to increase its presence in the telecommunications industry. The Company's ability to generate additional revenues and earnings from the deployment of its PCDMs will depend upon continued market acceptance of PCDMs. The Company intends to expand its marketing presence with the retail grocers associations, convenience store operators associations, retail stores at both the corporate and store levels, and other types of corporate or association member entities to familiarize these groups with the Company's PCDM. These retailers are the distribution system for prepaid telephone calling cards, and management believes that increased exposure to PCDM retailers will be a significant factor in the Company's ability to expand the market for its PCDM products. To further increase the likelihood of receiving PCDM orders from sellers of prepaid telephone calling cards, the Company intends to offer additional and more flexible financing alternatives. CONTRACTS ITVMs General. The Company's lottery contracts typically are entered into following a competitive bidding process. Once a lottery has determined to utilize ITVMs in its distribution network, the lottery usually will request proposals from ITVM providers. Lotteries within the United States typically follow a procedure whereby the lottery issues a Request for Proposal ("RFP") to determine the contract award for installation of ITVMs. The RFP generally seeks information concerning each company's products, cost of the products or services to be provided, quality of management, experience in the industry and other factors that the lottery may deem material to a contract award. The RFP also may specify product criteria and other qualifications or conditions that must be satisfied, such as UL((R)) listing and FCC approval of the ITVM and in-state or minority supplier requirements. -9- 10 Generally, an evaluation committee comprised of key lottery staff members appraises the proposals based on an established point system, and the contract is awarded to the company with the most points. The nature of the RFP process varies from jurisdiction to jurisdiction. The length of time that a lottery might take to award a contract can be difficult to predict, and delays in the contract award process are frequent and unpredictable. Additionally, the point system or the weighing of the various points varies from jurisdiction to jurisdiction, which often makes it difficult for the bidding companies to determine the relative importance of the various factors to be considered by the evaluation committee. In certain cases the contract award is challenged by the losing bidder, which can result in protracted legal proceedings for all parties. The Company offers lotteries a choice of three types of contracts: (i) Standard Lease Agreements, (ii) Sales Agreements, and (iii) Percentage Lease Agreements. ITVM lease revenues as a percentage of the Company's total revenues were 63.3%, 67.3% and 57.9% in 1996, 1997 and 1998, respectively. The Standard Lease Agreements provide that the lottery will pay a fixed monthly price per machine for a specific period of time. These agreements typically specify a number of years for the initial contract term with additional option periods at the election of the lottery. The lottery may award a separate service contract for the maintenance of the machines, incorporate the cost of service into the established monthly lease price or perform machine service themselves. The lotteries also may select a similar type of arrangement as described above to procure the necessary supply of replacement parts for the ITVMs. As noted above, the lease payments provided for in the typical Standard Lease Agreement are fixed in most cases during the term of the agreement, and these agreements typically permit the lottery to order additional ITVMs at any time during the lease term. If the lottery orders a significant number of ITVMs near the end of the lease term, the Company would have to incur significant manufacturing costs but may receive lease payments for only a relatively short period of time through the remainder of the lease term. However, the Company believes that it is more likely that the lottery would elect to extend the lease term rather than return the ITVMs after only a short period of use. Additionally, the Company is unable to pass along to the lottery any increases in its manufacturing and service costs during the term of the typical Standard Lease Agreement. In the case of a Standard Lease Agreement which provides for a short initial term (such as one year) with an option for the lottery to extend the lease term for additional one-year periods, if the lottery does not extend the initial lease term, the Company might incur a loss on the manufacture of the ITVMs leased to the lottery under the initial lease agreement. Sales Agreements typically provide that the lottery will buy a certain number of ITVMs over a specific period of time. Under the Sales Agreement, the lottery generally pays for the ITVMs when delivered and has complete ownership of the ITVMs. The lottery usually will contract with a vendor to maintain and service the ITVMs, although some lotteries provide the maintenance and service with their own service staffs. The lottery generally will enter into a parts replacement contract with the vendor for replacement parts. All types of the ITVM contracts typically contain stringent installation, performance and maintenance requirements. Failure to perform the contract requirements may result in significant liquidated damages or contract termination. The Company has various contract performance standards to which it must adhere. To date, the Company has satisfied all of its contractual installation, performance and maintenance requirements and therefore has not had any contracts terminated by any lotteries. The Company's lottery contracts also typically require the Company to indemnify the lottery, its officers and retailers for any liabilities arising from the operation of the ITVMs or any services provided by the Company. The Company typically is required to obtain liability insurance, fidelity insurance and performance and litigation bonds to protect itself and the lottery from potential liability. No such indemnification or insurance claims have ever been asserted against the Company. The Company's contracts generally have an initial term of one to five years with options to extend the duration of the contracts for periods between one and five years. The option extensions generally are at the -10- 11 lottery's discretion and are exercised under the same terms and conditions as the original contract. As of December 31, 1998, the initial term of five of the Company's contracts had expired, and in each case, the lottery exercised its option to extend the term. The Company's contracts with lotteries, like most other types of state contracts, typically permit a lottery to terminate the contract upon 30 days written notice for any reason. Upon termination of a lease contract, the lottery would return the leased equipment to the Company. It is uncertain, however, whether the Company would be able to re-lease or sell any ITVMs that may be returned to the Company following the expiration or cancellation of a lease. To date, no lottery has terminated its contract with the Company. Upon termination of a contract, the lottery may award new contracts through a competitive bid process. As noted above, the Company believes that 31 states and the District of Columbia utilize ITVMs in some manner as part of their instant ticket distribution system. The Company's ITVMs have been deployed in 23 of those states as well as seven international jurisdictions, and four additional states and five international jurisdictions currently are testing the Company's ITVMs or have requested that the Company provide ITVMs for testing. Set forth below is certain information regarding the Company's contract status and the number of Company ITVMs sold or leased in each of these jurisdictions as of December 31, 1998. All of the Company's existing contracts, except for the contract with the Maryland Lottery, have provisions that allow the lotteries to order additional ITVMs in the future.
NO. OF ITVMS STATE STATUS OF CONTRACT AWARD TYPE OF CONTRACT SOLD OR LEASED ----- ------------------------ ---------------- -------------- Arizona Awarded in October 1993; renewed through Standard Lease/ 221 June 1999. Maintenance Colorado Awarded in June 1996; renewed through June Standard Lease/ 484 2000. Maintenance District of Columbia Awarded December 1997; renewed through Standard Lease 8 December 2000. Florida Awarded September 1996; renewed through June Standard Lease/ 734 2000. Maintenance Georgia (1) Awarded in May 1993; renewed through May Standard Lease/ 500 2003. Maintenance Idaho Purchases made by purchase orders in May and Sales 185 August 1995, August 1996 and August 1997. Indiana Awarded in July 1995; expired in October Standard Lease 700 1997, with two one-year renewals at the option of the lottery; both renewal options have been exercised. Iowa Awarded in August 1994; expired in December Standard Lease/ 531 1998, with two one-year renewals at the Maintenance option of the lottery; both renewal options have been exercised through December 2000.
-11- 12 Kansas Awarded July 1997; expired July 1998 with Standard Lease/ 74 five one-year renewals at the option of the Maintenance lottery; renewed through July 1999. Kentucky Purchased in June 1991. Sales 912 Maine Awarded in July 1995; expired in July 1998, Standard Lease/ 198 with two one-year extensions at the Maintenance lottery's option; renewed through July 1999. Maryland Awarded in September 1993; expired in Sales/Maintenance 301 September 1998; additional contract awarded that expires June 2003 Minnesota Awarded in December 1996; expires three Standard Lease/ 10 years from acceptance of each ITVM, with two Maintenance one-year renewals at the option of the lottery New Hampshire Awarded in August 1994; renewed through June Standard Lease 250 2000 New Jersey (2) Purchase order received in December 1996 Sales 200 New Mexico Awarded May 1997; expires May 2002, with Standard Lease 200 five one-year renewals at the option of the lottery New York (3) Awards of purchase contracts made in May Sales/Maintenance/ 3,139 1992 and January 1993; deployment completed Standard Lease in June 1992 and February 1993, respectively; initial one-year purchase and three-year maintenance contract entered into in March 1995, with a one-year renewal option by the lottery; initial five-year lease contract awarded in January 1997 for up to 1,000 units, with a one-year renewal option as mutually agreed Ohio Awarded in January 1992; extended in June Standard Lease/ 1,681 1993 and June 1995; expired in June 1997; Maintenance new contract awarded April 1997; extended through June 1999, with two two-year extensions at the option of the lottery Oregon Purchase orders issued in May 1995 and Sales 520 January 1997 Rhode Island (4) Awarded in June 1994; renewed through June Standard Lease/ 170 1999 Maintenance
-12- 13 Texas Awarded in January 1995; renewed through Standard Lease/ 1,466 February 1999; leased on month-to-month Maintenance basis pending award of new contract. Washington Awarded in December 1998; expires in Standard Lease/ 136 December 2002, with two one year renewal Maintenance options. West Virginia (3) Awarded in May 1992; initial deployment Sales 55 completed in June 1992; additional units deployed in April 1994 Barcelona, Spain (5) Awarded in February 1994; additional units Standard Lease 11 deployed in October 1995 Brazil Purchase orders received in October 1996 and Sales 104 October 1998. Denmark Purchase order received in April 1998 Sales 100 Iceland Purchase orders issued in January and Sales 31 October 1997 Israel Purchase order issued in July 1997 Sales 40 Quebec Purchase order received in June 1998 Sales 50 Western Australia Purchase order received in May 1995 Sales 8 Total Sold or Leased 13,019 ======
- ------------------------- (1) The Company's contract is for the lease of ITVMs to Scientific Games, Inc., the primary contractor for the Georgia Lottery. In September 1994, the Company and Scientific Games, Inc. agreed to convert the contract from a Percentage Lease Agreement to a Standard Lease Agreement. (2) The Company's contract is for the sale of 200 ITVMs to GTECH Corporation for use by the New Jersey Lottery, which were delivered in 1997. (3) The Company's contract was for the sale of ITVMs to Scientific Games, Inc. for use by the New York and West Virginia Lotteries. The Company is not the sole manufacturer of ITVMs for the New York Lottery. The Company entered into a sales/maintenance contract in March 1995 directly with the New York Lottery, including maintenance of ITVMs previously provided. (4) Effective October 1, 1995, the Company and the Rhode Island Lottery agreed to convert the contract from a Percentage Lease Agreement to a Standard Lease Agreement. (5) The Company's contract is with Entitat Autonomas, which provides lottery services to various Spanish lotteries. * * * * * -13- 14 Substantially all of the Company's revenues are derived from its contracts with a limited number of state lottery authorities or their representatives for the lease, sale or service of ITVMs. In particular, during 1998, the Company's contract with the New York Lottery accounted for 24% of the Company's revenues, and contracts with the Texas Lottery and the Ohio Lottery accounted for 16% and 14% of the Company's revenues, respectively. PCDMs Unlike the competitive bidding process applicable to the lotteries' awards of ITVM contracts, purchasers of PCDMs typically do not issue RFPs or otherwise mandate a competitive bidding process. Information regarding the Company and its PCDM, and information regarding a telephone company's product needs and criteria and other qualifications or conditions that must be satisfied, typically is exchanged on a less formal basis in sales presentations and subsequent meetings between representatives of the Company and representatives of the telephone company. Due to the often complex and highly structured organization of some telephone companies, the length of time that a company might take to decide whether to select the Company's PCDM can be difficult to predict and, similar to the lotteries' contract award process, delays in PCDM selection decisions can be frequent and unpredictable. Unlike the Company's experience in the ITVM industry in which a lottery typically enters into a lease or sales contract with the successful bidder, most purchasers of the Company's PCDMs to date have ordered PCDMs solely through purchase orders rather than contracts, although several customers entered into a lease agreement for PCDMs. Like contracts with the lotteries, however, these purchase orders may contain stringent installation, performance and service requirements. As of December 31, 1998, the Company had sold 756 PCDMs and had 95 PCDMs under lease. MANUFACTURING PROCESS The manufacturing process consists of purchasing component parts, assembling the ITVMs and PCDMs and then testing the final products. Generally, the Company's machines use components which are built to Company specifications and are available from multiple sources. The Company has a strict policy of product procurement that emphasizes quality, satisfactory inventory of raw materials, and cost. The Company has a primary vendor and secondary suppliers for most of its components, and the Company typically has been able to obtain adequate supplies of required components on a timely basis from its suppliers or, when necessary, from alternative sources of supply. However, certain important components, such as components of the Company's ITVM burster, PTVM dispensing mechanism and PCDM dispensing mechanism currently are purchased from a single source. The purchase of components from single-source suppliers subjects the Company to certain risks, including the continued availability of suppliers, price increases, potential quality assurance problems and lead time considerations. Because other suppliers exist that can duplicate these components should the Company elect or be forced to use a different supplier, the Company does not believe that any such change in suppliers would result in the termination of a production contract. However, the Company could experience a delay of 30 to 60 days in the production of machines should it elect or be forced to use other suppliers for these components. Such a delay adversely could affect the Company's ability to make timely deliveries of machines and to obtain new contracts. The single-source supplier of certain components of the Company's burster mechanism, PTVM dispensing mechanism and PCDM dispensing mechanism is Algonquin Industries, Inc. Kazmier J. Kasper, a director of the Company, is the President and owner of Algonquin Industries. See "Item 13. Certain Relationships and Related Transactions. " The Company assembles the components utilizing a core group of manufacturing employees and, on an as-needed basis, contracting with employment agencies for appropriately trained manufacturing labor. The use of temporary, contract manufacturing labor gives the Company the flexibility to meet the production schedules required by large orders. -14- 15 The Company's Quality Control Department has responsibility for measuring quality levels and overseeing appropriate corrective action in all areas of the business. This includes supplier performance, in-house manufacturing and field performance. The Quality Control Department is responsible for measuring part, operator and assembly quality performance at all stages of the production process, stopping the assembly line or stopping shipments if necessary to assure that quality standards are met. The Quality Control Department also is responsible for measuring vendor product quality and taking appropriate actions, including rejection and disposition of substandard material. The Quality Control Department also is responsible for vendor quality system evaluation and vendor disqualification if necessary to ensure superior product quality. The Company's manufacturing facility is located in Cincinnati, Ohio and has the capacity to produce and provide inventory for approximately 300 machines per week. The Company believes that this facility is suitable and adequate for its current and anticipated manufacturing needs at the present time. RESEARCH AND NEW PRODUCT DEVELOPMENT Since its inception, the Company has developed many of the technological advancements used in the ITVM industry. The Company believes that its ITVM was the first to obtain UL((R)) listing and FCC approval. The Company also believes that it was the first to (i) manufacture and deliver ITVMs under a lease contract agreement, (ii) offer a "random play" push button selector option through which the ITVM rather than the player randomly selects the game to be played and (iii) receive patent protection for the technology used in its ITVM burster dispensing mechanism. The Company currently employs two engineers and four technicians for research and development but currently subcontracts the majority of its research and development projects to independent contractors to reduce costs. The Company's copyrighted software is upgraded continually to meet the different demands of the various lotteries. In many instances, after an ITVM feature has been developed for a specific lottery, it is incorporated into the product line as a standard feature of the machine. The Company retains proprietary rights in all such developments. The Company's ITVM may be purchased with an optional modem communication system which allows lotteries to gather sales data from each ITVM on an hourly, daily, weekly or monthly basis, depending on the needs of the customer. This data includes the daily or weekly sales totals and breakdown of these totals by game, including the total tickets sold. The Company has developed software to enable each ITVM equipped with the system to communicate to the host system automatically if there is a malfunction with the ITVM, thus greatly enhancing the Company's ability to provide prompt service for the ITVM. The Company has developed software to enable an ITVM equipped with the system to communicate with the host computer if a ticket bin is empty, which allows the lottery to call the retailer or agent and inform them of the situation. Additionally, by utilizing this system with the optional BETA BRITE((R)) message display, the lottery can change the message display on any or all of its ITVMs. The Company has incorporated its patented pull-tab lottery ticket dispensing mechanism into a combination ITVM which also contains the Company's patented burster mechanism. The Company currently has approximately 30 combination ITVMs under lease to two state lotteries. The pull-tab dispensing mechanism also has been incorporated into the Company's PCDMs, and the Company believes that the ability of the mechanism to dispense a variety of thicknesses of prepaid telephone calling cards significantly differentiates the Company's PCDMs from those of its competitors. The Company has developed the MVP to address the specific needs of convenience store and grocery check-out lanes. The MVP may be installed in a variety of configurations including under-the-counter. This new technology reduces ticket shrinkage and increases sales volume of instant tickets and may also be tied into the Point of Service register. -15- 16 In an effort to expand its product lines into new markets, the Company has developed a device which dispenses stored value "smart cards." This product will be marketed in the future to the financial services industry to the extent that consumer use of smart cards develops in the future. Research and development expenditures were $665,449, $545,039 and $618,819 for 1996, 1997 and 1998, respectively. The Company expects that its research and development efforts for the foreseeable future will be conducted by both Company employees and independent contractors. CUSTOMER SERVICE AND PRODUCT REPAIR Typically, the Company or its subcontractors install and service the machines purchased or leased by the Company's customers. The Company also provides maintenance of the ITVMs leased or sold to certain lotteries. Additionally, the Company provides part replacement, repair and technical services for various customers that have leased or purchased the Company's ITVMs and PCDMs. Service is provided to the retailers by the Company's staff of trained service technicians and dispatchers after a customer's representative informs the Company of the problem via the Company's toll-free telephone service line. The service dispatcher either resolves the matter over the telephone or immediately dispatches one of the Company's service technicians to the machine's location. The modular design and manufacturing standards of the Company's machines enable the Company to conduct any necessary repairs and maintenance quickly and efficiently. The Company estimates that the meantime for all repairs is less than 15 minutes after the Company's service technician arrives at the machine's location. The Company believes, based on actual data collected from various customers that have installed the Company's ITVMs and PCDMs, that the Company's machines have experienced substantially fewer