SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
Form 10-Q
[X] Quarterly Report under Section 13 or 15(d) of the Securities Exchange Act
of 1934
For the Quarterly Period Ended: June 30, 2002
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ___________ to ____________
Commission File Number: 0-28318
MULTIMEDIA GAMES, INC.
(Exact Name of Registrant as Specified in its Charter)
TEXAS 74-2611034
(State or Other Jurisdiction of (IRS Employer Identification
Incorporation) Number)
8900 Shoal Creek Blvd., Suite 300
Austin, Texas 78757
(Address of Principal Executive Offices)
(512) 371-7100
(Registrant's Telephone Number, Including Area Code)
(Former name, former address and former
fiscal year, if changed since last report)
Indicate by check whether the Registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the past 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 __
As of June 30, 2002 there were 12,817,413 shares of the Company's Common Stock,
par value $.01, outstanding.
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
------------------------------
Item 1. Financial Statements
Condensed Consolidated Balance Sheets
(As of June 30, 2002 (unaudited) and September 30, 2001 (audited)).............................................3
Unaudited Condensed Consolidated Statements of Income
(For the three months ended June 30, 2002 and 2001)............................................................4
Unaudited Condensed Consolidated Statements of Income
(For the nine months ended June 30, 2002 and 2001).............................................................5
Unaudited Condensed Consolidated Statements of Cash Flows
(For the nine months ended June 30, 2002 and 2001).............................................................6
Notes to Unaudited Consolidated Financial Statements............................................................7
Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations................12
Item 3. Quantitative and Qualitative Disclosures about Market Risk............................................27
PART II. OTHER INFORMATION
--------------------------
Item 1. Legal Proceedings.....................................................................................28
Item 4. Submission of Matters to a Vote of Security Holders...................................................29
Item 6. Exhibits and Reports on Form 8-K......................................................................29
-2-
PART I
FINANCIAL INFORMATION
MULTIMEDIA GAMES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
AS OF JUNE 30, 2002 AND SEPTEMBER 30, 2001
JUNE 30, SEPTEMBER 30,
2002 2001
------------------ ------------------
(Unaudited) (Audited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 19,593,000 $ 4,868,000
Accounts receivable
Trade 4,471,000 3,794,000
Game reserve -- 81,000
Other 494,000 123,000
Allowance for doubtful accounts (620,000) (343,000)
Inventory 1,409,000 2,634,000
Prepaid expenses 2,798,000 1,877,000
Notes receivable 974,000 711,000
Deferred taxes 627,000 765,000
------------------ ------------------
Total current assets 29,746,000 14,510,000
Restricted cash and long-term investments 1,393,000 1,764,000
Inventory - non-current 5,636,000 4,096,000
Property and equipment, net 37,797,000 21,664,000
Deferred taxes 313,000 1,895,000
Other assets 549,000 375,000
Goodwill, net 342,000 363,000
------------------ ------------------
Total assets $ 75,776,000 $ 44,667,000
================== ==================
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Current portion of long-term debt $ 277,000 $ --
Accounts payable and accrued expenses 12,525,000 7,673,000
Federal income tax payable -- 1,150,000
State income tax payable 2,025,000 1,377,000
Halls' share of surplus 765,000 --
Prize fulfillment fees payable 20,000 99,000
------------------ ------------------
Total current liabilities 15,612,000 10,299,000
Long-term debt, less current portion 372,000 --
Other long-term liabilities 1,398,000 2,000,000
------------------ ------------------
Total liabilities 17,382,000 12,299,000
------------------ ------------------
Commitments and contingencies (Note 2)
Stockholders' equity:
Preferred stock, Series A, $0.01 par value, 2,000,000 shares
authorized, none and 9,203 shares issued and outstanding,
respectively -- --
Common stock, $0.01 par value, 25,000,000 shares authorized
13,891,758 and 12,983,538 shares issued, and
12,817,413 and 11,909,799 shares outstanding, respectively 139,000 130,000
Additional paid-in capital 40,434,000 32,586,000
Stockholders' notes receivable (2,190,000) (1,896,000)
Treasury stock, 1,074,345 and 1,073,739 shares
at cost, respectively (5,847,000) (5,830,000)
Retained earnings 25,858,000 7,378,000
------------------ ------------------
Total stockholders' equity 58,394,000 32,368,000
------------------ ------------------
Total liabilities and stockholders' equity $ 75,776,000 $ 44,667,000
================== ==================
The accompanying notes are an integral part of the condensed
consolidated financial statements.
-3-
MULTIMEDIA GAMES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE MONTHS ENDED JUNE, 2002 AND 2001
2002 2001
----------------- ----------------
(Unaudited) (Unaudited)
REVENUES:
Gaming revenue - Class II $ 74,048,000 $ 32,692,000
Gaming revenue - Class III 1,630,000 1,369,000
Player station sale and lease revenue 2,546,000 1,228,000
Other 396,000 150,000
----------------- ----------------
Total revenues 78,620,000 35,439,000
Bingo prizes and related costs (395,000) (426,000)
Allotments to hall operators (52,366,000) (23,180,000)
----------------- ----------------
Net revenues 25,859,000 11,833,000
----------------- ----------------
OPERATING COSTS AND EXPENSES:
Cost of electronic player stations sold 1,334,000 592,000
Selling, general and administrative expenses 8,809,000 5,003,000
Write off of offering costs 780,000 --
Amortization and depreciation 3,622,000 2,685,000
----------------- ----------------
Total operating costs and expenses 14,545,000 8,280,000
----------------- ----------------
Operating income 11,314,000 3,553,000
Interest income 76,000 25,000
Interest expense (10,000) (198,000)
----------------- ----------------
Income before income taxes 11,380,000 3,380,000
Income tax expense (4,537,000) (1,425,000)
----------------- ----------------
Net income $ 6,843,000 $ 1,955,000
----------------- ----------------
Basic earnings per share $ 0.54 $ 0.23
================= ================
Diluted earnings per share $ 0.47 $ 0.16
================= ================
The accompanying notes are an integral part of the condensed
consolidated financial statements.
-4-
MULTIMEDIA GAMES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
FOR THE NINE MONTHS ENDED JUNE 30, 2002 AND 2001
2002 2001
----------------- ----------------
(Unaudited) (Unaudited)
REVENUES:
Gaming revenue - Class II $ 201,672,000 $ 76,836,000
Gaming revenue - Class III 4,419,000 3,393,000
Player station sale and lease revenue 6,324,000 3,135,000
Other 1,049,000 666,000
----------------- ----------------
Total revenues 213,464,000 84,030,000
Bingo prizes and related costs (1,127,000) (1,914,000)
Allotments to hall operators (142,792,000) (54,260,000)
----------------- ----------------
Net revenues 69,545,000 27,856,000
----------------- ----------------
OPERATING COSTS AND EXPENSES:
Cost of electronic player stations sold 4,149,000 1,502,000
Selling, general and administrative expenses 23,960,000 13,105,000
Write off of offering costs 780,000 ---
Amortization and depreciation 10,433,000 7,294,000
----------------- ----------------
Total operating costs and expenses 39,322,000 21,901,000
----------------- ----------------
Operating income 30,223,000 5,955,000
Interest income 189,000 82,000
Interest expense (38,000) (530,000)
----------------- ----------------
Income before income taxes 30,374,000 5,507,000
Income tax expense (11,890,000) (2,243,000)
----------------- ----------------
Net income $ 18,484,000 $ 3,264,000
----------------- ----------------
Basic earnings per share $ 1.50 $ 0.39
================= ================
Diluted earnings per share $ 1.27 $ 0.31
================= ================
The accompanying notes are an integral part of the condensed
consolidated financial statements.