mechanical problems and machine failures than machines currently sold by other industry participants. The Company also believes that the superior performance of its ITVMs and PCDMs will assist in the increased acceptance of these products among lotteries and providers of long distance telephone service. The Company generally grants a 360-day repair or replacement warranty covering all parts and components of its machines. However, the warranty period may vary depending on the bid specifications. In certain circumstances, the Company may warrant the product for the complete life of the contract. In these instances, the contract generally will be a lease with the Company retaining ownership of the machine. Provisions for estimated warranty costs are recorded at the time of sale and are periodically adjusted to reflect actual experience. See Note 1 of Notes to Financial Statements contained in the Company's 1998 Annual Report, which is filed as Exhibit 13 to this report. PATENTS, TRADEMARKS AND COPYRIGHTS The Company currently has five U.S. patents and one pending patent application relating to its ITVMs and has filed a disclosure document with the United States Patent and Trademark Office ("PTO"), all as described below. The Company owns by assignment U.S. Patent No. 4,982,337 entitled "System for Distributing Lottery Tickets." The assignment is recorded at the PTO. This patent is for the Company's burster technology, which is the key component of the Company's ITVM. The patent expires no later than December 31, 2007. The Company believes this patent is essential to the Company's business. Additionally, the Company has developed improvements to the burster technology disclosed in this patent and the patent application on those improvements has issued as U.S. Patent No. 5,836,498. The improved burster provides for an increased range of operation for reliable and effective separation of the adjacent tickets along the lines of weakness. Additionally, foreign patent applications are pending on these improvements. The Company has developed a new system designed specifically for retail sale of lottery tickets and other items at the retail point of sale. The system utilizes the Company's burster technology and includes other modular -16- 17 and distributed components that can be adapted for use at the point of sale. The Company has a pending patent application at the PTO on this technology as well as corresponding foreign pending patent applications. The Company was issued U.S. Patent No. 5,330,185 on July 19, 1994 for the "Method and Apparatus for Random Play of Lottery Games." This patent expires no later than March 30, 2013 and has been assigned to the Company, and the assignment is recorded at the PTO. The technology disclosed in this patent allows a lottery game user to select a random play button as opposed to selecting a specific game of a multiple-game ITVM. Once the random play button is pressed, the ITVM selects the game to be played based upon a random number generation algorithm, thereby adding another element of chance to the lottery ticket purchase. The Company believes that this patent gives the Company a competitive advantage over other manufacturers that do not have ITVMs with similar capabilities. The patent for the random play feature is considered important but not essential to the Company's business. The Company was issued U.S. Patent No. 5,472,247 on December 5, 1995, for a "Multi-Point High Security Locking Mechanism for Lottery Machines." This patent expires no later than July 18, 2014 and has been assigned to the Company, and the assignment is recorded at the PTO. Because of the threat of break-in and theft of cash and lottery tickets contained within the ITVMs, the machines must be secured against unauthorized break-in or theft. The technology disclosed in this patent is a locking mechanism which provides a number of resistance points, all of which function to impede the unauthorized opening of a door located on the chassis of the Company's ITVM. The patent for the multi-point, high security locking mechanism is considered important but not essential to the Company's business. The Company was issued U.S. Design Patent No. 376,621 on December 17, 1996 for the Company's double-game countertop ITVM. This patent expires no later than December 17, 2010 and has been assigned to the Company, and the assignment is recorded at the PTO. The Company believes that this patent is important but not essential to the Company's business. The Company has submitted an Information Disclosure Document to the PTO for the purpose of identifying technology relating to its "Software Release Control and Data Security for ITVMs." The technology allows secure remote transmissions of software updates and operations data between the ITVM and the Company or the respective lottery. The invention also includes a key management system to control the keys used to encrypt data sent to and decrypt the data received at the ITVM. The Disclosure Document was filed on April 28, 1993. The dispensing technology used in the Company's PTVM and PCDM was developed by Algonquin Industries, Inc. and is licensed to the Company pursuant to an exclusive license agreement with Algonquin Industries. Algonquin Industries has been granted six U.S. Patents and one is pending for these mechanisms. Under the terms of the license agreement, the Company is the sole entity entitled to use this technology on its ITVMs. See "Item 13. Certain Relationships and Related Transactions." The Company currently uses operating software to perform all functions required to dispense and account for instant lottery tickets and prepaid telephone calling cards. This software is a stand-alone program which does not require any other software to operate. The software is designed to allow updates to be made quickly and inexpensively. The software was designed by Future Designs, a subcontractor to the Company, and employees of the Company. Future Designs has assigned all of its right, title and interest in and to the software to the Company. The Company intends to continue to develop software using both employees and subcontractors who agree to assign the copyright to developed software to the Company. The Company has obtained federal registration in the United States of the following trademarks: INTERLOTT, INTERLOTT and design, and INSTANT SUCCESS. The Company also has obtained registration of the trademark INTERLOTT in international class 9 on June 21, 1994. This registration will remain in force for ten years. The Company does not deem the trademarks to be critical to the future of its business. -17- 18 The Company enforces a policy requiring all of its employees and subcontractors to execute confidentiality and proprietary rights agreements at the commencement of their employment or contract for service with the Company. The agreements generally provide that all inventions or discoveries and all confidential information developed or made known to the employees or subcontractors during the term of their employment or contract for service will be assigned to the Company and will be kept confidential and not disclosed to third parties. COMPETITION Competition in the markets for the Company's ITVM and PCDM is based on a number of factors, including technological features, product quality and reliability, price, compatibility, ease of installation and use, marketing and distribution capabilities, product delivery time, and service and support. The Company is aware of four manufacturers of ITVMs and approximately four manufacturers of PCDMs in the United States, and competition among these manufacturers is intense. Of the four ITVM competitors, the Company has the largest share of the ITVM market in the United States. The Company is not aware of any published data regarding market shares in the PCDM industry, but the Company does not believe that it has the largest market share in the PCDM industry. In addition, the ITVM and PCDM markets are relatively new markets that have grown rapidly, and additional domestic and international manufacturers, some of which have substantially greater resources and experience than the Company, may elect to enter these markets. The instant ticket market also may face competition from other types of lottery and gaming products, including particularly on-line lottery products. The long distance telephone market similarly may face competition from other types of communications products, including facsimile, e-mail and other on-line products. The Company believes that its patented dispensing technologies make its ITVM and PCDM dispensing mechanisms technologically superior to the dispensing mechanisms of its competitors and that this is a significant competitive advantage for the Company. The Company also believes that its products have earned a strong reputation for their performance, reliability and cost effectiveness. To remain competitive, the Company believes that it will need to continue to incorporate new technological developments into its existing products and to develop new products, as well as to maintain a competitive price for its products. These efforts, together with the Company's continuing sales and marketing efforts, will be critical to the Company's future success. Although the Company believes that its current successes, coupled with its history of continued product enhancement and cost reduction, will enable it to compete favorably with its competitors, there can be no assurance that the Company will be able to maintain or improve its competitive position in the ITVM and PCDM markets. GOVERNMENT REGULATION ITVMs Lotteries are not permitted in the various states and jurisdictions of the United States unless expressly authorized by legislation in the subject jurisdiction. Similarly, the commencement of ITVM sales and leasing in new jurisdictions requires authorizing legislation and implementing regulations at the state level. The Company cannot predict the nature of the regulatory process in any jurisdiction that may authorize the purchase and lease of ITVMs in the future. Any such regulatory process may be burdensome to the Company or its key personnel and stockholders and could include requirements that the Company would be unable to satisfy. Currently, 37 states and the District of Columbia have enacted legislation to allow for the operation of a lottery, and 31 of these jurisdictions utilize ITVMs in some manner as part of their instant ticket distribution process. The operation of the lotteries in each of these jurisdictions is strictly regulated. The formal rules and regulations governing lotteries vary from jurisdiction to jurisdiction but typically authorize the lottery, create the governing authority, dictate the price structure, establish allocation of revenues, determine the type of games permitted, detail appropriate marketing structures, specify procedures for selecting vendors and define the qualifications of lottery personnel. No assurance can be given that there will not be an adverse change in the -18- 19 lottery laws of any jurisdiction in which the Company does business. Although the Company believes that it is unlikely that states which have enacted legislation that expressly authorize the use of ITVMs will adopt legislation in the foreseeable future that prohibits the use of ITVMs, there can be no assurance that such legislation will not be adopted in one or more jurisdictions in the foreseeable future. To ensure the integrity of the lottery, state laws provide for extensive background investigations of each of the lottery's vendors and their affiliates, subcontractors, officers, directors, employees and principal stockholders. These investigations generally require detailed disclosure on a continuous basis with respect to the vendors, affiliates, subcontractors, officers, directors, employees and principal shareholders and, in the event the lottery deems any of such persons to be unsuitable, the lottery may require the termination of such persons. The failure of any such persons associated with the Company to obtain or retain approval in any jurisdiction could have a material adverse effect on the Company. Generally, regulatory authorities have broad discretion when granting such approvals. Although the Company has never been disqualified from a lottery contract as a result of a failure to obtain any such approvals, no assurance can be given that such approvals will be obtained or retained in the future. The Federal Gambling Devices Act of 1962 (the "Act") makes it unlawful, with certain exceptions, for a person or entity to transport any gambling devices across interstate lines unless that person or entity has first registered with the United States Department of Justice. Although the Company believes that it is not required to register under such Act, the Company has voluntarily registered under the Act and intends to renew its registration annually. The Act also imposes various record keeping and equipment identification requirements. Violation of the Act may result in seizure or forfeiture of equipment, as well as other penalties. The Company may retain governmental affairs representatives in various jurisdictions of the United States to monitor legislation, advise the Company on contract proposals, and assist with other issues that may affect the Company. The Company believes it has complied with all applicable state regulatory provisions relative to disclosure concerning the activities of itself and its advisors. The Company is not dependent on any such representative for any material contract. International jurisdictions that operate lotteries also impose strict regulations. International regulations may vary from those in the United States. Additionally, international regulations frequently impose restrictions on international corporations doing business within the specific jurisdiction. As a result, the Company may contract with local representation or align itself with a local partner when pursuing international contracts. Laws and regulations of individual states and countries are subject to change. The failure to comply with such laws and regulations could have an adverse impact on the operations of the Company. PCDMs The Company is not aware of any federal, state or local regulations that apply to the manufacture, lease or sale of PCDMs. BACKLOG The Company's backlog of ITVMs committed for production as of December 31, 1998 was approximately $5,640,000, which was equal to the total base lease payments or sales value for the 897 ITVMs that were committed for production but had not been shipped to the Washington Lottery as of December 31, 1998. At December 31, 1997, the backlog of ITVMs committed for production was approximately $4,250,000, which was equal to the total base lease payments or sales value for the 847 ITVMs that were committed for production but had not been shipped to the Maryland and Ohio Lotteries as of December 31, 1997. See "Lottery Contracts." It is anticipated that substantially all of the Company's backlog at December 31, 1998 will be shipped on or before June 30, 1999. The Company had no backlog of PCDMs committed for production at December 31, 1998. -19- 20 The Company has entered into various lease or sales agreements that permit the lotteries, at their sole option, to lease or purchase up to a total of 2,500 additional ITVMs as of December 31, 1998. However, the Company does not include these additional ITVMs in backlog ITVMs that may be sold or leased under existing contracts unless the Company has received a firm order for the ITVMs. Due to the relatively large size of individual orders, the small number of customers and the long sales cycle of the lottery industry, management considers backlog to be an indicator of current activity and not necessarily predictive of future orders. EMPLOYEES The Company utilizes a work force of full-time employees supported from time to time by temporary or contract manufacturing and engineering personnel. As of December 31, 1998, the Company had 194 full-time employees, of which 78 were manufacturing employees, 7 were engineering employees, 84 were service employees, 15 were clerical and administrative employees and 10 were executives or senior managers. Two of the executives and senior managers were devoted to sales and 8 were devoted to management and administration. The Company intends to increase sales and marketing personnel during 1999 through the addition of one employee, to increase engineering personnel through the addition of one employee and to increase management and administrative personnel through the addition of two employees. No Company employees are represented by any union, and the Company believes that its relations with its employees are good. ITEM 2. PROPERTIES The Company's executive offices are located in approximately 11,750 square feet of leased space in Cincinnati, Ohio. This facility houses the Company's executive, administrative, sales, engineering and service personnel. The lease for this facility expires on December 31, 1999. The Company's manufacturing and distribution facilities are in a facility containing approximately 35,000 square feet of leased space located a very short distance from the Company's executive offices. The facility is comprised of approximately 5,000 square feet of office space and approximately 30,000 square feet of manufacturing space with the capacity to produce and provide inventory for approximately 300 machines per week. The lease for this facility also expires on December 31, 1999. The Company believes that these two facilities are suitable for and adequate to support its operations for the foreseeable future. The Company also leases approximately 1,000 square feet of warehouse and office space in Alpharetta, Georgia for the purpose of storing and repairing ITVMs used in connection with the Georgia Lottery. Scientific Games, Inc. provides this space to the Company at no cost under the terms of the Company's contract with Scientific Games. The lease has been renewed through May 2003. See "Item 1. Business -- Contracts -- ITVMs." The Company believes that this facility is suitable for and adequate to support its operations for the Georgia Lottery. ITEM 3. LEGAL PROCEEDINGS In January 1996, the Company filed a lawsuit in the United States District Court for the Southern District of Ohio against Lottery Enterprises, Inc. ("LEI, " now known as On-Point Technology Systems, Inc.) to collect sums that the Company alleged were owed to it under an Agreement in Principle dated March 23, 1995, relating to the Company's potential acquisition of LEI by merger (the "Transaction"). The parties did not consummate the Transaction. The Agreement in Principle required LEI to reimburse the Company's reasonable out-of-pocket expenses incurred in connection with the Transaction in the event the parties failed to execute a definitive merger agreement within 120 days of March 23, 1995, and the primary reason that the parties did not execute a definitive merger agreement was other than a breach of the Agreement in Principle by the Company. The Agreement in Principle also required LEI to pay the Company a "break-up fee" in the event that, within one year after the termination or abandonment of the Transaction by LEI, LEI entered into a binding commitment to engage in a -20- 21 recapitalization, debt issuance or working capital financing other than in the ordinary course of business, and the primary reason for the termination or abandonment of the Transaction was other than termination or breach of the Agreement in Principle by the Company. The Company sought reimbursement of approximately $241,000 in out-of-pocket expenses and a break-up fee exceeding $988,000. LEI denied any liability to the Company and also asserted counterclaims against the Company for unfair competition and tortious interference seeking unspecified money damages exceeding $500,000. LEI claimed that the Company had competed unfairly with LEI and had wrongfully interfered with LEI's business by misrepresenting Lei's financial condition to the Pennsylvania state lottery agency and by utilizing information about LEI received during the due diligence conducted in connection with the Transaction. LEI also claimed that it was entitled to recover from the Company unspecified costs and expenses that it incurred in connection with the Transaction and sought a declaration from the Court that it was not obligated to pay the Company a break-up fee under the Agreement in Principle. In 1997, the Court ruled that the Company was entitled to summary judgement in its favor on LEI's counterclaims for unfair competition and tortious interference. The Court also ruled that within one year after the Transaction was abandoned or terminated, LEI did enter into a recapitalization, debt issuance or working capital financing other than in the ordinary course of business. The Court left open the question whether LEI had abandoned or terminated the Transaction (as opposed to the Company), and the question of whether LEI was obligated to reimburse the Company's out-of-pocket expenses incurred in connection with the Transaction, both of which were to be determined at trial. On March 4, 1999, the Company and LEI entered into a confidential settlement agreement that resolved all claims asserted in the lawsuit on satisfactory terms. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted by the Company to a vote of its stockholders during the fourth quarter ended December 31, 1998. ITEM 4(A). EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below, in accordance with General Instruction G(3) to Form 10-K and Instruction 3 to Item 401(b) of Regulation S-K, is certain information regarding the executive officers of the Company. L. Rogers Wells, Jr., age 61, is Chairman of the Board and Chief Executive Officer of the Company and has been the principal stockholder of the Company since purchasing 80% of the Common Stock of the Company in September 1992. Mr. Wells served as a director of the Company from 1992, and as Chairman of the Board and Chief Executive Officer of the Company from 1993, until his resignation from these positions in October 1994. He was re-elected to these positions in February 1995. In addition, Mr. Wells owns American Materials, Incorporated, which assembles and distributes automobile and truck components and serves as a regional warehousing and distribution center for various businesses. Mr. Wells also owns International Investments, Inc. which invests in and provides financing to various businesses, including the Company. See "Item 13. Certain Relationships and Related Transactions." Mr. Wells has been active in various other industries, including manufacturing, mining, explosives and banking. From 1987 through 1991, Mr. Wells served as Secretary of Finance and Administration for the Commonwealth of Kentucky, and from 1989 through 1991 served as Secretary to the Governor's Executive Cabinet. During his tenure as Secretary of Finance and Administration, Mr. Wells served as Chairman of various finance and development authorities, including the Kentucky Rural Economic Development Authority, the Kentucky Infrastructure Authority and the Kentucky Housing Corporation. Edmund F. Turek, age 72, was Vice Chairman of the Board of Directors of the Company from May 1997 through February 1999 and has been a director of the Company since 1990. Mr. Turek served as Chairman of the Board, President and Chief Executive Officer of the Company from February 1990 to September 1992 and -21- 22 continued to serve as President of the Company until May 1997, when he was appointed Vice Chairman of the Company. Mr. Turek became a consultant to the Company in February 1999. See Item 13. "Certain Relationships and Related Transactions." Mr. Turek began to develop the Company's ITVM in 1987 and has guided the product through six generations to the current model. Mr. Turek was Vice President of Peripheral Products in the computer division of SCI Systems, Inc. from 1984 to 1989 where he developed business opportunities in the commercial market for the design and manufacture of computer products. From 1953 to 1984, Mr. Turek held management, product development and operations positions with various companies in the computer and aerospace industries. David F. Nichols, age 37, has been President of the Company since May 1997 and was appointed a director in December 1997. Mr. Nichols served as Senior Vice President of Sales and Marketing of the Company from August 1994 to May 1997 and as Vice President-Operations of the Company from March 1993 until August 1994. From December 1991 to December 1992, he was Executive Director of the Board of Tax Appeals of the Commonwealth of Kentucky. From March 1990 to December 1991, he was Principal Assistant to the Secretary of Finance and Administration for the Commonwealth of Kentucky, and from March 1989 to March 1990, he was Principal Assistant to the Kentucky Office for Social Security. From June 1988 to December 1988, he was Deputy Director of the Kentucky Democratic Party. Thomas W. Stokes, age 35, has been Vice President of the Company since May 1997. Mr. Stokes served as Director of Operations from January 1996 to May 1997 and as Purchasing Manager from March 1993 to December 1995. From 1988 to 1992, he served as unit controller for a food management company. Dennis W. Blazer, age 51, has been Chief Financial Officer of the Company since July 1998. From December 1973 to July 1998, he served in various capacities for The Plastic Moldings Corporation, most recently as Vice President of Finance and Administration. Mr. Blazer previously served as an auditor and tax consultant with Ernst & Ernst, certified public accountants. Mr. Blazer is a certified public accountant. The executive officers of the Company are appointed by and serve at the discretion of the Board of Directors. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Information relating to the market for, holders of and dividends paid on the Company's Common Stock is set forth under the caption "Corporate Data and Shareholder Information" on the inside back cover page of the Company's 1998 Annual Report. Such information is incorporated herein by reference. The 1998 Annual Report is filed as Exhibit 13 to this report. ITEM 6. SELECTED FINANCIAL DATA Selected financial data for the Company for each year of the five-year period ended December 31, 1998 is set forth under the caption "Selected Financial Data" on page 7 of the 1998 Annual Report. Such financial data is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS A discussion of Interlott's financial condition and results of operations as of the dates and for the periods covered by the financial statements contained in the 1998 Annual Report is set forth under the caption "Management's Discussion and Analysis" on pages 7 through 9 of the 1998 Annual Report. Such discussion is incorporated herein by reference. -22- 23 The following risk factors apply to Interlott and its business: WE MAY EXPERIENCE FLUCTUATIONS IN OUR FINANCIAL RESULTS AND, AS A RESULT, OUR STOCK PRICE. In the past, we have experienced significant fluctuations in our financial results. Our revenues, capital expenditures and operating results can vary significantly due to: - our dependence on a small number of major customers; - relatively long sales cycles; - the unpredictable timing and amount of contracts awarded by state lotteries and telephone companies; o the extended time between the award of a contract and the receipt of revenues from the sale or lease of ITVMs and PCDMs; - changes in customer budgets; and - working capital required to manufacture ITVMs and PCDMs pursuant to new orders. These factors may make it difficult to forecast revenues and expenditures over extended periods. Consequently, our operating results for any period could be below the expectations of securities analysts and investors. This in turn could lead to sudden and sometimes dramatic declines in the market price of our stock. OUR GROWTH WILL DEPEND UPON CONTINUED MARKET ACCEPTANCE OF ITVMS AND PCDMS. Our ability to generate additional revenues and earnings will depend upon the continuation of existing leases of ITVMs and PCDMs, the distribution of ITVMs and PCDMs in additional states and international jurisdictions, the approval of lotteries in remaining states and international jurisdictions and increased future orders of ITVMs and PCDMs. The market for ITVMs has grown rapidly since first deployed to serve instant lotteries in 1991. As of December 31, 1998, 31 states, the District of Columbia and eight international jurisdictions used ITVMs as part of their instant ticket distribution system. We leased or sold ITVMs in 23 of those states and in seven international jurisdictions. Similarly, the use of PCDMs to distribute prepaid telephone calling cards has grown significantly in the last few years. We have marketed PCDMs since 1995, and as of December 31, 1998, we had sold or leased 851 PCDMs. However, the popularity of instant lottery games and prepaid telephone calling cards and the demand for ITVMs and PCDMs may not continue and, as a result, we may not be able to successfully market and sell our products. Although the total dollar amount of instant ticket sales continues to increase, the rate of increase has declined from 23.7% to 6.9% for the lottery industry's fiscal year ended June 30, 1992 through June 30, 1997. It is critical to our continued success that we develop relationships with additional lotteries and telephone companies and that additional states authorize instant lotteries. WE DEPEND ON LARGE CONTRACTS FROM A LIMITED NUMBER OF ITVM CUSTOMERS. We have traditionally derived a significant portion of our revenues from a limited number of state lottery authorities or their representatives for the lease, sale or service of ITVMs. In particular, during 1998, a contract with the New York Lottery accounted for 24% of our total revenues. Additionally, a contract with the Texas Lottery accounted for 16% of our machine lease revenues in 1998, and a contract with the Ohio Lottery generated 14% of our machine sale revenues in 1998. This can cause our revenues and earnings to fluctuate between quarters based on the timing of orders and realization of revenues from these orders. Further, none of our large customers has any obligation to lease or purchase additional machines from us. A loss of any of these large contracts could have a material adverse effect on our business, financial condition and results of operations. WE MAY NOT BE SUCCESSFUL IN PROTECTING OUR PROPRIETARY RIGHTS OR AVOIDING CLAIMS THAT WE INFRINGE THE PROPRIETARY RIGHTS OF OTHERS. We principally rely upon patent, copyright, trademark and trade secret laws, license agreements and employee nondisclosure agreements to protect our proprietary rights and technology. These laws and contractual provisions provide only limited protection. Our success depends largely on our burster technology that is protected -23- 24 by a patent that expires on December 31, 2007. Additionally, we have four other patents and one pending patent application with the United States Patent and Trademark Office. We also have an exclusive license agreement with Algonquin Industries, Inc. for use of their patented pull-tab instant ticket dispensing mechanism in our PTVM and PCDM. We cannot be certain that we and Algonquin have taken adequate steps to prevent misappropriation of the technology that we use or that competitors will not independently develop technologies that are substantially equivalent or superior to our technology. Moreover, we could incur substantial costs and diversion of management resources in the defense of any claims relating to the proprietary rights of others, which could have a material adverse effect on our business, financial condition and results of operations. WE MAY NOT BE ABLE TO ADAPT TO CHANGES IN TECHNOLOGY, PRODUCTS AND INDUSTRY STANDARDS. The instant ticket market, the ITVM market, the prepaid telephone calling card market and the PCDM market are characterized by rapidly changing technology and evolving industry practices. Competitors may introduce other types of lottery, gaming and prepaid telephone calling card products. To be successful, we must: - use leading technologies effectively; - continue developing our technical expertise; - enhance our existing products and services; and - develop new products and services. If we fail to do any of these things, our customers may choose to purchase products and services from our competitors. Our inability to anticipate changes in technology and industry practices and to develop and introduce new products and services in a timely manner would likely result in a material adverse effect on our business, financial condition and results of operation. THE STATE LOTTERIES CAN CANCEL THEIR CONTRACTS WITH US FOR ANY REASON AND CAN ASSESS SIGNIFICANT DAMAGES AGAINST US IF WE DO NOT SATISFACTORILY PERFORM THE CONTRACTS. Our contracts with lotteries, like most other types of state contracts, typically permit a lottery to terminate the contract upon 30 days written notice for any reason. We cannot assure you that we could re-lease or sell any ITVMs that may be returned to us by a lottery following the cancellation or expiration of a lease. These lottery contracts also impose demanding installation, performance and maintenance requirements. Our failure to perform the contract requirements could result in significant liquidated damages or contract termination. Our lottery contracts typically require us to indemnify the lottery, its officers and retailers for any liabilities arising from the operation of the ITVMs or any services that we provide. These provisions present an ongoing risk of significant damage assessments or contract terminations, which could have a material adverse effect on our business, financial condition and results of operation. A SINGLE STOCKHOLDER CONTROLS A MAJORITY OF OUR STOCK AND CAN EXERT SIGNIFICANT INFLUENCE OVER OUR CORPORATE MATTERS. As of December 31, 1998, Mr. L. Roger Wells, Jr. beneficially owned 51.6% of the outstanding common stock. As a result, Mr. Wells may be able to exert significant influence over the election of directors and the outcome of certain corporate actions requiring stockholder approval. This concentration of ownership in a single stockholder also can delay or prevent a change of control. OUR ITVM LEASE CONTRACTS MAY RESULT IN LOSSES. Our ITVM lease revenues as a percentage of our total revenues were 63.3% in 1996, 67.3% in 1997 and 57.9% in 1998. Our standard lease agreements provide for fixed lease payments during the term of the agreement and typically permit the lottery to order additional ITVMs at any time during the lease term. If a lottery orders a large number of ITVMs near the end of the lease term, we would incur significant manufacturing costs but may receive lease payments for only a relatively short period of time through the remainder of the lease term. -24- 25 Additionally, we are unable to pass along to the lottery any increases in manufacturing and service costs during the term of the lease agreement. Our standard lease agreements provide for a short initial term, such as one year, with an option for the lottery to extend the lease term for additional one-year periods. If the lottery does not extend the initial lease term, we might incur a loss on the manufacture of the ITVMs if we are unable to re-lease or sell the ITVM. THE ITVM AND PCDM MARKETS ARE VERY COMPETITIVE. The ITVM and PCDM markets are relatively new markets that have grown rapidly in recent years. We may not be able to compete successfully against current or future competitors, many of whom may have greater resources and experience than us. The instant ticket market also may face competition from other types of lottery and gaming products, particularly on-line lottery products. The long distance telephone market similarly may face competition from other types of communications products, including facsimile, e-mail and other on-line products. If the ability to provide ITVMs and PCDMs internationally becomes a competitive advantage in the instant ticket lottery and prepaid calling card industries, we will have to expand our presence internationally or risk a competitive disadvantage relative to our competitors. Increased competition could cause us to increase our selling and marketing expenses and research and development costs. We may not be able to offset the effects of any such increased costs through an increase in the number of lottery contracts and higher revenue from sales and leases of ITVMs and PCDMs, and we may not have the resources to compete successfully. These developments could have a material adverse effect on our business, financial condition and results of operation. BECAUSE WE DEPEND UPON SINGLE OR LIMITED SOURCE SUPPLIERS, WE COULD TEMPORARILY LOSE OUR SUPPLY OF SOME CRITICAL PARTS OR EXPERIENCE SIGNIFICANT PRICE INCREASES. We currently purchase certain important parts, such as components of our ITVM burster, PTVM dispensing mechanism and PCDM dispensing mechanism from a single source. The purchase of these components from outside suppliers on a sole source basis subjects us to certain risks, including the continued availability of suppliers, price increases and potential quality assurance problems. Because other suppliers exist that can duplicate these components should we elect or be forced to use a different supplier, we do not believe that any such change in suppliers would result in the termination of a production contract. However, we could experience a delay of 30 to 60 days in the production of ITVMs and PCDMs should we elect or be forced to use other suppliers. Any delay of more than 30 to 60 days could have a material adverse effect on our business, financial condition and results of operation. WE MAY NOT BE ABLE TO RETAIN OUR KEY EXECUTIVES AND RESEARCH AND DEVELOPMENT PERSONNEL. As a small company with only 194 employees, our success depends in large part on the continued service of our key management, sales, product development and operational personnel, including Mr. L. Rogers Wells, Jr., our Chairman and Chief Executive Officer, and David F. Nichols, our President. We do not currently have employment agreements with any of our employees. Our success also depends on our ability to attract and retain additional personnel with a variety of skills, especially engineering and marketing expertise. Our inability to hire and retain qualified personnel would likely have a material adverse effect on our current business, any new product development efforts and future business prospects. THE SUCCESS OF OUR INTERNATIONAL OPERATIONS IS SUBJECT TO MANY UNCERTAINTIES. In each of 1997 and 1998, our sales and leases of ITVMs and PCDMs outside the United States represented an immaterial percentage of our total revenues. However, we intend to increase our marketing activities in international jurisdictions, including expansion into several countries. Our ability to expand our business into international markets may be adversely affected by the following: - customizing our products for use in international countries; - longer accounts receivable payment cycles; -25- 26 - difficulties in managing international operations; - availability of trained personnel to install and implement our systems; - exchange rate fluctuations; - political instability; - tariffs and other trade barriers; - potentially adverse tax obligations; - restrictions on the repatriation of earnings; and - the burdens of complying with a wide variety of international laws and regulations. In addition, the laws of some countries do not protect our intellectual property rights to as great an extent as the laws of the United States. Such factors could have a material adverse effect on our international revenues and earnings and our overall financial performance. FAILURE TO ACHIEVE YEAR 2000 COMPLIANCE COULD NEGATIVELY AFFECT OUR BUSINESS. The Year 2000 issue is the result of potential problems with computer systems or any equipment with computer chips that store dates as two digits rather than four (e.g., "99" for 1999). On January 1, 2000, these systems and equipment may read "00" as the year 1900 instead of the year 2000. This problem could result in an interruption in, or failure of, certain of our normal business activities and operations. We have analyzed the Year 2000 issue with respect to the hardware and software we use to provide our products and services and our computerized information and operating systems. We do not believe that the costs necessary to resolve the known Year 2000 problems will be material to our operating results. If our projected timetable or cost estimates are incorrect, our business, financial condition and results of operation could be negatively affected. We are also discussing the Year 2000 issues with our significant customers, manufacturers and suppliers. If they are unprepared for Year 2000 problems, our business activities and operations could be negatively affected. We are not yet certain to what extent our significant customers, manufacturers and suppliers are Year 2000 compliant. If their systems are not timely converted or if their converted systems are not compatible with ours, we may experience a significant number of operational inconveniences and inefficiencies for us and our customers that may divert our time and attention and financial and human resources from our ordinary business activities. Any Year 2000 problems we have may result in a materially adverse affect on our business, financial condition and results of operation. OUR INDUSTRY IS SUBJECT TO SIGNIFICANT GOVERNMENT REGULATION WHICH COULD NEGATIVELY AFFECT US. State and local governments strictly regulate the operation of lotteries and the sales and leasing of ITVMs. Further, international jurisdictions that operate lotteries impose strict regulations which may vary from those in the United States. Any adverse change in the lottery laws of any jurisdiction in which we sell and lease ITVMs could impose burdensome requirements or requirements that we may be unable to satisfy. Our failure to comply with changing lottery-related laws and regulations could have a material adverse effect on our business, financial condition and results of operation. In addition, state laws provide for background investigations on each of the lottery's vendors and their affiliates, subcontractors, officers, directors, employees and principal stockholders. The failure of any of these parties associated with us to obtain or retain approval in any jurisdiction could have a material adverse effect on our business, financial condition and results of operation. FUTURE SALES OF OUR COMMON STOCK IN THE PUBLIC MARKET COULD ADVERSELY AFFECT OUR STOCK PRICE AND OUR ABILITY TO RAISE FUNDS IN NEW STOCK OFFERINGS. The market price of our common stock could drop as a result of sales of large numbers of shares in the market, or the perception that such sales could occur. This is particularly true due to our relatively small number of stockholders and the resulting low trading volume of our common stock in the public market. These factors also -26- 27 could make it more difficult for us to raise funds through future offerings. Our principal stockholder, Mr. L. Rogers Wells, Jr., owns a majority of our common stock. We have 3,210,000 shares of common stock outstanding. Approximately 1,400,800 of these shares are freely transferable without restriction or further registration under the Securities Act of 1933. The remaining 1,809,200 shares outstanding are held by our executive officers and directors and will become eligible for sale in the future without registration under the Securities Act at such times and in such amounts as permitted by Securities and Exchange Commission Rule 144 or an exemption under the Securities Act. In addition, we have registered under the Securities Act 320,000 shares of common stock issuable under our two stock incentive plans. OUR FORWARD LOOKING STATEMENTS MAY BE INCORRECT. Some of the statements in this report and in our 1998 Annual Report are forward looking statements about what may happen in the future. They include statements regarding our current beliefs, plans, expectations and assumptions about matters such as our expected financial position and operating results, our business strategy and our financing plans. These statements can sometimes be identified by our use of forward looking words such as "anticipate," "believe," "estimate," "expect," "intend," "plan," "seek," "should" and similar expressions. Our forward looking statements are subject to numerous risks, uncertainties and assumptions, many of which are beyond our control. These risks, uncertainties and assumptions include the risk factors discussed above. We cannot guarantee that our forward looking statements will turn out to be correct or that our beliefs, plans, expectations and assumptions will not change. Our actual results could be very different from and worse than our expectations as expressed in our forward looking statements. ITEM 7(A). QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following financial statements of the Company and the independent auditors' report thereon, which are set forth on pages 9 through 16 of the 1998 Annual Report, are incorporated herein by reference: Balance Sheets at December 31, 1997 and 1998 Statements of Income for each of the years in the three-year period ended December 31, 1998 Statements of Stockholders' Equity for each of the years in the three-year period ended December 31, 1998 Statements of Cash Flows for each of the years in the three-year period ended December 31, 1998 Notes to Financial Statements The Company is not required to provide supplementary financial information specified by Item 302 of Regulation S-K. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Within the two-year period ended December 31, 1998 and subsequently, the Company had no change in independent accountants or disagreements with independent accountants on accounting and financial disclosure. -27- 28 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information relating to the directors of the Company will be set forth under the captions "Proposal 1 -- Election of Directors -- Nominees" and "Proposal 1 -- Election of Directors -- Information Regarding Nominees and Continuing Directors" in the Company's Proxy Statement for its 1999 Annual Meeting of Stockholders to be held on May 6, 1999. Such information is incorporated herein by reference. Pursuant to Instruction 3 to Item 401(b) of Regulation S-K and General Instruction G(3) to Form 10-K, information relating to the executive officers of the Company is set forth in Part 1, Item 4(A) of this report under the caption "Executive Officers of the Registrant." Information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, by directors and executive officers of the Company and beneficial owners of more than 10% of the Company's Common Stock will be set forth under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement referred to in this Item 10 above. Such information is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION Information relating to executive compensation will be set forth under the captions "Proposal 1 -- Election of Directors -- Director Compensation" and "Executive Compensation" in the Proxy Statement referred to in Item 10 above. Such information (other than the subsection of "Executive Compensation" entitled "Compensation Committee Report on Executive Compensation") is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding ownership of the Company's Common Stock as of December 31, 1998 by certain persons will be set forth under the caption "Stock Ownership" in the Proxy Statement referred to in Item 10 above. Such information is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and transactions between the Company and certain of its affiliates will be set forth under the caption "Certain Transactions" in the Proxy Statement referred to in Item 10 above. Such information is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents Filed as Part of This Report. 1. Financial Statements The following financial statements of the Company and the independent auditors' report thereon are included in the Company's 1998 Annual Report and are incorporated by reference in Item 8 hereof: Balance Sheets at December 31, 1997 and 1998 Statements of Income for each of the years in the three-year period ended December 31, 1998 -28- 29 Statements of Stockholders' Equity for each of the years in the three-year period ended December 31, 1998 Statements of Cash Flows for each of the years in the three-year period ended December 31, 1998 Notes to Financial Statements 2. Financial Statement Schedules The following financial statement schedule and the independent auditors' report thereon are set forth beginning on page S-1 of this report: Schedule II - Valuation and Qualifying Accounts All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted because such schedules are not required under the related instructions or are inapplicable or because the information required is included in the financial statements or notes thereto. 3. Exhibits The following exhibits are filed with or incorporated by reference in this report. Where such filing is made by incorporation by reference to a previously filed registration statement or report, such registration statement or report is identified in parentheses. The Company will furnish any exhibit upon request to Dennis W. Blazer, Chief Financial Officer of the Company, 10830 Millington Court, Cincinnati, Ohio 45242. There is a charge of $.50 per page to cover expenses of copying and mailing. 3.1 Certificate of Incorporation of the Company, as amended, including Certificate of Designation of Series A Preferred Stock (Exhibit 3.1 to the Company's Registration Statement on Form S-1, No. 33-75142). 3.2 Bylaws of the Company (Exhibit 3.2 to the Company's Registration Statement on Form S-1, No. 33-75142). 4.1 Promissory Note of the Company dated September 22, 1992 to Baumgartner & Brucher Radiology Associates, Inc. Profit Sharing Plan for the benefit of Thomas E. Turek, M.D. (Exhibit 4.2 to the Company's Registration Statement on Form S-1, No. 33-75142). 4.2 Promissory Note of the Company dated September 22, 1990 to Mr. Thomas Goila (Exhibit 4.3 to the Company's Registration Statement on Form S-1, No. 33-75142). 4.3 Loan Agreement dated October 29, 1997 between the Company and Mercantile Business Credit Inc (Exhibit 4.3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997). 4.3(a) Revolving Credit Note dated October 29, 1997 between the Company and Mercantile Business Credit Inc. (Exhibit 4.3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997). -29- 30 4.3(b) Security Agreement dated October 29, 1997 between the Company and Mercantile Business Credit Inc. (Exhibit 4.3(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997). 4.3(c) Patent, Trademark and License Security Agreement dated October 29, 1997 between the Company and Mercantile Business Credit Inc. (Exhibit 4.3(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997). 4.3(d) First Amendment to the Loan Agreement dated October 29, 1998 between the Company and Mercantile Business Credit, Inc.-- filed herewith. 10.1 Assignment of United States Letters Patent from BLM Resources, Inc. to the Company with respect to United States Patent No. 4,982,337, "System for Distributing Lottery Tickets" (Exhibit 10.5 to the Company's Registration Statement on Form S-1, No. 33-75142). 10.2 Pull-Tab Manufacturing and License Agreement between Algonquin Industries, Inc., Kazmier Kasper and the Company dated as of January 13, 1994 (Exhibit 10.6 to the Company's Registration Statement on Form S-1, No. 33-75142). 10.3 Lease Agreement dated January 14, 1991 by and between Gallenstein & Gallenstein and the Company related to the Company's premises located at 6665 Creek Road, Cincinnati, Ohio 45242 (Exhibit 10.7 to the Company's Registration Statement on Form S-1, No. 33-75142). 10.3(a) Addendum dated May 2, 1994 to Lease Agreement dated January 14, 1991 (Exhibit 10.7) by and between Gallenstein & Gallenstein and the Company related to the Company's premises located at 6665 Creek Road, Cincinnati, Ohio 45242 (Exhibit 10.7(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1994). 10.4 Management Contracts and Compensatory Plans (a) 1994 Stock Incentive Plan (Exhibit 10.24 to the Company's Registration Statement on Form S-1, No. 33-75142). (b) 1994 Directors Stock Incentive Plan (Exhibit 10.25 to the Company's Registration Statement on Form S-1, No. 33-75142). (c) Employment Agreement effective February 1, 1995 between L. Rogers Wells, Jr. and the Company (Exhibit 10.4(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997). 11 Statement Regarding Computation of Per Share Earnings -- filed herewith. 13 1998 Annual Report -- filed herewith*. 23 Consent of KPMG LLP -- filed herewith. 24 Powers of Attorney -- filed herewith. 27 Financial Data Schedule (for SEC use only) -- filed herewith. -30- 31 (b) Reports on Form 8-K. No Current Reports on Form 8-K were filed by the Company during the quarter ended December 31, 1998. (c) See Item 14(a)(3) above. (d) See Item 14(a)(2) above. - ----------------- * Except for portions of the 1998 Annual Report that are expressly incorporated by reference into this Annual Report on Form 10-K, the 1998 Annual Report is furnished to the Commission solely for the information of the Commission and not deemed to be "filed" with the Commission for purposes of the Securities Exchange Act of 1934, as amended. -31- 32 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on March 25, 1999. INTERLOTT TECHNOLOGIES, INC. (REGISTRANT) By:/s/ L. Roger Wells, Jr. ---------------------------------------- L. Rogers Wells, Jr. Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 25, 1999. Signature Title /s/ L. Rogers Wells, Jr. Chairman of the Board and Chief Executive Officer - ------------------------- L. Rogers Wells, Jr. /s/ Edmund F. Turek Director - ------------------------- Edmund F. Turek /s/ David F. Nichols President and Director - ------------------------- David F. Nichols Gary S. Bell * Secretary, Treasurer and Director - ------------------------- Gary S. Bell Kazmier J. Kasper * Director - ------------------------- Kazmier J. Kasper H. Jean Marshall * Director - ------------------------- H. Jean Marshall John J. Wingfield * Director - ------------------------- John J. Wingfield /s/ Dennis W. Blazer Chief Financial and Accounting Officer - ------------------------- Dennis W. Blazer *By: /s/ L. Rogers Wells, Jr. ------------------------ L. Rogers Wells, Jr. as attorney-in-fact -32- 33 INDEX OF FINANCIAL STATEMENT SCHEDULES
Page ---- Report of Independent Auditors ...........................................S-2 Schedule II - Valuation and Qualifying Accounts ..........................S-3
S-1 34 Independent Auditors' Report The Board of Directors and Stockholders Interlott Technologies, Inc.: Under date of February 26, 1999, we reported on the balance sheets of Interlott Technologies, Inc. as of December 31, 1997 and 1998, and the related statements of income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1998, as contained in the 1998 annual report to stockholders. These financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1998. In connection with our audits of the aforementioned financial statements, we also audited the related financial statement schedule as listed in the accompanying index. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG LLP Cincinnati, Ohio February 26, 1999 S-2 35 INTERLOTT TECHNOLOGIES, INC. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E - ----------------------------------------------------------------------------------------------------------- ADDITIONS DESCRIPTION BALANCE AT CHARGED TO CHARGED TO DEDUCTIONS BALANCE AT BEGINNING COSTS AND OTHER END OF PERIOD EXPENSES ACCOUNTS OF PERIOD - ----------------------------------------------------------------------------------------------------------- Allowance for doubtful accounts 1996 101,613 57,500 0 43,688 115,425 - ----------------------------------------------------------------------------------------------------------- 1997 115,425 52,500 0 74,424 93,501 - ----------------------------------------------------------------------------------------------------------- 1998 93,501 60,000 0 0 153,501 - ----------------------------------------------------------------------------------------------------------- Inventory valuation reserve 1996 0 275,000 0 0 275,000 - ----------------------------------------------------------------------------------------------------------- 1997 275,000 0 0 0 275,000 - ----------------------------------------------------------------------------------------------------------- 1998 275,000 933,110 0 0 1,208,110 - -----------------------------------------------------------------------------------------------------------
S-3 36 INTERLOTT TECHNOLOGIES, INC. INDEX OF EXHIBITS The following exhibits are filed with or incorporated by reference in this report. Where such filing is made by incorporation by reference to a previously filed registration statement or report, such registration statement or report is identified in parenthesis.
EXHIBIT NO. DESCRIPTION PAGE - ----------- ----------- ---- 3.1 Certificate of Incorporation of the Company, as amended, including Certificate of Designation of Series A Preferred Stock (Exhibit 3.1 to the Company's Registration Statement on Form S-1, No. 33-75142). 3.2 Bylaws of the Company (Exhibit 3.2 to the Company's Registration Statement on Form S-1, No. 33-75142). 4.1 Promissory Note of the Company dated September 22, 1992 to Baumgartner & Brucher Radiology Associates, Inc. Profit Sharing Plan for the benefit of Thomas E. Turek, M.D. (Exhibit 4.2 to the Company's Registration Statement on Form S-1, No. 33-75142). 4.2 Promissory Note of the Company dated September 22, 1990 to Mr. Thomas Goila (Exhibit 4.3 to the Company's Registration Statement on Form S-1, No. 33-75142). 4.3 Loan Agreement dated October 29, 1997 between the Company and Mercantile Business Credit, Inc. (Exhibit 4.3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997). 4.3(a) Revolving Credit Note dated October 29, 1997 between the Company and Mercantile Business Credit, Inc. (Exhibit 4.3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997). 4.3(b) Security Agreement dated October 29, 1997 between the Company and Mercantile Business Credit, Inc. (Exhibit 4.3(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997). 4.3(c) Patent, Trademark and License Security Agreement dated October 29, 1997 between the Company and Mercantile Business Credit, Inc. (Exhibit 4.3(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997). 4.3(d) First Amendment to the Loan Agreement dated October 29, 1998 between the Company and Mercantile Business Credit, Inc. -- filed herewith. 10.1 Assignment of United States Letters Patent from BLM Resources, Inc. to the Company with respect to United States Patent No. 4,982,337, "System for Distributing Lottery Tickets" (Exhibit 10.5 to the Company's Registration Statement on Form S-1, No. 33-75142).
E-1 37 10.2 Pull-Tab Manufacturing and License Agreement between Algonquin Industries, Inc., Kazmier Kasper and the Company dated as of January 13, 1994 (Exhibit 10.6 to the Company's Registration Statement on Form S-1, No. 33-75142). 10.3 Lease Agreement dated January 14, 1991 by and between Gallenstein & Gallenstein and the Company related to the Company's premises located at 6665 Creek Road, Cincinnati, Ohio 45242 (Exhibit 10.7 to the Company's Registration Statement on Form S-1, No. 33-75142). 10.3(a) Addendum dated May 2, 1994 to Lease Agreement dated January 14, 1991 by and between Gallenstein & Gallenstein and the Company related to the Company's premises located at 6665 Creek Road, Cincinnati, Ohio 45242 (Exhibit 10.7(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1994). 10.4 Management Contracts and Compensatory Plans (a) 1994 Stock Incentive Plan (Exhibit 10.24 to the Company's Registration Statement on Form S-1, No. 33-75142). (b) 1994 Directors Stock Incentive Plan (Exhibit 10.25 to the Company's Registration Statement on Form S-1, No. 33-75142). (c) Employment Agreement effective February 1, 1995 between L. Rogers Wells and the Company (Exhibit 10.4(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997). 11 Statement Regarding Computation of Per Share Earnings-- filed herewith. 13 1998 Annual Report-- filed herewith*. 23 Consent of KPMG LLP-- filed herewith. 24 Powers of Attorney-- filed herewith. 27 Financial Data Schedule (for SEC use only)-- filed herewith.
- ----------------- * Except for portions of the 1998 Annual Report that are expressly incorporated by reference into this Annual Report on Form 10-K, the 1998 Annual Report is furnished to the Commission solely for the information of the Commission and not deemed to be "filed" with the Commission for purposes of the Securities Exchange Act of 1934, as amended. -2- EX-4.3(D) 2 FIRST AMENDMENT TO THE LOAN AGREEMENT 1 EXHIBIT 4.3(d) FIRST AMENDMENT TO LOAN AGREEMENT THIS FIRST AMENDMENT TO LOAN AGREEMENT (the "Amendment") is made and entered into this 29th day of October, 1998, by and between INTERLOTT TECHNOLOGIES, INC., a Delaware corporation ("Borrower"), and MERCANTILE BUSINESS CREDIT INC., a Missouri corporation ("Lender"). WITNESSETH: WHEREAS, Borrower and Lender have heretofore entered into that certain Loan Agreement dated October 29, 1997 (the "Loan Agreement"; all capitalized terms used and not otherwise defined in this Amendment shall have the respective meanings ascribed to them in the Loan Agreement as amended by this Amendment); and WHEREAS, Borrower and Lender desire to amend the Loan Agreement in the manner hereinafter set forth; NOW, THEREFORE, in consideration of the premises and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, Borrower and Lender hereby agree as follows: 1. Section 2.09 of the Loan Agreement hereby is deleted in its entirety and the following substituted in lieu thereof: 2.09 Early Termination and Early Termination Fee. Borrower may elect to terminate this Agreement at any time. Borrower hereby agrees that in the event that Lender or Borrower elects to terminate this Agreement (including, without limitation, any termination by Lender as a result of the occurrence of any Event of Default under this Agreement), Borrower will pay to Lender the total of the following: (a) if such termination occurs prior to the last day of the Revolving Credit Period, an early termination fee in the amount of $15,000.00; (b) any amount of interest accrued through the date of termination with respect to the outstanding Borrower's Obligations; and (c) the Outstanding Borrower's Obligations. 2. Pursuant to Borrower's request, Lender hereby waives payment of the anniversary fee required to be paid by Borrower on October 29, 1998, pursuant to Section 2.08 of the Loan Agreement. This paragraph is not and shall not be construed as (a) a waiver of any of the other terms, provisions, conditions or covenants contained in the Loan Agreement, including, without limitation, payment of any subsequent anniversary fee payable under Section 2.08 of the Loan Agreement or (b) a commitment on the part of Lender to waive any future anniversary fee or other fee or payment required to be paid by Borrower under the Loan Agreement. 2 3. Borrower hereby agrees to reimburse Lender upon demand for all out-of-pocket costs and expenses (including, without limitation, reasonable attorneys' fees and expenses) incurred by Lender in the preparation, negotiation and execution of this Amendment and any and all other agreements, documents, instruments and/or certificates relating to the amendment of Borrower's existing credit facilities with Lender (collectively, the "Loan Documents"). Borrower further agrees to pay or reimburse Lender for (a) any stamp or other taxes (excluding income or gross receipts taxes) which may be payable with respect to the execution, delivery, filing and/or recording of the Loan Documents and (b) the cost of any filings and searches, including, without limitation, Uniform Commercial Code filings and searches. All of the obligations of Borrower under this paragraph shall survive the payment of the Borrower's Obligations and the termination of the Loan Agreement. 4. All references in the Loan Agreement to "this Agreement" and any other references of similar import shall henceforth mean the Loan Agreement as amended by this Agreement. 5. Except to the extent specifically amended by this Amendment, all of the terms, provisions, conditions, covenants, representations and warranties contained in the Loan Agreement shall be and remain in full force and effect and the same are hereby ratified and confirmed. 6. This Amendment shall be binding upon and inure to the benefit of Borrower and Lender and their respective successors and assigns, except that Borrower may not assign, transfer or delegate any of its rights or obligations under the Loan Agreement as amended by this Amendment. 7. Borrower hereby represents and warrants to Lender that: (a) the execution, delivery and performance by Borrower of this Amendment are within the corporate powers of Borrower, have been duly authorized by all necessary corporate action and require no action by or in respect of, consent of or filing or recording with, any governmental or regulatory body, agency or official or any other Person; (b) the execution, delivery and performance by Borrower of this Amendment do not conflict with, or result in a breach of the terms, conditions or provisions of, or constitute a default under or result in any violation of, the terms of the Certificate or Articles of Incorporation or By-Laws of Borrower, any applicable law, rule, regulation, order, writ, judgment or decree of any court or governmental or regulatory agency or instrumentality or any agreement, document or instrument to which Borrower is a party or by which Borrower or any of its Property or assets is bound or to which Borrower or any of its Property or assets is subject; -2- 3 (c) this Amendment has been duly executed and delivered by Borrower and constitutes the legal, valid and binding obligation of Borrower enforceable against Borrower in accordance with its terms, except as such enforceability may be limited by (i) applicable bankruptcy, insolvency or similar laws affecting the enforcement of creditors' rights generally and (ii) general principles of equity (regardless of whether such enforceability is considered in a proceeding in equity or at law); (d) all of the representations and warranties of Borrower set forth in the Loan Agreement and the other Transaction Documents are true and correct in all material respects on and as of the date of this Amendment as if made on and as of the date of this Amendment; and (e) as of the date of this Amendment, no Default or Event of Default under or within the meaning of the Loan Agreement has occurred and is continuing. 8. In the event of any inconsistency or conflict between this Amendment and the Loan Agreement, the terms, provisions and conditions contained in this Amendment shall govern and control. 9. This Amendment shall be governed by and construed in accordance with the substantive laws of the State of Missouri (without reference to conflict of law principles). 10. ORAL AGREEMENTS OR COMMITMENTS TO LOAN MONEY, EXTEND CREDIT OR TO FORBEAR FROM ENFORCING REPAYMENT OF A DEBT, INCLUDING PROMISES TO EXTEND OR RENEW SUCH DEBT, ARE NOT ENFORCEABLE. TO PROTECT BORROWER AND LENDER FROM MISUNDERSTANDING OR DISAPPOINTMENT, ANY AGREEMENTS REACHED BY BORROWER AND LENDER COVERING SUCH MATTERS ARE CONTAINED IN THE LOAN AGREEMENT AS AMENDED BY THIS AMENDMENT AND THE OTHER TRANSACTION DOCUMENTS, WHICH LOAN AGREEMENT AS AMENDED BY THIS AMENDMENT AND OTHER TRANSACTION DOCUMENTS ARE A COMPLETE AND EXCLUSIVE STATEMENT OF THE AGREEMENTS BETWEEN BORROWER AND LENDER, EXCEPT AS BORROWER AND LENDER MAY LATER AGREE IN WRITING TO MODIFY THEM. 11. Notwithstanding any provision contained in this Amendment to the contrary, this Amendment shall not be effective unless and until Lender shall have received: (a) this Amendment, duly executed by Borrower; and (b) a Secretary's Certificate certifying as to duly adopted resolutions of the Board of Directors of Borrower which authorize the execution, delivery and performance -3- 4 of this Amendment and containing any incumbency certificate, which shall identify by name and title and bear the signatures of all of the officers of Borrower executing this Amendment. IN WITNESS WHEREOF, Borrower and Lender have executed this First Amendment to Loan Agreement as of the date first set forth above. INTERLOTT TECHNOLOGIES, INC. By -------------------------------- Title: ---------------------------- MERCANTILE BUSINESS CREDIT INC. By -------------------------------- Title: ---------------------------- -4- 5 SECRETARY'S CERTIFICATE I, Gary S. Bell , hereby certify to Mercantile Business Credit Inc. ("Mercantile") that I am the duly elected, qualified and acting Secretary of INTERLOTT TECHNOLOGIES, INC., a Delaware corporation (the "Company"), and as such have charge of the corporate books and records of the Company. I further certify to Mercantile as follows: 1. There have been no amendments or other changes to the Certificate of Incorporation or Bylaws of the Company since October 29, 1997. 2. Exhibit A attached hereto and made a part hereof is a true, correct and complete copy of certain resolutions duly adopted by the Board of Directors of the Company effective as of October 29, 1998, in accordance with the laws of the State of Delaware and the Certificate of Incorporation and Bylaws of the Company and that such resolutions are on the date hereof still in full force and effect. 3. The following named individuals are duly elected officers of the Company and hold the offices opposite their respective names, and that the signatures written opposite each name and title is such individual's correct signature.