-5-
MULTIMEDIA GAMES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED JUNE 30, 2002 AND 2001
2002 2001
----------------- ----------------
(Unaudited) (Unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 18,484,000 $ 3,264,000
Adjustments to reconcile net income to cash and cash equivalents
provided by operating activities:
Amortization and depreciation 10,433,000 7,294,000
Options issued to consultants 54,000 --
Provision for bad debts 616,000 50,000
Loss on disposal of property and equipment -- 1,000
Inventory reserve 325,000 180,000
Deferred taxes 1,720,000 (872,000)
Tax benefit of stock options exercised 4,692,000 1,609,000
(Increase) decrease in:
Accounts receivable (1,387,000) (403,000)
Inventory (4,390,000) (4,609,000)
Prepaid expenses (921,000) (1,891,000)
Other assets (30,000) (28,000)
Federal and state income tax payable (5,194,000) (2,187,000)
Other long-term liabilities -- 500,000
Prize fulfillment fees payable (79,000) (42,000)
Notes receivable (263,000) 1,856,000
Accounts payable and accrued expenses 4,352,000 4,519,000
Halls' share of surplus 846,000 (367,000)
----------------- ----------------
NET CASH PROVIDED BY OPERATING ACTIVITIES 29,258,000 8,874,000
----------------- ----------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment and patents (22,939,000) (8,310,000)
Proceeds from sale of property and equipment -- 40,000
Restricted cash and long-term investments
and other long-term liabilities 269,000 (13,000)
----------------- ----------------
NET CASH USED IN INVESTING ACTIVITIES (22,670,000) (8,283,000)
----------------- ----------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options, warrants,
and related tax benefit 7,803,000 5,261,000
Proceeds from (repayments on) note payable, net 649,000 (943,000)
Principal payments of debt -- (274,000)
Payment on NGI lawsuit settlement -- (440,000)
Increase in stockholders' notes receivable (294,000) (1,104,000)
Preferred stock dividends (4,000) (74,000)
Purchase of treasury stock (17,000) (1,797,000)
----------------- ----------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 8,137,000 629,000
----------------- ----------------
Net increase in cash and cash equivalents 14,725,000 1,220,000
Cash and cash equivalents, beginning of period 4,868,000 1,315,000
----------------- ----------------
Cash and cash equivalents, end of period $ 19,593,000 $ 2,535,000
================= ================
SUPPLEMENTAL CASH FLOW DATA:
Interest paid $ 38,000 $ 440,000
================= ================
Federal income tax paid $ 5,359,000 $ 1,710,000
================= ================
NON-CASH TRANSACTIONS:
Transfer of inventory to property and equipment $ 3,750,000 $ 1,956,000
================= ================
Offset a note receivable against related deferred revenue $ -- $ 400,000
================= ================
The accompanying notes are an integral part of the condensed
consolidated financial statements.
-6-
MULTIMEDIA GAMES, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The accompanying financial statements should be read in conjunction with the
Company's consolidated financial statements and footnotes contained within the
Company's Annual Report on Form 10-K for the year ended September 30, 2001.
The financial statements included herein as of June 30, 2002, and for each of
the three and nine months ended June 30, 2002 and 2001 have been prepared by the
Company without an audit, pursuant to accounting principles generally accepted
in the United States of America, and the rules and regulations of the Securities
and Exchange Commission. They do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States of America for complete financial statements. The information presented
reflects all adjustments consisting solely of normal recurring adjustments which
are, in the opinion of management, considered necessary to present fairly the
financial position, results of operations, and cash flows for the periods.
Operating results for the three and nine months ended June 30, 2002 are not
necessarily indicative of the results which will be realized for the year ending
September 30, 2002.
Revenue Recognition. The Company derives its Class II gaming revenues primarily
from participation arrangements with its customers. Under these arrangements,
the Company retains ownership of player stations installed at customers' bingo
halls and receives revenue based on a percentage of the hold per day generated
by each player station. The hold per day is reported by the Company as gaming
revenue and represents the total amount wagered by end users on its player
stations less the total amount of prizes paid to end users. Payments made to the
halls for their share of the hold per day are recorded in the Company's results
of operations as "Allotments to Hall Operators" and are deducted from the
Company's total revenues to arrive at its net revenues. A comparatively small
and declining share of the Company's Class II gaming revenue is from the sale of
Class II player stations under lease-purchase arrangements. Under lease-purchase
arrangements, the Company receives a series of lease payments based on a
percentage of a customer's revenue generated from the leased player station. At
the end of the lease period, the Company transfers ownership of the player
station to the customer.
The majority of the Company's Class III video lottery systems are sold for an
up-front purchase price. In addition, the Company also receives back-office fees
based on a share of the hold per day. Back-office fees cover service and
maintenance of the back-office server installed in each hall to run the
Company's Class III games and the related player tracking systems. For those
video lottery systems sold to customers, the back-office fees are considerably
smaller than the revenue share received from Class II player stations being
rented under participation agreements, and generally only cover the Company's
operating costs. Accordingly, the Company derives revenues from Class III gaming
to a greater extent from the sale of player stations as compared to the Class II
market. The Company also enters into either participation or lease-purchase
arrangements for its Class III systems that are similar to those for its Class
II systems.
Inventory. The Company's current inventory consists primarily of completed
player station units and computer equipment components for Class III electronic
player stations expected to be sold within the next year. Non-current inventory
comprises both completed Class II player stations, and new and refurbished
computer equipment components for Class II player stations the Company expects
to lease to hall operators under operating leases. Accordingly, the Company
transfers these leased units from inventory to property and equipment upon
consummation of the leases. Inventory is carried at the lower of cost (first-in,
first-out) or market. The Company annually evaluates its inventory's
obsolescence and update the reserve as necessary.
Property and Equipment. Property and equipment are stated at cost. The cost of
property and equipment is depreciated over their estimated useful lives
generally using the straight-line method. Equipment under leases which could
convey ownership to the lessee at the end of the lease term is depreciated over
the shorter of the lease term or three years. Substantially all of the Company's
property and equipment is depreciated over two to five years. Sales and
retirements of depreciable property and equipment are recorded by removing the
related cost and accumulated depreciation from the accounts. Gains or losses on
sales and retirements of property are reflected in operations.
The Company's agreements with the tribes provide that ownership of any MegaBingo
satellite dishes and monitoring equipment purchased by the Company and placed at
the hall locations revert to the ownership of the tribe at the end of the
agreement. Accordingly, such equipment is depreciated over the shorter of the
term of the agreement or three years. This provision does not apply to
electronic player stations and related equipment, except for electronic player
stations purchased by the tribe.
-7-
MULTIMEDIA GAMES, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Internally developed gaming software is stated at cost, and its cost is
depreciated over its estimated useful life, generally using the straight-line
method. Substantially all of the Company's internally developed software is
depreciated over 18 months to five years. Game software development costs are
capitalized while the project is under development and are depreciated once the
software is placed into service. Any subsequent software maintenance costs are
expensed as incurred. Software development projects which are discontinued are
expensed as such determination is made.
Management reviews its property and equipment for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If such assets are considered to be impaired, the
impairment is measured by the amount by which the carrying amount of the assets
exceeds their fair value, considering the discounted future net cash flows.
Assets to be disposed of are reported at the lower of the carrying amount or the
fair value less costs of disposal.
Reclassifications. Certain reclassifications were made to the prior period
financial statements to conform to the current period financial statement
presentation. These reclassifications did not have a significant impact on
previously reported financial position or results of operations.
Accounting Estimates. The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, disclosure of contingent assets and
liabilities at the date of the financial statements, and the reported amounts of
revenues and expenses during the reporting period. Examples include provisions
for bad debts and inventory obsolescence, asset lives of equipment, deferred tax
assets, and the provision for and disclosure of litigation and loss
contingencies. Actual results may differ materially from these estimates in the
near term.
Stock Split. On January 24, 2002, the Board of Directors authorized a
three-for-two split of the Company's common stock, paid in the form of a stock
dividend on February 11, 2002. All references in the accompanying financial
statements to the number of common shares and per-share amounts have been
restated to reflect the stock split.
Income Per Common Share. Income per common share is computed in accordance with
Statement of Financial Accounting Standards No. 128 (FAS 128). Presented below
is the computation of basic and diluted earnings per share also presented in the
accompanying statements of income.
THREE MONTHS ENDED
JUNE 30,
2002 2001
------------------- -------------------
Income available to common shareholders - basic $ 6,843,000 $ 1,930,000
=================== ===================
Income available to common shareholders - diluted $ 6,843,000 $ 1,955,000
=================== ===================
Weighted average common shares outstanding 12,669,643 8,480,390
Effect of dilutive securities:
Options 1,787,471 1,664,068
Warrants 143,262 1,549,329
Convertible preferred stock -- 647,326
------------------- -------------------
Weighted average common and potential shares outstanding 14,600,376 12,341,113
=================== ===================
Basic earnings per share $ 0.54 $ 0.23
=================== ===================
Diluted earnings per share $ 0.47 $ 0.16
=================== ===================
-8-
MULTIMEDIA GAMES, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
NINE MONTHS ENDED
JUNE 30,
2002 2001
------------------- -------------------
Income available to common shareholders - basic $ 18,480,000 $ 3,190,000
=================== ===================
Income available to common shareholders - diluted $ 18,484,000 $ 3,264,000
=================== ===================
Weighted average common shares outstanding 12,348,204 8,250,195
Effect of dilutive securities:
Options 2,010,097 1,092,181
Warrants 215,354 534,950
Convertible preferred stock 15,427 650,970
------------------- -------------------
Weighted average common and potential shares outstanding 14,589,082 10,528,296
=================== ===================
Basic earnings per share $ 1.50 $ 0.39
=================== ===================
Diluted earnings per share $ 1.27 $ 0.31
=================== ===================
Stock-Based Compensation. The Company applies Accounting Principles Board
Opinion, or APB, No. 25 in accounting for its stock option plans, rather than
the alternative fair value accounting provided under SFAS No. 123, "Accounting
for Stock-Based Compensation." Under APB 25, no compensation expense is
recognized for grants of options to common law employees and directors at an
exercise price equal to or greater than the market price of the stock on the
date of grant. Accordingly, based on the Company's grants in 2001 and 2000, no
compensation expense has been recognized.
2. COMMITMENTS AND CONTINGENCIES
Indian Gaming. Virtually all of the Company's business relates to gaming
activities on Native American lands. These activities are subject to the Johnson
Act and to the Indian Gaming Regulatory Act (IGRA) which created the National
Indian Gaming Commission (NIGC). IGRA identifies three classes of gaming, which
are each subject to varying degrees of regulation by federal, state and tribal
gaming authorities. Most of the Company's revenues are derived from Class II
gaming, which includes bingo and games similar to bingo, and which under IGRA
are regulated by the NIGC and Native American gaming authorities, and are not
regulated by states. All other common gambling games, including slot machines,
most table games and video lottery terminals, are Class III gaming and may be
played only pursuant to a compact between a Native American tribe and the state
in which that tribe is located. The Johnson Act defines "illegal games" and
"illegal equipment," which include any "machine or mechanical device" designed
"primarily" for gambling that, when operated, delivers money to a player "as the
result of the application of an element of chance." In recently adopted
regulations, however, the NIGC has determined that electronic or
electromechanical devices that serve to broaden player participation in the game
of bingo and games similar to bingo by allowing multiple players to play with or
against one another rather than with or against a machine are not Johnson Act
devices.
IGRA requires all Native American tribes to adopt ordinances regulating gaming
conducted on their lands. These ordinances often include establishing gaming
commissions that make their own judgments about whether an activity is Class II
or Class III gaming. While IGRA is intended to preempt state regulation of Class
II gaming, individual states are becoming increasingly proactive in attempting
to regulate Native American gaming conducted within their borders. This includes
states' making their own assessment of whether an activity is Class II or Class
III gaming, attempting to influence Class II gaming, and including Class II
gaming devices in the total when considering limits on the number of Class III
devices allowed. This will likely lead to litigation and other conflicts between
tribes and states.
Some fundamental issues relating to the scope and intent of IGRA, the
jurisdiction and authority of the NIGC, other federal agencies, state
authorities and Native American governments, and the regulation of gaming on
Native American lands remain unresolved and ambiguous. As a result, the legality
of the Company's activities can be subject to regulatory challenges, litigation,
and enforcement actions by multiple regulatory bodies. Any such action could
materially and adversely affect the Company's ability to install and operate its
player stations and games, could be costly to defend and could divert
management's time and attention away from operations.
While the Company treats all regulatory issues with importance, there are two
regulatory issues that are viewed as most critical and to which the Company
devotes the greatest amount of human and financial resources. One is the "game
classification" issue, i.e., whether a gaming activity is Class II gaming and
therefore subject only to self regulation by tribal gaming authorities and to
the rules and regulations under IGRA, or whether it is Class III gaming, which
can be legally conducted only pursuant to a compact between the tribe and the
state in which the tribe is located. The second is whether the player stations
used in the play of the Company's games are "technological aids" to the play of
Class II gaming, and therefore legal under IGRA, or whether the player stations
are illegal Johnson Act devices or illegal electronic facsimiles of Johnson Act
devices.
-9-
MULTIMEDIA GAMES, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
In January 2001, the Company introduced a new Class II game called MegaNanza.
MegaNanza generated approximately $47.5 million, or 36%, of total revenues for
the Company's fiscal year ended September 30, 2001, and approximately $158.8
million, or 74%, of total revenues for the nine months ended June 30, 2002. On
April 15, 2002, the Company received an advisory opinion from the Deputy General
Counsel of the NIGC stating that MegaNanza and its related family of games were
Class III games as defined by IGRA. The advisory opinion relied heavily upon two
factors in reaching its conclusion. First, that the ball draw for each MegaNanza
bingo game occurred prior to, rather than after, the sale of bingo cards to
players and, second, upon proposed rules published by the NIGC on March 22, 2002
that would have changed the definitions of legally permissible technological
aids and illegal electronic facsimiles used in the play of Class II gaming in a
manner adverse to the Company's method of operating its games.
On April 18, 2002, the Company filed a lawsuit in the United States District
Court for the Northern District of Oklahoma against the NIGC seeking a judicial
declaration that the MegaNanza family of games are Class II games. These games
operate in what is called "nonstandard sequence," meaning that the ball draw
occurs before bingo cards are sold to players. On June 14, 2002, the NIGC,
represented by and acting through the Department of Justice (DOJ) filed a motion
to dismiss the case, claiming the Court lacked jurisdiction on various
procedural grounds. On July 11, 2002, the Company responded to the DOJ's motion
to dismiss. The Court has yet to rule on the DOJ's motion.