NAME OFFICE SIGNATURE L. Rogers Wells Chairman ------------------------ David Nichols President ------------------------ Gary Bell Secretary ------------------------ Thomas Stokes V.P. Operations ------------------------ Dennis Blazer Chief Financial Officer ------------------------
Executed as of the 29th day of October, 1998. ------------------------------------- , Secretary ------------------------- EX-11 3 STATEMENT RE: COMPUTATION OF EARNINGS PER SHARE 1 EXHIBIT 11 INTERLOTT TECHNOLOGIES, INC. Computation of earnings per share
Three Months Ended Year Ended December 31, December 31, ------------------------- -------------------------- 1998 1997 1998 1997 ---------- ---------- ---------- ---------- Weighted average common 3,210,000 3,210,000 3,210,000 3,210,000 shares outstanding during the period Income 476,489 436,709 $1,622,313 $1,451,654 Net Income per share $ 0.15 $ 0.14 $ 0.51 $ 0.45 Assuming full dilution: 3,210,000 3,210,000 3,210,000 3,210,000 Weighted average common shares outstanding during the period Assuming exercise of 550 4,870 10,649 2,661 options Weight average common 3,210,550 3,214,870 3,220,649 3,212,661 shares outstanding as adjusted Net income 476,489 $ 436,709 $1,622,313 $1,451,654 Income per common share assuming full dilution $ 0.15 $ 0.14 $ 0.50 $ 0.45
EX-13 4 1998 ANNUAL REPORT 1 EXHIBIT 13 Annual Report 1998 INTERLOTT TECHNOLOGIES, INC. 2 COMPANY PROFILE At Interlott Technologies, Inc. we develop new approaches to vending by engineering systems that utilize our patented technology in concert with the latest telecommunications, hardware, and software, in response to market needs. Since the Company's founding in 1990, we have been committed to providing unsurpassed reliability, dependability, and security through efficient dispensing technology that offers our customers and their customers convenience, and sure, quick delivery. Through this commitment, we have become the leading supplier of Instant Ticket Vending Machines (ITVMs) for lotteries worldwide. Our dispensing technology and philosophy of responding to our customers' needs have earned us recognition as a leader and positioned us to expand into new markets where our innovative technology will enhance the way companies do business. Table of Contents ================================================ To Our Shareholders 1 - ------------------------------------------------ Answering market needs with innovative products 2 - ------------------------------------------------ Integrating quick, convenient delivery with market insight 4 - ------------------------------------------------ Conclusion 5 - ------------------------------------------------ Selected Financial Data 7 - ------------------------------------------------ Management's Discussion & Analysis 7 Financial Statements 10 - ------------------------------------------------ Corporate Data & Shareholder Information 17 ================================================
INTERLOTT TECHNOLOGIES, INC. 3 Placing products and information at a fingertip - Photo of world with a finger pushing button on it 4 Annual Report 1998 Photo of L. Rogers Wells and David Nichols in front of Interlott sign L. Rogers Wells, Jr. David F. Nichols Chairman of the Board President and Chief Executive Officer Dear Fellow Shareholders: 1998 marks the fourth straight year of profitability for our Company. It was also a year during which we won four of the six contracts awarded for supplying machines to lottery customers. A year during which we completed the development of our counter top version of the ITVM. A year during which we developed a methodology for automated remote machine reporting and signed our first contract utilizing this technology. The accomplishments of 1998 provide the basis for a bright future for the Company. Revenues for 1998 topped $24 million, a 26% increase over 1997 and a record level for the Company, net income exceeded $1.6 million, a 12% increase over 1997, and cash flow from operations increased 20% to $6.7 million. The Company was awarded new or extended contracts with Arizona, Florida, Indiana, Kansas, Ohio, Texas and Washington. We now have contracts with 23 of the 32 domestic lotteries which utilize vending technology to promote growth of their instant (scratch-off) games. In addition, phone card machines were deployed both domestically and internationally. Our continued commitment to understanding and answering the needs of our customers was further evidenced with the development of our counter-top vending units providing for growth of instant ticket sales for the lotteries, while addressing the retailers' concern for security and optimum use of counter space. Similarly, our automated reporting system answered the lotteries' need for tracking sales and obtaining marketing information at minimal cost. By the end of 1998 we had approximately 9,000 machines leased or on order to be leased by eighteen domestic lotteries. This clearly illustrates our commitment to leasing rather than selling our equipment and our desire to "partner" with our customers. Future lease revenues for this equipment totaled more than $70 million at year end. Once again, your management and Board of Directors would like to thank you for your continued loyalty and support as we work together for the continued growth of the Company. Sincerely, /s/ L. Rogers Wells, Jr. - ----------------------------- L. Rogers Wells, Jr. Chairman of the Board and CEO 1 5 Photo of burster with Photo of Photo of montage of pull instant tickets feeding Ohio 12 game ITVM, tab tickets and various into it Wisconsin 8 game ITVM plastic cards including and phone, transit and smart Kansas 6 game PTVM cards from INNOVATION Answering market needs with innovative products - Our dispensing systems represent a convergence of today's latest technologies with uniquely engineered mechanisms. Between the idea and implementation lies technological innovation -- the intangible commodity that has made Interlott a leader in the dispensing industry. Interlott succeeds as a company because we respond to our customers' needs with breakthrough dispensing systems that place products and information at a fingertip. Illustration of the U.S. indicating what companies have the ITVM contracts with the lotteries to implementation INTERLOTT TECHNOLOGIES, INC. Current Lottery contracts: Interlott's Competitors' Potential Non-Lottery States
2 6 Photo of woman Close up of a hand Photo of a woman Photo of a couple purchasing a phone card inserting a phone card into purchasing a smart card presenting a card for a from a King's Island a phone slot from an Interlot SCDM purchase PCDM
evolution Interlott's role as a technological leader began with the invention of our patented Burster. The Burster was the key component in the development of the first automated Instant Ticket Vending Machine (ITVM) by Interlott. This state-of-the-art technology gave lotteries the freedom to reliably sell instant game tickets in a wide variety of sizes, shapes and paper stocks without the intervention of a ticket agent. Continually addressing the needs of our customers-lotteries, retailers and players alike-we refined the ITVM. The request by all to make more games available in the smallest space possible, led the evolution from our original four game unit to our present day sixteen game ITVM. As a result of this technology, instant ticket sales have risen, allowing Interlott to capture more than 70% of the ITVM market. refinement Lotteries also needed a way to securely dispense their individual paper pull-tab tickets. Our unique, ShurShuttle dispensing process was the answer. Incorporated in our complete line of our Pull Tab Vending Machines (PTVMs) it ensures that ticket dispensing is flawless, efficient, and completely secure. With the emergence of the prepaid telephone card industry, the capabilities of our unique ShurShuttle dispenser were again recognized. This patented technology has become the key component in dispensing individual products, from paper tickets to plastic cards, as utilized in our Phone Card Dispensing Machines (PCDMs) and Smart Card Dispensing Machines (SCDMs). We continue to explore opportunities to utilize our dispensing technology in new looking ahead arenas. Closed-end environments such as theme parks, college campuses, and military bases provide us a multitude of opportunities. We continue to identify venues for our products where speed and convenience are priorities, such as parking garages, transit terminals, malls, and vacation resorts. Internationally, with the advent of the Eurodollar, we perceive new applications for our technology every day. Interlott's financial strength and technological leadership are enabling us to take the Company in exciting new directions, responding to market needs with innovative products. We provide solutions by offering practical methods and advances in technology that place products and information at a fingertip. Bringing you tomorrow's solutions... today. 3 7 Close up of someone Close up of a woman A store manager opening selecting a ticket from an selecting a ticket from an the dispenser units behind Ohio 12 game ITVM MVP unit on a store check his convenience store out counter counter
Integrating convenient, quick delivery with market insight - Our patented Burster and ShurShuttle dispensers have been the catalysts enabling Interlott to offer sure, quick, and convenient delivery of products through our innovative vending systems. But our mission is ongoing. Capitalizing on the most advanced hardware, software and telecommunications technology available, we now provide the vendor the advantage of on-line service data transmission, inventory status, detailed accounting reports, and valuable market information. (from) (automation) automation automation Close up photo of various sales tapes with reports taken from an Interlott ITVM INTERLOTT to TECHNOLOGIES, INC. information 4 8 above of a line "http:/" symbol Man and woman in lottery Man initializing a out lanes in a representing the internet office reviewing sales transaction at an ITVM, every store results from the ITVMs in supposedly in the future their state
efficiency We recognized the opportunity to increase over-the-counter sales of instant scratch tickets and seized it. Customer lines can be long. Sales, inventory, and record keeping are labor intensive. Tickets are difficult to see. Shrinkage has eaten into profits. Still, the majority of instant tickets sales are impulse purchases made at the convenience store checkout. Over the past two years, we have been working with lotteries, retailers and players alike to develop the Modular Vending Platform (MVP), the smart instant ticket dispenser, which combines the latest technologies with our advanced engineering and design. The MVP reduces transaction time, automates the accounting process, improves ticket visibility, and eliminates shrinkage, resulting in more sales, less work, and increased profits. The MVP has been introduced insight across the U.S. in convenience stores, grocery chains, and hyper-markets and feedback has been overwhelmingly positive. As instant game sales represent an ever increasing percentage of lotteries' total revenues, obtaining sales and inventory data on a real time basis has become a necessity. Our insight into this situation prompted the development of our Automated Communication System (ACS). Using the latest telecommunications software and hardware, the ACS provides lotteries with instant reporting by all ITVMs located throughout each state for sales data, inventory and maintenance control. The ACS transmits detailed sales data via modem, generating reports instantaneously, which are made available to the lottery over the internet. opportunity The ACS provides demographic sales data and strategic marketing information to the lottery, empowering them to give players the games they want, when and where they want them. This ability translates into increased instant ticket revenues and the most efficient sales system to date. We continue to explore similar avenues where the ACS can be used to transform traditional vending into reliable, convenient market driven sales. We are breaking new ground, merging our dispensing technology with the latest innovations in hardware, software and telecommunications, to provide advanced vending systems to a variety of niche markets worldwide. We envision many different possibilities--from multifunctional ATMs to systems able to offer three dimensional products. The potential can be limitless. 5 9 REDEFINING AN INDUSTRY WITH EMPLOYEES, PARTNERS, AND TECHNOLOGY... At Interlott, we realize that it takes more than great products to build a successful company. To revolutionize an industry through technology, it takes management and employees who require more than the status quo. Our dispensing technology receives the insightful guidance of a committed corporate team and supportive client base. We work together to efficiency develop products that provide measurable benefits to our customers and in turn, to their customer. We offer a creative environment where people and ideas flourish to bring products and information to the world at the touch of a fingertip. Photo of the world with computer symbols surrounding it and a finger pushing a button on top of it Bringing you a tomorrow's solution...TODAY. INTERLOTT TECHNOLOGIES, INC. 6 10 Selected Financial Data
- --------------------------------------------------------------------------------------------------------------- Year Ended =============================================================================================================== Dec. 31 Dec. 31 Dec. 31 Dec. 31 Dec. 31 1994 1995 1996 1997 1998 =============================================================================================================== Revenues - --------------------------------------------------------------------------------------------------------------- Machine sales 40,650 9,746,339 5,596,698 4,567,441 8,229,950 - --------------------------------------------------------------------------------------------------------------- Machine leases 6,093,528 9,132,132 11,766,623 12,874,450 14,165,379 - --------------------------------------------------------------------------------------------------------------- Other 250,442 435,137 1,235,368 1,669,160 2,078,644 - --------------------------------------------------------------------------------------------------------------- Net revenues 6,384,620 19,313,608 18,598,689 19,111,051 24,473,973 - --------------------------------------------------------------------------------------------------------------- Net income (loss) (932,100) 1,987,219 1,320,597 1,451,654 1,622,313 - --------------------------------------------------------------------------------------------------------------- Income per share(1) (0.32) 0.62 0.41 0.45 0.51 - --------------------------------------------------------------------------------------------------------------- Depreciation and amortization 1,884,855 2,982,547 3,902,387 4,143,408 4,585,325 - --------------------------------------------------------------------------------------------------------------- Leased ITVMs, less accumulated depreciation 8,392,946 10,779,929 10,940,398 14,740,462 17,105,891 - --------------------------------------------------------------------------------------------------------------- Total assets 15,020,321 20,483,686 20,992,733 24,612,884 28,774,249 - --------------------------------------------------------------------------------------------------------------- Total debt 5,398,103 9,040,784 7,715,140 9,458,004 11,645,374 - --------------------------------------------------------------------------------------------------------------- Redeemable preferred stock 1,335,000 1,335,000 1,335,000 1,335,000 1,335,000 =============================================================================================================== (1)Reflects the weighted average number of shares outstanding for the respective periods, taking into account a 21.5 to 1 split of Common Stock effected in March, 1994. - ---------------------------------------------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION & ANALYSIS OVERVIEW The Company's revenue base consists of (1) payments from ITVM and PCDM leases (2) sales of ITVMs and PCDMs, (3) and to a lesser extent, sales of parts for ITVMs and PCDMs and service agreements. The Company emphasizes leasing rather than selling ITVMs to lotteries when possible. Leases provide the Company with a consistent revenue stream, opportunities to generate income on financing, and the potential to deploy a greater number of ITVMs within a lottery's budget due to the lower initial cash outlay required by the lottery. Leasing ITVMs also gives the lotteries the flexibility to enhance their ITVMs in the future with new technology from the Company. On the other hand, leasing ITVMs requires the Company to invest capital or otherwise finance the manufacture of ITVMs, unlike sales of ITVMs that result in the receipt of payment in full upon delivery of the ITVMs. When the Company sells ITVMs, the Company generally is able to manufacture and deliver the ITVMs and receive full payment for them before it must pay for the materials used to manufacture the ITVMs. Nevertheless, the Company believes that the advantages of leasing ITVMs as described above justify the initial capital investment or financing costs required to manufacture ITVMs for lease. The majority of ITVMs to date have been leased. For similar reasons, the Company emphasizes leasing rather than selling PCDMs to providers of prepaid telephone cards. As with ITVMs, the Company believes that the benefits to the Company of leasing PCDMs warrant the initial capital investment required to manufacture PCDMs. However, the great majority of the PCDMs deployed to date have been sold rather than leased. The Company historically has experienced fluctuations in its financial results primarily due to its dependence upon a small number of major customers and the unpredictable nature, timing and results of the lotteries' contract bid and award processes. The Company's revenues and capital expenditures can vary significantly from period to period because the Company's sales cycle may be relatively long and because the amount and timing of revenues and capital expenditures depend on factors such as the amount and timing of awarded contracts, changes in customer budgets and demands, and general economic conditions. Operating results may be affected by the lead-time sometimes required for business opportunities to result in signed lease or sales agreements, working capital requirements associated with manufacturing ITVMs pursuant to new orders, increased competition, and the extended time that may elapse between the award of a contract and the receipt of revenues from the sale or lease of ITVMs. - -------------------------------------------------------------------------------- RESULTS OF OPERATIONS The table below presents selected financial information derived from the Company's statements of income expressed as a percentage of revenues for the years indicated.