On June 17, 2002, the NIGC adopted final rules on the definitions of legally
permissible technological aids and illegal electronic facsimiles used in the
play of Class II gaming. This action was based on a two-to-one vote of the
Commission, with the NIGC Chairman in the minority. These new rules differed
significantly from the rules initially proposed by the NIGC on March 22, 2002,
which had been major concepts relied upon by the Deputy General Counsel of the
NIGC in her April 15, 2002 advisory opinion finding MegaNanza to be Class III
gaming. The final rules are believed by the Company to support its current
method of game operation, including the MegaNanza family of games. Nevertheless,
under the rules of IGRA that grant the Chairman exclusive authority to bring
enforcement actions against tribes believed by the Chairman to be conducting
illegal gaming, on June 17, 2002, the NIGC Chairman issued a Notice of Violation
(NOV) to the Company's largest customer, threatening the tribe with significant
fines and penalties unless it immediately ceased the play of MegaNanza.
In view of the threat raised by the NOV, the Company's largest customer
immediately ceased play of MegaNanza and, together with two of the Company's
other major tribal customers, sought to join in the Company's pending action
against the NIGC. Along with the Company, the tribes further sought an
injunction against the NIGC from pursuing the existing NOV or taking any other
enforcement actions against these tribes or any other Native American customers
of the Company. On June 24, 2002, the Court granted the relief requested by the
Company and enjoined the NIGC "from issuing or further pursuing any notices of
violation, penalties, or closure orders with respect to the MegaNanza family of
games." The injunction will remain in effect until further order of the Court.
The Company cannot predict what the outcome of the pending litigation against
the NIGC will be, including whether the Court will grant the NIGC's pending
motion to dismiss for lack of jurisdiction. A successful challenge to the Class
II status of the MegaNanza game could materially and adversely affect the
Company's business. Even if the Company is successful on the merits, litigation
is time-consuming, very costly and distracts management's attention away from
operations.
There is no assurance that new laws and regulations relating to the Company's
business will not be enacted or that existing laws and regulations will not be
amended or reinterpreted in a manner adverse to the Company's business. Any
regulatory change could materially and adversely affect the installation and use
of existing and additional player stations, games and systems, and the Company's
ability to generate revenues from some or all of its Class II games. Regulatory
uncertainty also increases the Company's cost of doing business. The Company
dedicates significant time and incurs significant expense for new game
development without any assurance that the NIGC or other federal, state and
local agencies or Native American governments will agree that new or enhanced
games meet applicable regulatory requirements. The Company also devotes
significant time and expense to dealing with federal, state and tribal agencies
having jurisdiction over Native American gaming, and in complying with the
various regulatory regimes that govern its business.
Other Litigation. On June 11, 2002, the Company was named a defendant in a
complaint filed in the Los Angeles County Superior Court alleging breach of
contract by the Company. The complaint alleges that in July 1995, the plaintiff
acquired the perpetual right to purchase at any time in the future 28,125 shares
of MGAM common stock at $2.64 per share. The warrant certificate issued to the
plaintiff at the time of purchase expressly stated that the plaintiff's
-10-
MULTIMEDIA GAMES, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
right to purchase common stock expired on July 31, 1998. On that date, the
market price of the Company's common stock was less than $2.64 per share and the
plaintiff's warrant was not exercised. Plaintiff alleges that representations
made to plaintiff at the time of purchase caused him to believe that there was
no expiration date to the warrants, and seeks damages in an amount equal to the
profit plaintiff could have realized by exercising the warrants and selling the
common stock at the highest sale price during the period from February 16, 2002
(the date plaintiff first demanded that the Company honor the plaintiff's
request to exercise the warrants) and the date the case comes to trial. In July
2002, the Company answered the complaint and denied any liability. The case is
in a very preliminary stage and no discovery has been taken. The Company intends
to vigorously defend the case and expects the cost of its defense to be
expensive. The Company cannot predict what the outcome of the case will be.
On June 22, 2002, the Company was named a defendant in a complaint filed by the
Oneida Indian Nation in the United States District Court for the Western
District of Washington alleging patent infringement by the Company. The
plaintiff alleges infringement of two patents, both entitled "Cashless
Computerized Video Game System and Method," and seeks damages in an unspecified
amount and an injunction against the Company for any future infringement. The
Company intends to vigorously defend the case and expects the cost of its
defense to be expensive. The Company cannot predict what the outcome of the case
will be.
Lease Commitment. On July 15, 2002, the Company entered into a 5-year lease
agreement for its new corporate offices in Austin, Texas. Under this operating
lease, annual payments will range from $500,000 to $620,000.
-11-
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
We are the leading supplier of online systems and linked, interactive electronic
games and player stations to the rapidly growing Native American gaming market.
We design and develop networks, software and content that provide our customers
with a comprehensive gaming system. Historically, we have focused our efforts on
Class II gaming systems and Class III video lottery systems used primarily by
Native American tribes.
We derive our Class II gaming revenues primarily from participation arrangements
with our customers. Under these arrangements, we retain ownership of player
stations installed at our customers' bingo halls and receive revenue based on a
percentage of the hold per day generated by each player station. The hold per
day is reported by us as gaming revenue and represents the total amount wagered
by end users on a given player station less the total amount of prizes paid to
end users. Payments made to the halls for their share of the hold per day are
recorded in our results of operations as "Allotments to Hall Operators," and are
deducted from our total revenues to arrive at our net revenues. A comparatively
small and declining share of our Class II gaming revenue is from the sale of
Class II player stations under lease-purchase arrangements. Under these
arrangements, we receive a series of lease payments based on a percentage of a
customer's revenue generated from the leased player station. At the end of the
lease period, we transfer ownership of the player station to the customer. Due
to the pace at which we introduce new technology into our games and systems, we
believe our Class II customers generally prefer to rent our player stations
under participation arrangements rather than to incur capital costs that may be
lost to obsolescence. Our reporting of revenues from our television bingo game
show, MegaBingo, which accounts for the balance of our Class II gaming revenues,
differs from this model. We record revenues from MegaBingo prior to the payment
of prizes to end users and prior to an allotment to the hall operator of its
share of MegaBingo revenues.
Our recent revenue growth has been driven primarily by our technological
innovations and the increase in the installed base of our player stations. Our
gaming platforms enable us to regularly launch new games that we believe provide
end users with greater levels of entertainment. We believe that this leads to a
greater number of end users and to increased end-user spending rates. Our
New-Generation gaming platform operates at considerably faster speeds than our
Legacy platform, generally resulting in end users playing a greater number of
games on our New-Generation platform than they otherwise could have on our
Legacy gaming platform in the same amount of time. As a result of the faster
speed of play and higher payout ratios, we believe that end users derive a
higher level of satisfaction from playing our New-Generation platform games. We
believe that this enhanced satisfaction results in end users playing games for
longer periods of time than they would have played on our Legacy platform,
resulting in a higher hold per day on our New-Generation platform player
stations.
Since our inception, we have produced MegaBingo, a live paper bingo game
featuring a live bingo ball draw that we televise to multiple bingo halls
throughout the United States. MegaBingo enables players in participating halls
to compete with players in other halls in a single live bingo game to win a
large jackpot prize. During the nine months ended June 30, 2002, MegaBingo
revenues were $962,000, and represent a declining percentage of our revenues. In
May 1996, we introduced our Class II MegaMania game, the first in a series of
high-speed, interactive bingo games based on our Legacy platform and played on
player stations linked with one another via a nationwide, online
telecommunications network. In January 2001, we introduced our Class II
MegaNanza game, based on our New-Generation platform, which plays faster than
our Legacy games and has generated increased revenues for us and our customers.