Year Ended ---------------------------------- Dec. 31 Dec. 31 Dec. 31 1996 1997 1998 Revenues =================================================================== Machine sales 30.1% 24.0% 33.6% - ------------------------------------------------------------------- Machine leases 63.3 67.3 57.9 - ------------------------------------------------------------------- Other 6.6 8.7 8.5 - ------------------------------------------------------------------- Total revenues 100.0 100.0 100.0 - ------------------------------------------------------------------- Cost of revenues, excluding depreciation 47.6 41.7 48.4 - ------------------------------------------------------------------- Depreciation 20.3 20.6 17.5 - ------------------------------------------------------------------- Gross margin 32.1 37.7 34.1 - ------------------------------------------------------------------- Selling, general and administrative expenses 18.6 18.3 16.5 - ------------------------------------------------------------------- Research and development costs 3.6 2.9 2.5 - ------------------------------------------------------------------- Operating income 9.9 16.5 15.1 - ------------------------------------------------------------------- Interest expense 3.8 3.7 4.0 - ------------------------------------------------------------------- Income before income taxes 6.1 12.8 11.1 - ------------------------------------------------------------------- Income taxes (1.0) 5.2 4.5 =================================================================== Net income 7.1% 7.6% 6.6% ===================================================================
SUMMARY OF QUARTERLY DATA Quarterly financial data for the years ended December 31, 1997 and 1998 shown here (in thousands, except for per share data).
1997 First Second Third Fourth ===================================================================== Net sales $4,164 6,931 3,867 4,129 - --------------------------------------------------------------------- Gross profit 1,232 2,478 1,552 1,941 - --------------------------------------------------------------------- Net income 30 777 208 437 - --------------------------------------------------------------------- Basic income per share 0.01 0.24 0.06 0.14 - --------------------------------------------------------------------- Diluted income per share 0.01 0.24 0.06 0.13 =====================================================================
1998 First Second Third Fourth ===================================================================== Net sales $5,884 7,323 5,714 5,554 - --------------------------------------------------------------------- Gross profit 1,718 2,492 1,874 2,270 - --------------------------------------------------------------------- Net income 291 630 225 476 - --------------------------------------------------------------------- Basic income per share 0.09 0.19 0.07 0.15 - --------------------------------------------------------------------- Diluted income per share 0.09 0.19 0.07 0.15 =====================================================================
7 11 1997 Compared to 1998 Total revenues increased by $5,362,922 from $19,111,051 to $24,473,973 in 1998, or 28%, due primarily to a $3,662,509 increase in machine sales and a $1,290,929 increase in lease revenues accompanied by a $409,484 increase in other revenues. Revenues from sales increased by 80% from $4,567,441 in 1997 to $8,229,950 in 1998, as a result of an increase in ITVMs and PCDMs sold in 1998 over 1997. The units sold in 1998 included a greater number of higher priced machines than 1997. Revenues from leases increased by 10% from $12,874,450 in 1997 to $14,165,379 in 1998, resulting from the continuation of leases in nine states and the renewal of five leases in other states that had reached the conclusion of their original terms. The total number of ITVMs and PCDMs under lease increased in 1998 as a result of deployment of new units, offset by the retirement of older units. Other revenues increased by 25% from $1,669,160 in 1997 to $2,078,644 in 1998 as machines deployed prior to 1998 generated parts and service revenue for the entire year, and service for ITVMs in one state was taken over from a subcontractor. Lease revenues were 67% and 58% of total revenues for 1997 and 1998, respectively. Revenues from sales of ITVMs and PCDMs were 24% and 34% of total revenues in 1997 and 1998, respectively. The increase in lease revenues and increase in sales revenues reflect the cumulative effect of continuing revenues from machines under lease which were deployed prior to 1998 and the incremental revenue of new machines leased or deployed in 1998. Cost of revenues for machine sales and other increased 33% from $4,378,669 in 1997 to $5,809,057 in 1998. This increase reflects the 47% increase in number of machines sold, offset by lower costs of the units sold in 1998. Cost of revenues for leased ITVMs and PCDMs, excluding depreciation, increased 67% from $3,584,017 in 1997 to $6,020,437 in 1998. The increase in cost of leased revenues was the result of higher personnel and subcontractor costs related to the larger number of machines deployed during 1998. Depreciation of ITVMs and PCDMs increased by 9% from $3,924,244 in 1997 to $4,290,128 in 1998. The increase was lower than the related increase in the number of ITVMs and PCDMs, as certain units had been fully depreciated by the end of 1997. Selling, general and administrative expenses increased 16% from $3,492,020 in 1997 to $4,048,751 in 1998 as a result of increases in salaries and wages for additional staff and increases in travel and entertainment cost. However, selling, general and administrative expenses as a percentage of revenues, decreased slightly from 18% in 1997 to 17% in 1998. Research and development costs increased by 14% from $545,039 in 1997 to $618,819 in 1998. This increase resulted from continuing development and refinement of existing products to meet the various needs of customers for the Company's dispensing technologies. The Company maintains its philosophy of using contractors as the primary source of research and development efforts, allowing the Company to focus its expenditures on the technical expertise necessary to accomplish the specific project. Operating income increased by 16% from $3,187,062 in 1997 to $3,686,781 in 1998. This increase resulted from the continuing benefit of revenues derived from machines deployed in prior periods, including machines which had been fully depreciated, combined with ongoing machine sales and leases. Interest expense increased by 30% from $747,008 in 1997 to $967,768 in 1998. The increase reflects the cost of additional borrowings to finance leased equipment built and deployed in 1998, offset by lower interest rates resulting from utilization of the LIBOR option in the Company's agreement. Income taxes increased by 11% from $988,400 in 1997 to $1,096,673 in 1998 as a result of an increase in income before taxes of 11%. The effective tax rate remained consistent at 40% in 1997 and 1998. As a result of the above factors, the Company's net income increased by 12% from $1,451,654 in 1997 to $1,622,313 in 1998. 1996 COMPARED TO 1997 Total revenues increased by $512,362 from $18,598,689 to $19,111,051 in 1997, or 3%, due primarily to a $1,107,827 increase in lease revenues accompanied by a $433,792 increase in other revenues offset by a $1,029,257 decrease in sales of ITVMs and PCDMs. Revenues from leases increased by 9% from $11,766,623 in 1996 to $12,874,450 in 1997, resulting from the continuation of leases in nine states, the addition of leases in three states, and the renewal of a lease in another state which had reached the conclusion of the original term. The total number of ITVMs and PCDMs under lease increased to 6,834 in 1997 as a result of deployment of additional units, offset by the retirement of older units. Other revenues increased by 35% from $1,235,368 in 1996 to $1,669,160 in 1997 as ITVMs were deployed in one additional state and machines deployed prior to 1997 generated parts and service revenue for the entire year. Revenues from sales decreased by 18% from $5,596,698 in 1996 to $4,567,441 in 1997, as a result of a decrease in ITVMs and PCDMs sold in 1997 as compared to 1996. The decrease in units sold was partially offset by a greater number of higher priced units sold in 1997 as compared to those sold in 1996. Lease revenues were 63% and 67% of total revenues for 1996 and 1997, respectively. Revenues from sales of ITVMs and PCDMs were 30% and 24% of total revenues in 1997 and 1996, respectively. Cost of revenues for machine sales and other decreased 28% from $6,052,763 in 1996 to $4,378,669 in 1997. This decrease reflects the 35% decrease in number of machines sold offset by the higher cost of the higher priced units sold in 1997. Cost of revenues for leased ITVMs and PCDMs, excluding depreciation, increased 26% from $2,839,162 in 1996 to $3,584,017 in 1997. The increase in cost of leased revenues was the result of higher warranty parts costs and higher personnel and subcontractor costs related to the larger number of machines deployed during 1997. Depreciation of ITVMs and PCDMs increased by 5% from $3,744,065 in 1996 to $3,924,244 in 1997. The increase was lower than the related increase in the number of ITVMs and PCDMs, as certain units had been fully depreciated by the end of 1996. Selling, general and administrative expenses increased 1% from $3,461,364 in 1996 to $3,492,020 in 1997. Selling, general and administrative expenses as a percentage of revenues decreased slightly from 19% in 1996 to 18% in 1997. Research and development costs decreased by 18% from $665,449 in 1996 to $545,039 in 1997. This decrease results from the wind down of major projects such as the smart card dispensing machine, as well as the continuing development and refinement of existing products to meet the variety of the needs of the customers for our dispensing technologies. The Company maintains its philosophy of using contractors as the primary source of research and development efforts, allowing the Company to focus its expenditures on the technical expertise necessary to accomplish the specific project. Operating income increased by 74% from $1,835,886 in 1996 to $3,187,062 in 1997. This increase resulted from the continuing benefit of revenues derived from machines deployed in prior periods, including machines which had been fully depreciated, combined with the control of operating expenses. Interest expense increased by 4% from $718,642 in 1996 to $747,008 in 1997. The increase reflects the cost of additional borrowings to finance leased equipment built and deployed in 1997. To a lesser extent, interest expense was affected by the reduced interest rate of the new credit facility. The significant change in income taxes in 1997 resulted from the Company having used available net operating loss carryovers in 1996 and as a result, incurring taxes at an effective tax rate of 40% in 1997. As a result of the above factors, the Company's net income increased by 10% from $1,320,597 in 1996 to $1,451,654 in 1997. Liquidity and Capital Resources The Company's liquidity and capital resources are significantly impacted by its decision to use leasing as a means to market its ITVMs and PCDMs. Leasing generally offers the Company better gross margins than direct sales agreements. However, leasing inherently requires more capital and a longer-term payout than sales. As of December 31, 1998, the Company had a total of 7,812 ITVMs and PCDMs under operating and sales type leases. 8 12 Net cash provided by operating activities increased 2% from $7,281,457 in 1997 to $7,435,079 in 1998. Net cash used in investing activities increased 7% from $9,069,836 in 1997 to $9,735,516 in 1998. Net cash provided by financing activities increased by 26% from $1,742,864 in 1997 to $2,187,370 in 1998. At December 31, 1997 and 1998, the Company had working capital deficits of $4,328,068 and $7,466,831, respectively. These deficits reflect the classification of the Company's revolving credit facility as a current debt because of the revolver clause of the facility. At December 31, 1998, the Company was indebted to Mercantile Business Credit, Inc. in the aggregate principal amount of $11,166,374 pursuant to this revolving credit agreement The facility permits the Company to borrow up to $15,000,000 at the prime interest rate or the respective LIBOR rate plus two percent through October 2000, with two one-year extensions to October, 2002. Borrowings under this facility are collateralized by all of the assets of the Company and an assignment of all proceeds from lease agreements. The facility prohibits the declaration or payment of cash dividends until the Company has retired debt owed to two stockholders and all of the outstanding preferred stock of the Company. At December 31, 1998, the Company had $3,833,626 available under this facility. At December 31, 1998, the Company was indebted to two stockholders in the aggregate principal amount of $479,000 which had been incurred prior to 1992 to finance the manufacture of certain ITVMs. See Note 7 of Notes to Financial Statements. The Company's capital expenditures totaled $9,069,836 and $9,735,516 for 1997 and 1998, respectively. These amounts include $8,710,315 and $9,611,623 for the manufacture of machines leased during the respective periods. Other expenditures represent machinery and equipment costs for expanded capacity. The Company had no material commitments for additional capital expenditures as of December 31, 1998 other than for the manufacture of ITVMs and PCDMs for future lease. At December 31, 1998, the Company had estimated tax net operating loss carryforwards of approximately $1,021,000, which are available to offset future federal taxable income, if any, through 2009. The use of these carryforwards is subject to certain annual limitations due to ownership changes in 1992. IMPACT OF THE YEAR 2000 The Company relies on computer-based technology and utilizes a variety of third-party hardware and proprietary and third party software. The Company's dispensing equipment generally uses proprietary software, with third-party software being used more extensively for administrative functions, such as accounting and human resource management. In addition to such information technology (IT) systems, the Company's operations rely on various non-IT equipment and systems that contain embedded computer technology. Third parties, with whom the Company has commercial relationships, including vendors of materials and components incorporated into the Company's products and of products and services used by the Company in its operations (such as banking and financial services, data processing services, telecommunications services and utilities), also rely highly on computer based technology. The Company has assessed the potential effects of the Year 2000 issue on the Company's business, financial condition and results of operations. In conjunction with this assessment, the Company developed and commenced the implementation of the compliance program described below. The Company has undertaken a review of its proprietary IT systems relating to its dispensing equipment. No systems were identified as relating to the critical functions of the Company's ITVMs or PCDMs. As such, the Company believes that no remediation with regard to those proprietary IT systems is necessary at this time. The Company has contacted its third party providers of critical hardware and software and has obtained appropriate representations to the effect that such hardware or software is or will timely be Year 2000 compliant. The Company has undertaken a review of its non-IT systems and is implementing a remediation program with respect to those systems that are within the control of the Company. Selected non-IT suppliers and vendors have been contacted to identify any significant exposures that may exist and identify alternate sources or strategies where necessary. The Company has incurred minimal costs to date in assessing the potential effects of the Year 2000 issue on the Company and does not expect or anticipate any material expenditures in the future in connection with the Year 2000 issue. Nevertheless, the issues presented by the Year 2000 issue and the proposed solutions therefor are very complex and the Company's Year 2000 compliance depends heavily on the technical skills of employees and independent contractors and the representations and preparedness of third parties. Moreover, Year 2000 issues present a number of risks that are beyond the Company's reasonable control, such as the failure of utility companies to deliver electricity, the failure of telecommunications companies to provide voice and data services, the failure of financial institutions to process transactions and transfer funds, the failure of vendors to deliver materials or perform services required by the Company and the collateral effects on the Company of the effects of Year 2000 issues on the economy in general or on the Company's business partners and customers in particular. Although the Company believes that its Year 2000 compliance program is designed to appropriately identify and address those Year 2000 issues that are subject to the Company's reasonable control, there can be no assurance that the Company's efforts in this regard will be fully effective or that the Year 2000 issues will not have a material adverse effect on the Company's business, financial condition or results of operations. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS The words "expect", "anticipate", "intend", "plan", "believe", "seek", "estimate" and similar expressions used in this report are intended to identify forward-looking statements, although this report also contains other forward-looking statements. Any forward-looking statements in this report are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Act of 1995. Investors are cautioned that actual results may differ substantially from such forward-looking statements. Forward-looking statements involve risks and uncertainties including, but not limited to, continued acceptance of the Company's products and services in the marketplace, competitive factors, new products and technological changes, dependence upon third party vendors, a limited number of customers, political and other uncertainties related to customer purchases and other risks detailed in the Company's periodic filings with the Securities and Exchange Commission. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders: We have audited the accompanying balance sheets of Interlott Technologies, Inc. as of December 31, 1997 and 1998, and the related statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Interlott Technologies, Inc. as of December 31, 1997 and 1998, and the results of its operations and its cash flows for each of the years in the three year period ended December 31, 1998, in conformity with generally accepted accounting principles. /s/ KPMG LLP February 26, 1999 9 13 BALANCE SHEETS
December 31, --------------------------- 1997 1998 - --------------------------------------------------------------------------------------------------------------- ASSETS - --------------------------------------------------------------------------------------------------------------- Current assets: - --------------------------------------------------------------------------------------------------------------- Cash $ 143,071 30,004 - --------------------------------------------------------------------------------------------------------------- Accounts receivable, less allowance for doubtful accounts of $93,501 in 1997 and $153,501 in 1998 2,918,092 2,816,589 - --------------------------------------------------------------------------------------------------------------- Investment in sales type leases, current portion 216,485 888,627 - --------------------------------------------------------------------------------------------------------------- Inventories 4,051,495 3,129,959 - --------------------------------------------------------------------------------------------------------------- Prepaid expenses 147,450 82,105 =============================================================================================================== Total current assets 7,476,593 6,947,284 =============================================================================================================== Property and equipment: - --------------------------------------------------------------------------------------------------------------- Leased machines 25,718,832 29,484,623 - --------------------------------------------------------------------------------------------------------------- Machinery and equipment 519,388 631,111 - --------------------------------------------------------------------------------------------------------------- Building and leasehold improvements 265,854 271,433 - --------------------------------------------------------------------------------------------------------------- Furniture and fixtures 124,359 130,950 =============================================================================================================== 26,628,433 30,518,117 Less accumulated depreciation and amortization (11,382,120) (12,970,895) =============================================================================================================== Net property and equipment 15,246,313 17,547,222 =============================================================================================================== Investment in sales type leases, less current portion 1,051,011 3,766,408 - --------------------------------------------------------------------------------------------------------------- Product development rights, net of accumulated amortization of $513,333 in 1997 and $586,665 in 1998 586,667 513,335 - --------------------------------------------------------------------------------------------------------------- Deferred tax asset 252,300 -- =============================================================================================================== $ 24,612,884 28,774,249 =============================================================================================================== LIABILITIES AND STOCKHOLDERS' EQUITY - --------------------------------------------------------------------------------------------------------------- Current liabilities: - --------------------------------------------------------------------------------------------------------------- Notes payable to financial institutions $ 8,978,036 11,166,374 - --------------------------------------------------------------------------------------------------------------- Current portion of notes payable - related parties -- 192,302 - --------------------------------------------------------------------------------------------------------------- Current installments of long-term debt 968 -- - --------------------------------------------------------------------------------------------------------------- Accounts payable 1,142,065 1,479,831 - --------------------------------------------------------------------------------------------------------------- Accounts payable - related parties 328,960 215,734 - --------------------------------------------------------------------------------------------------------------- Accrued expenses 1,254,182 1,111,416 - --------------------------------------------------------------------------------------------------------------- Income taxes payable 100,450 248,458 =============================================================================================================== Total current liabilities 11,804,661 14,414,115 =============================================================================================================== Notes payable - related parties, excluding current portion 479,000 286,698 - --------------------------------------------------------------------------------------------------------------- Deferred income taxes -- 121,900 =============================================================================================================== Total liabilities 12,283,661 14,822,713 =============================================================================================================== Series A preferred stock, $.01 par value; 20,000,000 shares authorized, 1,335,000 shares issued and outstanding 1,335,000 1,335,000 =============================================================================================================== Stockholders' equity: - --------------------------------------------------------------------------------------------------------------- Common stock, $.01 par value; 20,000,000 shares authorized, 3,210,000 shares issued and outstanding in 1997 and 1998 32,100 32,100 - --------------------------------------------------------------------------------------------------------------- Additional paid-in capital 10,376,017 10,376,017 - --------------------------------------------------------------------------------------------------------------- Retained earnings 586,106 2,208,419 =============================================================================================================== Total stockholders' equity 10,994,223 12,616,536 - --------------------------------------------------------------------------------------------------------------- Commitments and contingent liabilities - --------------------------------------------------------------------------------------------------------------- $ 24,612,884 28,774,249 =============================================================================================================== See accompanying notes to financial statements.