In June, 2002, we introduced Reel Time Bingo, a New-Generation-based high-speed
standard sequence bingo game, in which the cards are purchased before the balls
are drawn. In June 1999, we first installed Class III video lottery systems in
the state of Washington, which currently is one of the states where Class III
video lottery systems are permitted by Native American-state compact.
The majority of our Class III video lottery systems are sold for an up-front
purchase price. In addition, we also receive back-office fees based on a share
of the hold per day. Back-office fees cover our service and maintenance of the
back-office server installed in each hall to run our Class III games and the
related player tracking systems. For those video lottery systems sold to our
customers, the back-office fees are considerably smaller than the revenue share
we receive from Class II player stations being rented under participation
agreements, and generally only cover our operating costs. Accordingly, we derive
our revenues from Class III gaming to a greater extent from the sale of player
stations as compared to the Class II market. We also enter into either
participation or lease-purchase arrangements for our Class III video lottery
systems that are similar to those for our Class II systems.
-12-
Our sales of Class III video lottery systems peaked in 2000, as initial sales
were made pursuant to newly adopted Native American-state compacts with the
State of Washington which limited the number of installed Class III video
lottery systems permitted on Native American land. We anticipate that the sale
of Class III video lottery systems will increase in 2002, as the compact limit
on the number of Class III video lottery systems has increased and new Native
American gaming facilities are under construction.
We have license agreements with WMS Gaming Inc. and Bally Gaming Inc. to use
certain trademarks, logos and graphics in connection with our Class III games.
We, in turn, resell these licenses to our customers in connection with the
installation of our Class III video lottery terminals using these licenses.
Revenues from these license fees are included in other revenues in our results
of operations. We also have a similar license agreement for the Class II market
with Bally Gaming Inc. We do not resell Class II licenses, as we only install
our Class II games and player stations with our customers on a participation
arrangement basis.
In addition to bingo prizes and related costs and allotments to hall operators,
our next largest expense directly related to our Class II and Class III gaming
revenue is amortization and depreciation. We own approximately 83% of our Class
II player stations and we generally depreciate the cost of these player stations
over three years. With certain Class III customers, we sell player stations
under lease purchase agreements, and depreciate these player stations over the
term of the lease, which is generally one to three years. We also capitalize
certain costs related to the design and development of our gaming products and
systems. We generally amortize internally developed games over an eighteen month
period, and gaming platforms over a three-year period. During the nine months
ended June 30, 2002, we capitalized $720,000 of internal software costs. Our
cost of player stations sold is the smallest component of our expenses as a
percentage of our total revenues, and is commensurate with the contribution made
by player station sales to our total revenues.
RECENT DEVELOPMENTS
On March 22, 2002, the NIGC proposed rules that, if adopted, could have resulted
in a finding that MegaNanza was a Class III game. Based in part on these
proposed rules, the Deputy General Counsel of the NIGC issued an advisory
opinion on April 15, 2002 with a finding that MegaNanza was a Class III game. On
June 17, 2002, the NIGC adopted final rules on the definitions of legally
permissible technological aids and illegal electronic facsimiles used in the
play of Class II gaming. We believe that MegaNanza is a Class II game,
particularly in light of the final rules, and we do not believe MegaNanza is
being played in any casino under the jurisdiction of a tribal gaming
commissioner currently maintaining a determination that MegaNanza is a Class III
game. However, on June 17, 2002, the NIGC issued a notice of violation to our
largest customer based on its use of MegaNanza, threatening the tribe with fines
and penalties unless it immediately ceased play of the game.
These actions by the NIGC have adversely affected our operating results. Despite
a preliminary injunction issued on June 24, 2002 by the court in our litigation
with the NIGC, our largest customer nevertheless asked us to replace our
MegaNanza games with Reel Time Bingo, our second game introduced on our New
Generation platform. Ultimately, our customer removed 450 of our MegaNanza
player stations; of these, approximately 100 stations were already scheduled for
removal as part of our ongoing program of changing the mix of player stations
and games at customer facilities in order to attain an optimum overall return.
However, the remaining player stations were located in a major metropolitan
area, and were among the machines generating our highest hold per day.
To date, we have realized a lower hold per player station on our Reel Time Bingo
games than we have historically realized with MegaNanza. We believe this is a
result of technical and operational challenges we face as we introduce new
machines. In particular, we believe that our holds on Reel Time Bingo will
improve as players gain familiarity with the game, more player stations are
added to the network, and we make minor technical improvements based upon our
experience operating the game. Nevertheless, during the quarter ended June 30,
2002, we experienced a loss of revenue resulting from the difference between the
holds experienced with Reel Time Bingo and holds we would have realized had we
been able to continue operating our MegaNanza games with our largest customer,
and resulting from start-up operational and technical difficulties we
experienced as we switched from one game to the other. We also experienced
increased costs associated with increasing the presence of our customer service
personnel at our customers' gaming facilities during the transition, and with
changing game-specific glass and other player station graphics.
-13-
RESULTS OF OPERATIONS
NUMBER OF INSTALLED PLAYER STATIONS
The following table outlines our installed player station base as of June 30:
2002 2001
-------------- --------------
INSTALLED END OF PERIOD:
Class II
New-Generation Platform 4,603 1,164
Legacy Platform 2,472 3,259
-------------- --------------
Total Class II 7,075 4,423
============== ==============
Class III 2,093 1,381
============== ==============
THREE MONTHS ENDED JUNE 30, 2002 AND 2001
Total revenues increased 122% to $78.6 million in the three months ended June
30, 2002, from $35.4 million in the same period of 2001. This increase primarily
resulted from more MegaNanza electronic player stations being in place during
the second quarter of fiscal 2002 compared to the same quarter of fiscal 2001.
For the three months ended June 30, 2002, New-Generation games generated
revenues of $60.4 million, based on an average of 4,197 electronic player
stations in daily operation during the period. For the three months ended June
30, 2002, we had an average of 2,531 Class II Legacy player stations in daily
operation, a 25% decrease from 3,364 in the same period of 2001. This decrease
was primarily the result of the replacement of many of our Legacy player
stations with our more profitable New-Generation player stations. Total revenues
from Class III games increased 19% to $1.6 million for the three months ended
June 30, 2002, from $1.4 million for the same period in 2001. This primarily
resulted from an increase in the number of Class III player stations installed,
from 1,381 as of June 30, 2001, to 2,093 as of June 30, 2002.
Player station sale and lease revenue increased by 107% to $2.5 million for the
three months ended June 30, 2002 from $1.2 million in same period of 2001. This
increase was primarily the result of the sale of Class III player stations
during the current quarter and corresponding growth in revenue from Class III
licensing fees.
Other revenue, which consisted primarily of service and maintenance fees,
increased 164% to $396,000 for the three months ended June 30, 2002, from
$150,000 in the same period of 2001. This increase was related to a greater
number of player stations in place.
Bingo prizes and related costs decreased 7% to $395,000 for the three months
ended June 30, 2002 from $426,000 in the same period of 2001. This decrease was
caused primarily by lower insurance costs due to the changes in game format.
Allotments to hall operators increased 126% to $52.4 million for the three
months ended June 30, 2002, from $23.2 million in the same period of 2001. This
increase was attributable to the increase in hall commissions related to our
Class II gaming, and is commensurate with the overall increase in our Class II
gaming revenue.
Cost of sales increased to $1.3 million for the three months ended June 30, 2002
from $592,000 in the same period of 2001. This increase was commensurate with
the overall increase in our player stations and licenses sold.
Selling, general and administrative expenses increased 76% to $8.8 million for
the three months ended June 30, 2002 from $5.0 million in the same period of
2001. This increase is commensurate with the overall increase in revenues.
Salaries and wages increased primarily as a result of additional personnel hired
to address our Class II electronic gaming network needs and the pursuit of new
business, including the Class III video lottery business. Employee benefits
increased as a result of accrued performance-based incentives to be paid as
year-end bonuses to officers and employees, and an increase in health and life
insurance premiums due to a greater number of employees. Legal and professional
fees increased primarily as a result of the need for increased legal and
professional services related to the NIGC litigation.
Write off of offering costs related to the abandoned public offering amounted to
$780,000 for the three months ended June 30, 2002. No such fees were recorded in
the prior fiscal year.
-14-
Amortization and depreciation expense increased 33% to $3.6 million for the
three months ended June 30, 2002, from $2.7 million for the same period of 2001,
primarily as a result of depreciation on a greater number of player stations in
service. Amortization and depreciation for 2001 was comparably higher because it
included a greater number of Class III player stations under lease-purchase
agreements. We depreciate these over their shorter lease-purchase term of six to
eighteen months, rather than the three-year schedule on which we depreciate
Class II player stations rented to our customers.
Interest income increased 204% to $76,000 for the three months ended June 30,
2002, from $25,000 in the same period of 2001. The interest income increase was
primarily the result of greater cash balances compared to the same quarter of
the last fiscal year.
Interest expense decreased 95% to $10,000 for the three months ended June 30,
2002, from $198,000 in the same period of 2001. This decrease related to the
decrease in our outstanding debt, primarily from the payment of the remaining
balance on our existing credit facility in September 2001.
Income tax expense increased 218% to $4.5 million for the three months ended
June 30, 2002, from $1.4 million in the same period of 2001. This represented an
effective tax rate of 40% and 42%, respectively, for each of the three months
ended June 30, 2002 and 2001.
NINE MONTHS ENDED JUNE 30, 2002 AND 2001
Total revenues increased 154% to $213.5 million in the nine months ended June
30, 2002, from $84.0 million in the same period in 2001. This increase was
primarily the result of the introduction of MegaNanza in January 2001. For the
nine months ended June 30, 2002, New-Generation games generated revenues of
$158.8 million, based on an average of 3,426 electronic player stations in daily
operation during the period. For the nine months ended June 30, 2002, we had an
average of 2,758 Class II Legacy player stations in daily operation, a 24%
decrease from 3,634 in the same period of 2001. This decrease was primarily the
result of the replacement of many of our Legacy player stations with our more
profitable New Generation player stations. Total revenues from Class III games
increased 30% to $4.4 million for the nine months ended June 30, 2002, from $3.4
million for the same period in 2001. This primarily resulted from an increase in
the number of Class III player stations installed, from 1,381 as of June 30,
2001, to 2,093 as of June 30, 2002.
Player station sale and lease revenue increased by 102% to $6.3 million for the
nine months ended June 30, 2002, from $3.1 million for the same period of 2001.
This increase was primarily the result of increased Class III player station and
license placement in the third quarter of fiscal 2002.
Other revenue, which consisted primarily of service and maintenance fees,
increased 58% to $1.0 million for the nine months ended June 30, 2002, from
$666,000 in the same period of 2001. This increase was related to a greater
number of player stations in place.
Bingo prizes and related costs decreased 41% to $1.1 million for the nine months
ended June 30, 2002, from $1.9 million in the same period of 2001. This decrease
was caused primarily by the decrease in MegaBingo revenues discussed above.
Allotments to hall operators increased 163% to $142.8 million for the nine
months ended June 30, 2002, from $54.3 million in the same period in 2001. This
increase was attributable to the increase in hall commissions related to our
Class II gaming activities and is commensurate with the overall increase in our
Class II gaming revenue.
Cost of sales increased 176% to $4.1 million for the nine months ended June 30,
2002, from $1.5 million in the same period of 2001. This increase was
commensurate with the overall increase in our player stations and licenses sold.
Selling, general and administrative expenses increased 82% to $24.0 million for
the nine months ended June 30, 2002, from $13.1 million in the same period of
2001. Salaries and wages increased primarily as a result of additional personnel
hired to address our Class II electronic gaming network needs and the pursuit of
new business, including the Class III video lottery business. Employee benefits
increased as a result of accrued performance-based incentives covering
substantially all employees, and an increase in health and life insurance
premiums due to a greater number of employees. Advertising and promotions
expenses increased primarily as a result of our enhanced effort to advertise and
promote certain games in 2002. Legal and professional fees increased primarily
as a result of increased
-15-
legal and professional services related to the NIGC litigation. Consulting and
contract labor increased primarily due to our increased emphasis on the
development, upgrade and maintenance of games and systems.
Write off of offering costs related to the abandoned public offering amounted to
$780,000 for the nine months ended June 30, 2002. No such fees were recorded in
the prior fiscal year.
Amortization and depreciation expense increased 43% to $10.4 million for the
nine months ended June 30, 2002, from $7.3 million for the same period of 2001,
primarily as a result of depreciation on a greater number of player stations in
service. Amortization and depreciation for 2001 was comparably higher because it
included a greater number of Class III player stations under lease-purchase
agreements. We depreciate these over their shorter lease-purchase term of six to
eighteen months, rather than the three-year schedule on which we depreciate
Class II player stations rented to our customers.
Interest income increased 130% to $189,000 for the nine months ended June 30,
2002, from $82,000 in the same period of 2001. The interest income increase was
primarily the result of greater cash balances during this fiscal year.
Interest expense decreased 93% to $38,000 for the nine months ended June 30,
2002, from $530,000 in the same period of 2001. This decrease related to the
decrease in our outstanding debt, primarily from the payment of the remaining
balance on our existing credit facility in September 2001.
Income tax expense increased 430% to $11.9 million for the nine months ended
June 30, 2002, from $2.2 million in the same period of 2001. This represented an
effective tax rate of 39% and 41% for the nine months ended June 30, 2002 and
2001, respectively.
The trademarks and tradenames used by us include: Betnet(TM), MegaBingo(R),
MegaMania(R), MegaNanza(TM), and Reel Time Bingo(TM). All references herein to
those trademarks and tradenames are deemed to include the applicable tradename
or trademark designation.
-16-
CRITICAL ACCOUNTING POLICIES
We prepare our condensed consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America. As
such, we are required to make certain estimates, judgments and assumptions that
we believe are reasonable based on the information available. These estimates
and assumptions affect the reported amounts of assets and liabilities at the
date of the financial statements, and the reported amounts of revenues and
expenses during the periods presented. There can be no assurance that actual
results will not differ from those estimates. We believe the following represent
our most critical accounting policies:
Revenue Recognition. We derive our Class II gaming revenues primarily from
participation arrangements with our customers. Under these arrangements, we
retain ownership of player stations installed at our customers' bingo halls and
receive revenue based on a percentage of the hold per day generated by each
player station. We report the hold per day as gaming revenue. The hold
represents the total amount wagered by end users on our player stations less the
total amount of prizes paid to end users. Payments made to the halls for their
share of the hold per day are recorded in our results of operations as
"Allotments to Hall Operators," and are deducted from our total revenues to
arrive at our net revenues. A comparatively small and declining share of our
Class II gaming revenue is from the sale of Class II player stations under
lease-purchase arrangements. Under our lease-purchase arrangements, we receive a
series of lease payments based on a percentage of a customer's revenue generated
from the leased player station. At the end of the lease period we transfer
ownership of the player station to the customer.