10 14 STATEMENTS OF INCOME
Years Ended December 31, -------------------------------------------- 1996 1997 1998 - ------------------------------------------------------------------------------------------------ Revenues: - ------------------------------------------------------------------------------------------------ Machine sales $ 5,596,698 4,567,441 8,229,950 - ------------------------------------------------------------------------------------------------ Machine leases 11,766,623 12,874,450 14,165,379 - ------------------------------------------------------------------------------------------------ Other 1,235,368 1,669,160 2,078,644 ================================================================================================ 18,598,689 19,111,051 24,473,973 ================================================================================================ Cost of revenues: - ------------------------------------------------------------------------------------------------ Machines sales and other 6,052,763 4,378,669 5,809,057 - ------------------------------------------------------------------------------------------------ Machine leases 6,583,227 7,508,261 10,310,565 ================================================================================================ 12,635,990 11,886,930 16,119,622 ================================================================================================ Gross margin 5,962,699 7,224,121 8,354,351 - ------------------------------------------------------------------------------------------------ Operating expenses: - ------------------------------------------------------------------------------------------------ Selling, general and administrative expenses 3,461,364 3,492,020 4,048,751 - ------------------------------------------------------------------------------------------------ Research and development costs 665,449 545,039 618,819 ================================================================================================ 4,126,813 4,037,059 4,667,570 ================================================================================================ Operating income 1,835,886 3,187,062 3,686,781 ================================================================================================ Other income (expense) - ------------------------------------------------------------------------------------------------ Interest expense (718,642) (747,008) (967,768) - ------------------------------------------------------------------------------------------------ Interest income 10,353 -- -- ================================================================================================ (708,289) (747,008) (967,768) ================================================================================================ Income before income taxes 1,127,597 2,440,054 2,719,013 - ------------------------------------------------------------------------------------------------ Income taxes (193,000) 988,400 1,096,700 ================================================================================================ Net income $ 1,320,597 1,451,654 1,622,313 ================================================================================================ Basic income per share $ .41 .45 .51 ================================================================================================ Diluted income per share $ .41 .45 .50 ================================================================================================ See accompanying notes to financial statements.
STATEMENTS OF STOCKHOLDERS' EQUITY
Years ended December 31, 1996, 1997 and 1998 - ---------------------------------------------------------------------------------------------------------------------- Common Stock Additional (Accumulated ------------------------ Paid-in Deficit) Shares Amount Capital Retained Earnings Total ------ ------ ------- ----------------- ----- - ---------------------------------------------------------------------------------------------------------------------- Balances at December 31, 1995 3,210,000 $32,100 $10,376,017 $(2,186,145) $ 8,221,972 - ---------------------------------------------------------------------------------------------------------------------- Net income -- -- -- 1,320,597 1,320,597 ====================================================================================================================== Balances at December 31, 1996 3,210,000 32,100 10,376,017 (865,548) 9,542,569 - ---------------------------------------------------------------------------------------------------------------------- Net income -- -- -- 1,451,654 1,451,654 ====================================================================================================================== Balances at December 31, 1997 3,210,000 32,100 10,376,017 586,106 10,994,223 - ---------------------------------------------------------------------------------------------------------------------- Net income -- -- -- 1,622,313 1,622,313 ====================================================================================================================== Balances at December 31, 1998 3,210,000 $32,100 $10,376,017 $ 2,208,419 $12,616,536 ====================================================================================================================== See accompanying notes to financial statements
11 15 STATEMENTS OF CASH FLOWS
Years Ended December 31, --------------------------------------- 1996 1997 1998 - ---------------------------------------------------------------------------------------------------------- Cash flows from operating activities: - ---------------------------------------------------------------------------------------------------------- Net income $ 1,320,597 1,451,654 1,622,313 - ---------------------------------------------------------------------------------------------------------- Adjustments to reconcile net income to net cash provided by operating activities: - ---------------------------------------------------------------------------------------------------------- Depreciation and amortization 3,902,387 4,143,408 4,585,325 - ---------------------------------------------------------------------------------------------------------- Principal portion of sales type leases received -- 164,194 557,116 - ---------------------------------------------------------------------------------------------------------- Deferred income taxes (456,000) 203,700 374,200 - ---------------------------------------------------------------------------------------------------------- Gain on sale of equipment under sales type leases -- (447,915) (1,177,773) - ---------------------------------------------------------------------------------------------------------- Decrease in accounts receivable 607,423 298,927 101,503 - ---------------------------------------------------------------------------------------------------------- (Increase) decrease in inventories (605,391) 1,035,052 1,110,268 - ---------------------------------------------------------------------------------------------------------- Decrease in prepaid expenses 183,152 6,804 32,345 - ---------------------------------------------------------------------------------------------------------- (Decrease) increase in accounts payable (100,288) 217,852 337,766 - ---------------------------------------------------------------------------------------------------------- (Decrease) increase in accounts payable - related parties 306,416 22,431 (113,226) - ---------------------------------------------------------------------------------------------------------- (Decrease) increase in accrued expenses 206,216 186,650 (142,766) - ---------------------------------------------------------------------------------------------------------- Increase (decrease) in income taxes payable 101,750 (1,300) 148,008 ========================================================================================================== Net cash provided by operating activities 5,466,262 7,281,457 7,435,079 ========================================================================================================== Cash flows from investing activities: - ---------------------------------------------------------------------------------------------------------- Cost of leased machines (3,904,534) (8,710,315) (9,611,623) - ---------------------------------------------------------------------------------------------------------- Purchases of property and equipment (47,858) (359,521) (123,893) ========================================================================================================== Net cash used in investing activities (3,952,392) (9,069,836) (9,735,516) ========================================================================================================== Cash flows from financing activities: - ---------------------------------------------------------------------------------------------------------- Increase (decrease) in notes payable (1,320,985) 1,747,865 2,188,338 - ---------------------------------------------------------------------------------------------------------- Repayments of long-term debt (4,659) (5,001) (968) - ---------------------------------------------------------------------------------------------------------- Net cash provided by (used in) financing activities (1,325,644) 1,742,864 2,187,370 ========================================================================================================== Decrease (increase) in cash 188,226 (45,515) (113,067) - ---------------------------------------------------------------------------------------------------------- Cash at beginning of year 360 188,586 143,071 ========================================================================================================== Cash at end of year $ 188,586 143,071 30,004 ========================================================================================================== Supplemental disclosures of cash flow information: - ---------------------------------------------------------------------------------------------------------- Interest paid $ 643,822 671,515 902,252 - ---------------------------------------------------------------------------------------------------------- Income taxes paid $ -- 631,610 526,807 ========================================================================================================== See accompanying notes to financial statements.
12 16 NOTES TO FINANCIAL STATEMENTS Years ended December 31, 1996, 1997, and 1998 1. Summary of Significant Accounting Policies a. Business Description Interlott Technologies, Inc. (the Company), as renamed in June 1997 (formerly International Lottery, Inc.) was incorporated in February 1990 under the laws of Ohio, was reincorporated under the laws of Delaware on March 18, 1994 and does business under the name Interlott. The Company designs, manufactures, leases, sells and services vending machines for use in connection with public lotteries operated by states and foreign public entities, as well as for use by providers of prepaid telephone cards. b. Operating and Sales Type Leases Depending on the specific terms contained in a lease agreement, a lease is either classified as an operating lease or capitalized as a sales type lease, in accordance with Statement of Financial Accounting Standards (SFAS) No. 13, Accounting for Leases, as amended. The net investment in operating leases consists of leased machines, which are carried at cost, less the amount depreciated to date. Operating lease revenue consists of the contractual lease payments and is recognized ratably over the lease term. Expenses are principally depreciation and maintenance of the leased machines (see Note 1d). The net investment in sales type leases consists of the present values of the future minimum lease payments. Sales type lease revenues consist of the profits earned on the sales of the leased machines and interest earned on the present value of the lease payments. Interest revenue is recognized as a constant percentage return on the net investment. Any future losses related to lease cancellations would be recorded in the period such losses became known and estimable. c. Inventories Inventories consist of parts and supplies, and vending machines assembled or in the process of assembly. Inventories are stated at the lower of cost or market, with cost determined using standard costing which approximates the first-in, first-out method. d. Property and Equipment Property and equipment are stated at cost. Depreciation of property and equipment is calculated on the straight-line method over the estimated useful lives of the assets, to the Company's estimate of the assets' residual values, as follows: ------------------------------------------------------------- Leased machines 5 years Machinery and equipment 10 years Furniture and fixtures 5 years -------------------------------------------------------------
Leasehold improvements are amortized on the straight-line method over the lease term. Amortization of assets held under leasehold improvements is included with depreciation expense. e. Product Development Rights Product development rights represent the exclusive rights to certain patents and other related manufacturing technologies to manufacture and assemble the instant ticket vending machines. The asset is amortized on the straight-line method over fifteen years, which represents the lower of the remaining life of the patents or the estimated remaining life of the technology currently in use. The Company assesses the recoverability of this intangible asset by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future cash flows of the Company. The amount of the asset impairment, if any, is measured based on projected discounted operating cash flows using a discount rate reflecting the Company's average cost of funds. The assessment of the recoverability of the asset will be impacted if estimated future operating cash flows are not achieved. f. Income Taxes The Company accounts for income taxes using the asset and liability method. In accordance with this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under this method, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the rate change enactment date. g. Disclosure About Fair Value of Financial Instruments SFAS No. 107, Disclosure About Fair Value of Financial Instruments, defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties. The carrying amounts as of December 31, 1998 of cash, accounts receivable, accounts payable, accounts payable - related parties, accrued expenses and income taxes payable approximate fair value due to the short maturity of these investments. The carrying amount of notes payable to financial institutions and notes payable - related parties approximate fair value, as such borrowings bear interest at the Company's current rates for such types of instruments. h. Stock Incentive Plans Prior to January 1, 1996, the Company accounted for its stock incentive plans in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. On January 1, 1996, the Company adopted SFAS No. 123, Accounting for Stock-Based Compensation, which permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and pro forma income per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS No. 123 had been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123. i. Warranty Costs Provision for estimated warranty costs on machines sold is recorded at the time of sale and periodically adjusted to reflect actual experience. j. Research and Development Costs Research and development costs are charged to expense in the year incurred. k. Income Per Share Effective December 31, 1997, the Company adopted SFAS No. 128, Earnings Per Share, which simplified the standards for computing income per share. There was no material impact on the Company's previously reported annual or interim period income per share amounts, as a result of the adoption. Basic income per share is based upon the weighted average number of common shares outstanding. Diluted income per share is based upon the weighted average number of common shares outstanding, including the effects of all dilutive potential common shares outstanding. l. Use of Estimates Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates. m. Reclassifications Certain prior year amounts have been reclassified to conform with the current year presentation. 2. Investment in Sales Type Leases The Company leases 200 instant ticket vending machines (ITVMs) to one state lottery under a sales type lease that commenced in May 1997 and 585 ITVMs to another state lottery under a sales type lease that commenced in May 1998. The components of the net investment in sales type leases at December 31, 1997 and 1998 are as follows: 13 17
1997 1998 --------------------------------------------------- Minimum lease payments receivable $1,851,200 6,134,450 Less unearned revenue on lease payments receivable 583,704 1,479,415 --------------------------------------------------- 1,267,496 4,655,035 Less current portion 216,485 888,627 --------------------------------------------------- Investment in sales type leases, less current portion $1,051,011 3,766,408 ---------------------------------------------------
Future minimum lease payments to be received by the Company under these sales type leases are as follows:
Years ending December 31, ---------------------------------------- 1999 $1,480,200 2000 1,480,200 2001 1,480,200 2002 1,195,400 2003 498,450 ---------------------------------------- $6,134,450 ----------------------------------------
3. Inventories Inventories at December 31, 1997 and 1998 consist of the following:
1997 1998 ---------------------------------------------- Finished goods $1,155,808 1,528,656 Work in process 82,162 302,766 Raw materials and supplies 3,088,525 2,506,647 4,326,495 4,338,069 ---------------------------------------------- Less valuation reserve 275,000 1,208,110 ---------------------------------------------- $4,051,495 3,129,959 ----------------------------------------------
4. Leased Machines At December 31, 1997 and 1998, the Company leased 6,834 and 7,027 ITVMs to 14 state lotteries, respectively, under operating leases. The leases generally provide for the lotteries to make monthly or quarterly payments for rentals of the ITVMs over various lease terms. The components of the net investment in operating leases, which include estimated residual values, at December 31, 1997 and 1998 are as follows:
1997 1998 --------------------------------------------- Leased machines $25,718,832 29,484,623 Less accumulated depreciation 10,978,370 12,378,732 --------------------------------------------- $14,740,462 17,105,891 ---------------------------------------------
Future minimum lease payments to be received by the Company under operating leases are as follows:
Years ending December 31, ------------------------------------------ 1999 $ 9,357,250 2000 3,558,582 2001 963,792 2002 963,792 2003 375,000 ------------------------------------------- $15,218,416 -------------------------------------------
5. Notes Payable The Company had a revolving credit facility with a financial institution that permitted the Company to borrow through September 1998 up to $12,500,000 at the prime interest rate plus 1.0%. Draws against this facility were made in the form of demand notes. The Company paid an annual commitment fee of .25% on the unused portion of the commitment and a monthly usage fee equal to .25% of the highest outstanding balance during each month. Borrowings under this agreement were collateralized by all assets of the Company and assignment of proceeds from lease agreements. This borrowing was retired with proceeds from the new borrowing entered into in October 1997. In October 1997, the Company entered into a new revolving credit facility with a financial institution that permits the Company to borrow through October 2000 up to $15,000,000 at a floating rate indexed to the London Interbank Borrowing Offer Rate or the financial institutions prime interest rate of 5.63% and 7.75%, respectively at December 31, 1998. In conjunction with the establishment of the facility, the Company opened a lockbox and controlled disbursement account. All lockbox receipts are recorded as payments against the facility, and presented checks are recorded as draws on the facility. Borrowings under this credit facility are collateralized by all assets of the Company and assignment of proceeds from lease agreements. At December 31, 1997 and 1998, the Company had borrowings of $8,978,036 and $11,166,374 outstanding with additional borrowings of $6,021,964 and $3,833,626 available under the facility, respectively. 6. Long-Term Debt Long-term debt at December 31, 1997 represented a term note payable to a bank with final payment due February 20, 1998, payable in monthly installments of $448, including interest at a rate of 7.99% per annum. The note was collateralized by automotive equipment and was repaid in 1998. 7. Notes Payable - Related Parties The Company has the following notes payable to related parties at December 31, 1997 and 1998:
1997 1998 ---------------------------------------------------------------------- Note payable to a stockholder due in annual installments equal to twenty-five percent (25%) of the net profits, if any, of the Company from its business operations as reported in the Company's annual financial statements prepared in accordance with generally accepted accounting principles. The payments shall begin on the first business day of the fourth month of the Company's fiscal year, for income tax purposes, immediately following (1) the payment of all debts of the Company outstanding as of September 25, 1992 and (2) the posting by the Company of retained earnings of at least $1,000,000 determined in accordance with generally accepted accounting principles, and continue on the same day each year until the principal and unpaid interest is paid in full. The note bears interest at the prime rate of Chase Manhattan Bank of New York (7.75% at December 31, 1998). The note is unsecured. $400,000 400,000 Note payable to a stockholder due and limited to twenty-five percent (25%) of the net profits of the Company, if any, from its business operations as reported in the Company's annual financial statements prepared in accordance with generally accepted accounting principles. The payments shall begin on the first business day of the fourth month of the Company's first year, for income tax purposes, immediately following (1) the payments of all debts of the Company outstanding as of September 25, 1992; (2) the posting by the Company of retained earnings of at least $1,000,000 determined in accordance with generally accepted accounting principles; and (3) payment in full of principal and interest due by the Company to a stockholder in the amount of $400,000. The note does not provide for any interest and is unsecured. 79,000 79,000 ---------------------------------------------------------------------- 479,000 479,000 Less current portion - 192,302 ---------------------------------------------------------------------- $479,000 286,698 ----------------------------------------------------------------------
14 18 8. Income Taxes Income tax expense (benefit) is summarized as follows:
Year ended December 31, --------------------------------------------------- 1996 1997 1998 --------------------------------------------------- Current: Federal $ 200,000 557,400 566,000 State and local 63,000 156,000 156,500 Deferred: State and local (456,000) 275,000 374,200 --------------------------------------------------- $(193,000) 988,400 1,096,700 ---------------------------------------------------