The majority of our Class III video lottery systems to date have been sold for
an up-front purchase price. In addition, we also receive back-office fees based
on a share of the hold per day. Back-office fees cover our service and
maintenance of the back-office server installed in each hall to run our Class
III games and the related player tracking systems. For those video lottery
systems sold to our customers, the back-office fees are considerably smaller
than the revenue share we receive from Class II player stations being rented
under participation agreements, and generally only cover our operating costs.
Accordingly, we derive our revenues from Class III gaming to a greater extent
from the sale of player stations as compared to the Class II market. We also
enter into either participation or lease-purchase arrangements for our Class III
video lottery systems that are similar to those for our Class II systems.
Inventory. Our current inventory consists primarily of completed player station
units and computer equipment components for Class III electronic player stations
we expect to sell within the next year. Our non-current inventory comprises both
completed Class II player stations, and new and refurbished computer equipment
components for Class II player stations we expect to lease to hall operators
under operating leases. Accordingly, we transfer these leased units from
inventory to our property and equipment upon consummation of the leases.
Inventory is carried at the lower of cost (first-in, first-out) or market. We
annually evaluate our inventory's obsolescence and update the reserve as
necessary.
Property and Equipment. We state property and equipment at cost. The cost of
property and equipment is depreciated over their estimated useful lives
generally using the straight-line method. Equipment under leases which could
convey ownership to the lessee at the end of the lease term is depreciated over
the shorter of the lease term or three years. Substantially all of our property
and equipment is depreciated over two to five years. Sales and retirements of
depreciable property and equipment are recorded by removing the related cost and
accumulated depreciation from the accounts. Gains or losses on sales and
retirements of property are reflected in operations.
Our agreements with the tribes provide that ownership of any MegaBingo satellite
dishes or other monitoring equipment we purchased and placed at the hall
locations reverts to the tribe at the end of the agreement. We depreciate this
equipment over the shorter of the term of the agreement or three years.
Generally, these provisions do not apply to electronic player stations and
related equipment, except for player stations purchased by the tribe.
We state internally developed gaming software at cost, and we depreciate its
cost over its estimated useful life, generally using the straight-line method.
We depreciate substantially all of our internally developed software over 18
months to five years. We capitalize game software development costs when the
project is under development, and depreciate the software once in service. We
expense any subsequent software maintenance costs as incurred. Software
development projects which are discontinued are expensed as such determination
is made.
We review our review our property and equipment for impairment whenever events
or changes in circumstances indicate we may not recover the carrying amount of
an asset. We measure recoverability of assets to be held and used by comparing
the carrying amount of an asset to future net cash flows expected to be
generated by the asset. If
-17-
we determine an asset to be impaired, we measure the impairment as the amount by
which the carrying amount of the assets exceeds their fair value, considering
the discounted future net cash flows. We report assets to be disposed of at the
lower of the carrying amount or the fair value less costs of disposal.
Stock-based Compensation. We apply Accounting Principles Board Opinion, or APB,
No. 25 in accounting for our stock option plans, rather than the alternative
fair value accounting provided under SFAS No. 123, "Accounting for Stock-Based
Compensation." Under APB 25, no compensation expense is recognized for grants of
options to common law employees and directors at an exercise price equal to or
greater than the market price of the stock on the date of grant. Accordingly,
based on our grants in 2001 and 2000, no compensation expense has been
recognized.
ACCOUNTING PRONOUNCEMENTS ISSUED BUT NOT YET ADOPTED
Statement of Financial Accounting Statements, or SFAS, No. 142 requires, among
other things, that we no longer amortize goodwill, but instead test goodwill for
impairment at least annually. In addition, SFAS 142 requires us to identify
reporting units for the purposes of assessing potential future impairments of
goodwill, reassess the useful lives of other existing recognized intangible
assets, and cease amortization of intangible assets with an indefinite useful
life. An intangible asset with an indefinite useful life should be tested for
impairment in accordance with the guidance in SFAS 142. We are required to apply
SFAS 142 in fiscal years beginning after December 15, 2001 to all goodwill and
other intangible assets recognized at that date, regardless of when those assets
were initially recognized. SFAS 142 requires us to complete a transitional
goodwill impairment test six months from the date of adoption. We are also
required to reassess the useful lives of other intangible assets within the
first interim quarter after adoption of SFAS 142. Currently, we do not expect
that adopting SFAS 142 will have a material impact on our financial position and
results of operations.
In August 2001, the Financial Accounting Standards Board, or FASB, issued SFAS
No. 143, Accounting for Asset Retirement Obligations. This Statement is
effective for fiscal years beginning after June 15, 2002. SFAS No. 143 provides
accounting requirements for obligations associated with the retirement of
tangible long-lived assets and the associated asset retirement costs. Under the
Statement, the asset retirement obligation is recorded at fair value in the
period in which it is incurred by increasing the carrying amount of the related
long-lived asset. The liability is accreted to its present value in each
subsequent period and the capitalized cost is depreciated over the useful life
of the related asset. Adoption of this standard will not have any immediate
effect on our consolidated financial statements. We will apply this guidance
prospectively.
In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.
This statement eliminates the current requirement that gains and losses on debt
extinguishment must be classified as extraordinary items in the income
statement. Instead, such gains and losses will be classified as extraordinary
items only if they are deemed to be unusual and infrequent, in accordance with
the current GAAP criteria for extraordinary classification. In addition, SFAS
145 eliminates an inconsistency in lease accounting by requiring that
modifications of capital leases that result in reclassification as operating
leases be accounted for consistent with sale-leaseback accounting rules. The
statement also contains other nonsubstantive corrections to authoritative
accounting literature. The changes related to debt extinguishment will be
effective for fiscal years beginning after May 15, 2002, and the changes related
to lease accounting will be effective for transactions occurring after May 15,
2002.
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with
Exit or Disposal Activities, which addresses accounting for restructuring and
similar costs. SFAS No. 146 supersedes previous accounting guidance, principally
Emerging Issues Task Force, or EITF, Issue No. 94-3. We will adopt the
provisions of SFAS No. 146 for restructuring activities initiated after December
31, 2002. SFAS No. 146 requires that the liability for costs associated with an
exit or disposal activity be recognized when the liability is incurred. Under
EITF No. 94-3, a liability for an exit cost was recognized at the date of a
company's commitment to an exit plan. SFAS No. 146 also establishes that the
liability should initially be measured and recorded at fair value.
-18-
LIQUIDITY AND CAPITAL RESOURCES
At June 30, 2002, we had unrestricted cash and cash equivalents of $19.6
million, compared to $4.9 million at September 30, 2001. Our working capital at
June 30, 2002 was $14.1 million, compared to $4.2 million at September 30, 2001.
As of June 30, 2002, total contractual cash obligations were as follows:
LESS THAN ONE TO FOUR
ONE YEAR YEARS TOTAL
----------- ----------- -----------
Long-term debt/(1)/ $ 278,000 $ 372,000 $ 650,000
Operating leases/(2)/ 472,000 486,000 958,000
Purchase Commitments 250,000 -- 250,000
----------- ----------- -----------
Total $ 1,000,000 $ 858,000 $ 1,858,000
=========== =========== ===========
/(1)/ Long-term debt represents a three-year auto-
purchase loan that has an annual interest rate of
8% and matures in June 2005.