A reconciliation of income tax expense (benefit) in relation to the amounts computed by application of the U.S. Federal income tax rate of 34% to pretax income follows:
1996 1997 1998 ----------------------------------------------------------------------- Federal income tax expense at the statutory rate $383,000 830,000 924,400 Increase (reduction) in income taxes resulting from: Change in the beginning- of-the-year balance of the valuation allowance for the deferred tax assets allocated to income tax expense (672,000) - Amortization of product development rights 25,000 25,000 25,000 State and local taxes, net of federal benefit 63,000 103,000 103,300 Other 8,000 30,400 44,000 ----------------------------------------------------------------------- $(193,000) 988,400 1,096,700 -----------------------------------------------------------------------
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1997 and 1998 are presented below:
1997 1998 ---------------------------------------------------------------------- Deferred tax assets: Bad debt allowance $ 32,000 52,200 Warranty costs 9,000 10,100 Net operating loss carryforwards 400,000 347,100 Inventory valuation reserve -- 317,300 Other, net 73,300 -- ---------------------------------------------------------------------- Total gross deferred tax assets 514,300 726,700 ---------------------------------------------------------------------- Deferred tax liabilities: Property and equipment, principally due to differences in depreciation 127,000 537,800 Investment in sales type leases 135,000 310,800 ---------------------------------------------------------------------- Total gross deferred tax liabilities 262,000 848,600 ---------------------------------------------------------------------- Net deferred tax assets (liabilities) $252,300 (121,900) ----------------------------------------------------------------------
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future income and tax planning strategies in making this assessment. At December 31, 1998, the Company has net operating loss carryforwards for Federal income tax purposes of approximately $1,021,000, which are available to offset future Federal taxable income, if any, through 2009. However, due to an ownership change on September 25, 1992, utilization of these carryforwards is subject to certain annual limitations. 9. Redeemable Preferred Stock The Company's preferred stock is nonparticipating and has no rights to dividends. The holders of the preferred stock are entitled to sell to the Company all of their shares of preferred stock at a price of $1.00 per share upon (1) the payment of all debts of the Company outstanding as of September 25, 1992, (2) the reporting by the Company of retained earnings of at least $1,000,000 determined in accordance with generally accepted accounting principles, and (3) the payment in full by the Company of a promissory note in the original amount of $400,000 to a related party. Due to the redemption feature of the preferred stock, it has been classified separately from stockholders' equity in the Company's balance sheet. The Company may, at its discretion, redeem all or part of the outstanding preferred stock at any time. The redemption price for the preferred stock is $1.00 per share and may be payable in the form of a promissory note. 10. Stock Incentive Plans In March 1994, the Company and its Board of Directors approved and adopted the Company's 1994 Stock Incentive Plan and the Company's 1994 Directors' Stock Incentive Plan (collectively, the Plans), which became effective at the date of the initial public offering. The Plans provide for the issuance of stock options for up to 260,000 shares of common stock to officers, employees, consultants and other supporters of the Company and up to 60,000 shares of common stock to nonemployee directors of the Company. Stock options are granted with an exercise price equal to the stock's fair market value at the date of grant. Options may be exercised subject to a vesting schedule which provides for vesting each year for a period of four years subject to the recipient's continued employment or service to the Company, and must be exercised within 10 years after the date of grant. As permitted by SFAS No. 123, the Company applies the intrinsic value method prescribed by APB Opinion No. 25 and related interpretations in accounting for its stock option plans. Accordingly, no compensation cost has been recognized in the accompanying statements of income. A summary of the status of the Company's stock option plans as of December 31, 1996, 1997, and 1998 and the changes therein for the years then ended is presented below:
1996 1997 1998 --------------------------------------------------------------------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price --------------------------------------------------------------------------------- Outstanding at beginning of year 131,725 $ 9.66 147,225 $ 9.38 180,875 $ 9.12 Granted 15,500 7.00 37,000 8.00 36,300 6.75 Exercised -- -- -- -- -- -- Forfeited -- -- 3,350 11.50 5,000 11.50 --------------------------------------------------------------------------------- Outstanding at end of year 147,225 9.38 180,875 9.12 212,175 8.65 Options exercisable at year-end 49,926 10.05 79,660 9.77 120,794 9.48 --------------------------------------------------------------------------------- Weighted-average fair value of options granted during the year $ 5.11 $ 5.82 $ 5.16 ---------------------------------------------------------------------------------
Had compensation cost for options granted during 1996, 1997 and 1998 been determined consistent with the fair value methodology of SFAS No. 123, the Company's net income and income per share would have been reduced to the pro forma amounts presented below:
1996 1997 1998 ------------------------------------------------------------------------- Net income As reported $ 1,320,597 1,451,654 1,622,313 Pro forma 1,307,807 1,324,003 1,511,265 ------------------------------------------------------------------------- Basic income per share As reported .41 .45 .51 Pro forma .41 .41 .47 ------------------------------------------------------------------------- Diluted income per share As reported .41 .45 .50 Pro forma .41 .41 .47 -------------------------------------------------------------------------
The full impact of calculating compensation cost for stock options under SFAS No. 123 is not reflected in the pro forma net income amounts presented above because compensation cost is recognized over the options' vesting period of four years and compensation cost for options granted prior to January 1, 1995 is not considered. The fair value of options granted during 1996, 1997 and 1998 for purposes of the accompanying pro forma disclosures is estimated on the grant date using the Black-Scholes option-pricing model with the following weighted-average assumptions: no 15 19 dividends paid, as it has been the Company's policy not to declare or pay dividends since its initial public offering in 1994 and the Company does not anticipate paying dividends in the foreseeable future; expected volatility of 52%, 56% and 65%, respectively, based on the calculated volatility of the Company's stock since its initial public offering; risk-free rates of return of 6.66%, 5.86% and 4.98%, respectively; and expected lives of 10 years. Information about stock options outstanding at December 31, 1998 is as follows:
Options Outstanding Options Exercisable ------------------------------------------------------------------------------------------ Range Weighted-Avg. of Remaining Weighted-Avg. Weighted-Avg. Exercise Number Contractual Exercise Number Exercisable Prices Outstanding Life Price Exercisable Price ------------------------------------------------------------------------------------------ 6.50 - 8.63 165,550 7.75 $ 7.86 76,813 $ 8.33 10.13 - 11.50 46,625 5.53 11.43 44,125 11.50 ------------------------------------------------------------------------------------------ 212,175 7.26 $ 8.65 120,938 $ 9.49 ==========================================================================================
11. Income Per Share The computations of basic and diluted income per share for each year are as follows:
---------------------------------------------------------------------------- Net Per Earnings Shares Share 1996 (Numerator) (Denominator) Amount ---------------------------------------------------------------------------- Basic income per share: Net income available to common stockholders $1,320,597 3,210,000 0.41 ---------------------------------------------------------------------------- Diluted income per share: Effect of dilutive securities stock options -- 2,000 Net income available to common stockholders and assumed conversions 1,320,597 3,212,000 0.41 ---------------------------------------------------------------------------- 1997 ---------------------------------------------------------------------------- Basic income per share: Net income available to common stockholders 1,451,654 3,210,000 0.45 ---------------------------------------------------------------------------- Diluted income per share: Effect of dilutive securities stock options -- 2,661 Net income available to common stockholders and assumed conversions 1,451,654 3,212,661 0.45 ---------------------------------------------------------------------------- 1998 ---------------------------------------------------------------------------- Basic income per share: Net income available to common stockholders 1,622,313 3,210,000 0.51 ---------------------------------------------------------------------------- Diluted income per share: Effect of dilutive securities stock options -- 10,649 Net income available to common stockholders and assumed conversions 1,622,313 3,220,649 0.50 ----------------------------------------------------------------------------
Options to purchase 49,975, 129,725 and 52,475 shares of common stock were outstanding in 1996, 1997 and 1998, respectively, but were not included in the computation of diluted income per share because the options' exercise prices were greater than the average market price of common shares. 12. Noncash Investing Activities Upon lease expiration in 1998, one state lottery returned to the Company leased machines with a net book value of $442, 897. The Company used parts from these returned machines in the manufacturing of recertified new machines. Some of the recertified new machines were deployed in 1998 under new leases. 13. Related Party Transactions Accounts payable - related parties is $328,960 and $215,734 at December 31, 1997 and 1998, respectively, and represent management fees and expenses payable to a company owned 100% by the majority stockholder and parts expenses payable to an entity which is owned by a director. Amounts expensed related to the company owned by the majority stockholder were $73,321, $36,000 and $36,000 for the years ended December 31, 1996, 1997 and 1998, respectively. The entity owned by a director supplies the Company with certain parts for its dispensing mechanisms. In addition, on January 13, 1994, the Company entered into a manufacturing and license agreement with this entity pursuant to which the Company purchased an exclusive license to make, use and sell pull-tab lottery ticket dispensing mechanisms produced by this entity. The Company had purchases from this entity which were charged to cost of revenues of approximately $1,986,000, $2,996,000 and $3,800,887 for the years ended December 31, 1996, 1997 and 1998, respectively. Interest expense arising from notes payable-related parties amounted to $33,085, $33,714 and $33,401 for the years ended December 31, 1996, 1997 and 1998, respectively. 14. Customer and Supplier Concentrations A significant portion of the Company's revenues is derived from a limited number of state lottery authorities or their representatives for the lease, sale or service of ITVMs. For the years ended December 31, 1996, 1997 and 1998, one customer generated 45%, 29% and 24%, respectively, of the machine lease revenues. In addition, single state contracts generated 69%, 32% and 48% of the machine sales revenues for the years ended December 31, 1996, 1997 and 1998, respectively. Future revenue from machine sales is dependent upon the Company winning awards in a competitive bidding process. The Company currently purchases certain components used in its vending machines, including components used in its burster mechanism and its bill acceptor mechanism, from single suppliers. The purchase of components from outside suppliers on a sole source basis subjects the Company to certain risks, including the continued availability of suppliers, price increases and potential quality assurance problems. Because other suppliers exist that can duplicate these components should the Company elect or be forced to use a different supplier, the Company does not believe that any such change in suppliers would result in the termination of a production contract. However, the Company could experience a delay of 30 to 60 days in the production of vending machines should it elect or be forced to use other suppliers for these components. Any delay of more than 30 to 60 days could adversely affect the Company's ability to make timely deliveries of vending machines and to obtain new contracts. 15. Lease Commitments The Company leases its office, manufacturing and warehouse facilities under noncancelable operating leases. The leases expire on December 31, 1999, and require lease payments of $50,000, $91,000 and $69,000 a year, respectively, through expiration. Total rent expense under these leases approximated $91,000, $141,000 and $210,000, for the years ended December 31, 1996, 1997 and 1998, respectively. 16. Segment and Related Information Effective January 1, 1998, the Company adopted SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, which changes the way the Company reports information about its operating segments. The Company has two reportable segments: ITVMs and prepaid phone card dispensing machines (PCDMs). The ITVM segment is the larger of the Company's two segments. The Company designs, manufactures, sells, leases and services ITVMs that are used by public lotteries operated by states and foreign public entities to dispense instant winner lottery tickets primarily in retail locations such as supermarkets and convenience stores. Within the PCDM segment, the Company designs, manufactures, sells, leases and services PCDMs that are used by providers of long distance telephone service to dispense prepaid telephone calling cards in retail locations. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on segment operating profits.
ITVM PCDM Total ---------------------------------------------------------------------- 1996 Revenues $18,179,353 419,336 18,598,689 Segment gross margin 5,915,851 46,848 5,962,699 Total assets 19,158,006 745,958 19,903,964 Capital expenditures 3,902,041 2,493 3,904,534 Depreciation 3,734,696 9,369 3,744,065 ---------------------------------------------------------------------- 1997 Revenues 18,586,960 524,091 19,111,051 Segment gross margin 7,133,182 90,939 7,224,121 Total assets 23,105,044 459,168 23,564,212 Capital expenditures 8,661,022 49,293 8,710,315 Depreciation 3,910,146 14,098 3,924,244 ---------------------------------------------------------------------- 1998 Revenues 23,965,442 508,531 24,473,973 Segment gross margin 8,310,947 43,404 8,354,351 Total assets 27,478,447 742,362 28,220,809 Capital expenditures 9,486,255 125,368 9,611,623 Depreciation 4,231,700 58,428 4,290,128 ----------------------------------------------------------------------
Total assets for the segments excludes cash, prepaid expenses, net property and equipment other than leased machines and deferred tax assets, as such assets are not specifically identifiable to a particular segment. 17. Commitments and Contingent Liabilities As of December 31, 1998, the Company had outstanding purchase commitments for raw materials of approximately $4,368,184, of which $4,050,184 and $318,000 will be used in the manufacturing of instant ticket and prepaid telephone card vending machines, respectively. Management intends to utilize these commitments as machines are produced. 16 20 Photo of world with a finger pushing button on it Placing products and information at a fingertip- 21 CORPORATE DATA & SHAREHOLDER INFORMATION HEADQUARTERS Interlott Technologies, Inc. 10830 Millington Court Cincinnati, OH 45242 (513) 792-7000 INVESTOR INQUIRIES Chief Financial Officer 10830 Millington Court Cincinnati, OH 45242 (513) 792-7000 REGISTRAR AND TRANSFER AGENT First Union National Bank 230 South Tryon Street Charlotte, NC 28288-1154 CORPORATE COUNSEL Alston & Bird LLP Atlanta, Georgia Taft, Stettinius & Hollister LLP Cincinnati, Ohio INDEPENDENT AUDITORS KPMG Peat Marwick LLP Cincinnati, OH OFFICERS L. Rogers Wells, Jr. Chairman of the Board and CEO David F. Nichols President Gary S. Bell Secretary Thomas W. Stokes Vice President of Operations Dennis W. Blazer Chief Financial Officer DIRECTORS L. Rogers Wells, Jr. Chairman of the Board and CEO Edmund F. Turek Board Member Gary S. Bell Secretary Kazmier J. Kasper President, Algonquin Industries, Inc. a manufacturer of metal and machined parts H. Jean Marshall Project Director for the City of Cincinnati David F. Nichols President John J. Wingfield Manager, A. G. Edwards & Sons, Inc., Louisville an investment banking company The Company's Common Stock has been traded on the American Stock Exchange under the symbol "ILI" since the Company's initial public offering of Common Stock in April 1994. Prior to the initial public offering, there was no established trading market for the Company's Common Stock. The following tables show the high and low closing sale prices per share for the Common Stock as reported by the American Stock Exchange for the periods indicated:
1997 HIGH LOW ============================================== First Quarter $ 8 1/8 6 5/8 - ---------------------------------------------- Second Quarter 8 1/4 6 1/2 - ---------------------------------------------- Third Quarter 10 11/16 6 7/8 - ---------------------------------------------- Fourth Quarter 10 5/8 7 5/8
1998 HIGH LOW ============================================== First Quarter $ 9 3/4 7 3/4 - ---------------------------------------------- Second Quarter 14 9 5/8 - ---------------------------------------------- Third Quarter 10 3/4 7 7/8 - ---------------------------------------------- Fourth Quarter 8 1/8 6 1/2 ==============================================
At March 12,1998, there were approximately 68 stockholders of record and an unknown number of beneficial owners holding stock in nominee or "street" name. The Company has paid no cash dividends on its Common Stock and currently intends to retain all future earnings for use in the development of its business. Form 10-K: A copy of the Company's 1998 Annual Report on Form 10-K, as filed with the Securities and Exchange Commission, is available, without exhibits, free of charge to shareholders. Requests should be addressed to: Shareholder Relations Interlott Technologies, Inc. 10830 Millington Court Cincinnati, OH 45242 The 1999 Annual Meeting will be held at The Holiday Inn Cincinnati North at I-275, on May 6, 1999 at 10:00am, local time. INTERLOTT TECHNOLOGIES, INC. 22 INTERLOTT TECHNOLOGIES, INC. 10830 Millington Court Cincinnati, OH 45242 Phone 513.792.7000 Fax 513.792.7001 www.interlott.com EX-23 5 CONSENT OF KPMP LLP 1 EXHIBIT 23 Consent of Independent Auditors The Board of Directors and Stockholders Interlott Technologies, Inc.: We consent to incorporation by reference in the Registration Statement No. 333-08999 on Form S-3 of Interlott Technologies, Inc. of our report dated February 26, 1999, relating to the balance sheets of Interlott Technologies, Inc. as of December 31, 1997 and 1998, and the related statements of income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1998, and the related schedule, which report appears in the 1998 annual report to stockholders, which is incorporated by reference in the December 31, 1998 Form 10-K of Interlott Technologies, Inc. KPMG LLP March 24, 1999 EX-24 6 POWERS OF ATTORNEY 1 EXHIBIT 24 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENT, that the undersigned constitutes and appoints L. Rogers Wells, Jr. and Dennis W. Blazer and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K of Interlott Technologies, Inc. for the fiscal year ended December 31, 1998, and any and all amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission and the American Stock Exchange, granting unto said attorneys-in-fact and agents. and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. This 25th day of March, 1999. /s/ Gary S. Bell ----------------------------------- Gary S. Bell 2 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENT, that the undersigned constitutes and appoints L. Rogers Wells, Jr. and Dennis W. Blazer and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K of Interlott Technologies, Inc. for the fiscal year ended December 31, 1998, and any and all amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission and the American Stock Exchange, granting unto said attorneys-in-fact and agents. and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. This 25th day of March, 1999. /s/ Kazmier J. Kasper -------------------------------------------- Kazmier J. Kasper 3 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENT, that the undersigned constitutes and appoints L. Rogers Wells, Jr. and Dennis W. Blazer and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K of Interlott Technologies, Inc. for the fiscal year ended December 31, 1998, and any and all amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission and the American Stock Exchange, granting unto said attorneys-in-fact and agents. and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. This 25th day of March, 1999. /s/ H. Jean Marshall -------------------------------------------- H. Jean Marshall 4 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENT, that the undersigned constitutes and appoints L. Rogers Wells, Jr. and Dennis W. Blazer and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K of Interlott Technologies, Inc. for the fiscal year ended December 31, 1998, and any and all amendments thereto, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission and the American Stock Exchange, granting unto said attorneys-in-fact and agents. and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. This 25th day of March, 1999. /s/ John J. Wingfield -------------------------------------------- John J. Wingfield EX-27 7 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM INTERLOTT TECHNOLOGIES, INC. FINANCIAL STATEMENTS FOR THE PERIOD ENDED DECEMBER 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR DEC-31-1998 DEC-31-1998 30 0 2,817 0 3,130 6,947 30,518 12,971 28,774 14,414 287 1,335 0 32 12,584 28,774 8,230 24,474 16,120 20,787 0 0 968 2,719 1,097 1,622 0 0 0 1,622 0.51 0.50 AMOUNTS INAPPLICABLE OR NOT DISCLOSED AS A SEPARATE LINE ON THE CONDENSED BALANCE SHEETS AND STATEMENT OF OPERATIONS ARE REPORTED AS 0 HEREIN. RECEIVABLES ARE REPORTED NET OF ALLOWANCES IN THE CONDENSED BALANCE SHEETS.
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