/(2)/ Operating leases for our facilities and office
equipment that expire at various times throughout
2004.
On July 15, 2002, the Company entered into a 5-year
lease agreement for its new corporate offices in
Austin, Texas. Under this operating lease, annual
payments will range from $500,000, to $620,000.
Cash flow provided by operating activities was $29.3 million for the nine months
ended June 30, 2002, compared to $8.9 million for the same period in 2001. This
increase was primarily the result of improved operations for 2002, partially
offset by an increase in accounts receivable and inventory.
Cash used in investing activities was $22.7 million for the nine months ended
June 30, 2002, compared to $8.3 million for the same period in 2001. The
increase resulted from an increase in the acquisition of property and equipment
to $22.9 million for the nine months ended June 30, 2002, compared to $8.3
million for the same period in 2001. During the nine months ended June 30, 2002,
we spent $20.5 million for player stations. We also spent $2.4 million to
acquire an airplane, which we believe will provide a significant competitive
advantage and enable us to more rapidly respond to sales opportunities and
support issues throughout our customer base, much of which is located in areas
that are difficult to reach in a timely manner with standard commercial flights.
We do not believe ongoing expenses associated with the aircraft will be
material.
Cash provided by financing activities was $8.1 million for the nine months ended
June 30, 2002, compared to $629,000 for the same period in 2001. For the nine
months ended June 30, 2002, we received proceeds from the exercise of stock
options and warrants and the related tax benefit totaling $7.8 million. The cash
flow provided by financing activities for the nine months ended June 30, 2001
related primarily to proceeds from the exercise of stock options and warrants
and the related tax benefit totaling $5.3 million, partially offset by repayment
of debt, increase in stockholders' notes receivable, and the purchase of
treasury stock.
Our Board of Directors authorized us to repurchase 450,000 shares of our common
stock, effective April 2000, and an additional 1,500,000 shares of our common
stock, effective September 2001. The timing and total number of shares
repurchased will depend on prevailing market conditions and other investment
opportunities. During fiscal 2000 and 2001, we repurchased 190,875 and 831,866
shares of our common stock at an average cost of $2.67 and $6.31, respectively.
No shares were repurchased by us during the quarter ended June 30, 2002, when we
had approximately 3.0 million options and warrants outstanding, with exercise
prices ranging from $1.33 to $30.95 per share. Of the options and warrants
outstanding, approximately 740,000 were exercisable at June 30, 2002.
Our projected capital expenditures for the next year will be used primarily for
player stations to be placed under rental arrangements with our Class II
customers, and may include substantial capital expenditures in connection with
potential acquisitions and gaming facility development. In pursuing these
opportunities, we may make expenditures that could significantly affect our cash
flow and liquidity, and use a significant portion of both our cash flow from
operations and any proceeds we receive from any debt or equity financing we
undertake. Our total capital expenditures will depend upon the number of player
stations that we are able to place in service during the year. Additional
capital expenditures will be required for player stations if we are successful
in introducing our games into
-19-
new markets such as the charity bingo market. In addition to manufacturing our
own player stations, we also purchase player stations and licenses from Bally
Gaming Inc. and WMS Gaming Inc.
In May 2002, the New York Lottery notified us that it had selected us as the
winning vendor in a competitive procurement to provide the central system for
video lottery games to be operated at New York state racetracks. The award is
currently being appealed by certain competitors, and our entering into a
definitive agreement with the state of New York for this project is subject to
and contingent upon final negotiation of terms and final approval by New York
state officials. If we do enter into a definitive agreement with the state of
New York, we believe that it will be necessary to spend at least $10 million in
the following six months to develop, produce and implement the system.
We believe that our current operations can be sustained with cash from
operations. There can be no assurance, however, that our business will continue
to generate cash flow at current levels. Our performance and financial results
are, to a certain extent, subject to general conditions in or affecting the
Native American gaming industry and to general economic, political, financial,
competitive, legislative and regulatory factors beyond our control. There can be
no assurance that sufficient funds will be available to enable us to make
necessary capital expenditures and to make discretionary investments in the
future.
SEASONALITY
We believe our operations are not materially affected by seasonal factors,
although we have experienced fluctuations in our revenues from period to period.
After the holiday season, our revenues generally build steadily, with our last
fiscal quarter, ending September 30, traditionally being our strongest.
CONTINGENCIES
For information regarding contingencies, see "PART I - Item 1. Financial
Statements - Commitments and Contingencies, " and "PART II - Item 1. Legal
Proceedings."
INFLATION AND OTHER COST FACTORS
Our operations have not been, nor are they expected to be, materially affected
by inflation. However, our operational expansion is affected by the cost of
hardware components, which are not considered to be inflation sensitive, but
rather, sensitive to changes in technology and competition in the hardware
markets. In addition, we expect to continue to incur increased legal and other
similar costs associated with regulatory compliance requirements and the
uncertainties present in the operating environment in which we do business.
FUTURE EXPECTATIONS AND FORWARD-LOOKING STATEMENTS
This Quarterly Report and the information incorporated herein by reference
contains various "forward-looking statements" within the meaning of federal and
state securities laws, including those identified or predicated by the words
"believes," anticipates," "expects," "plans," or similar expressions. Such
statements are subject to a number of uncertainties and risks that could cause
the actual results to differ materially from those projected. These risks are
described throughout this Quarterly Report on Form 10-Q, which you should read
carefully, and include, but are not limited to, the uncertainties inherent to
the outcome of any litigation of the type described in this quarterly report
under "PART II - Item 1. Legal Proceedings," as well as those other factors as
described under "PART I - Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations - Certain Risk Factors." Given
these uncertainties, readers of this Quarterly Report are cautioned not to place
undue reliance upon such statements.
CERTAIN RISK FACTORS
The following risk factors could materially and adversely affect our operating
results and could cause actual events to differ materially from those predicted
in any forward-looking statements related to our business.
We face legal and regulatory uncertainties that threaten our ability to conduct
our business, increase our cost of doing business and divert substantial
management time away from our operations.
Virtually all of our business relates to gaming activities on Native American
lands. These activities are subject to the Johnson Act and IGRA, which created
the NIGC. IGRA identifies three classes of gaming which are each subject to
specific degrees of regulation. The Johnson Act defines "illegal games" and
"illegal equipment," which include any
-20-
"machine or mechanical device" designed "primarily" for gambling that, when
operated, delivers money to a player "as the result of the application of an
element of chance."
All Native American tribes are required by IGRA to adopt ordinances to regulate
gaming as a condition of their right to conduct gaming on Native American lands.
These ordinances often include the establishment of gaming commissions that make
their own judgment about whether an activity is Class II or Class III gaming.
Generally, this independent judgment has been exercised for games introduced
into the market prior to any determination of legality by the NIGC.
Historically, when the NIGC has determined that an activity is Class III gaming
after it has been introduced, tribes have either been unwilling to continue the
activity or game or have litigated the matter in federal court.
Individual states are also becoming increasingly proactive in attempting to
regulate Native American gaming conducted within their borders. State agencies
often make their own assessment of whether an activity is Class II or Class III
gaming independent of the NIGC, IGRA, and federal and Native American
governments.
Some fundamental issues relating to the scope and intent of IGRA, the
jurisdiction and authority of the NIGC, other federal agencies, state
authorities and Native American governments, and the regulation of gaming on
Native American lands remain unresolved and ambiguous. As a result, the legality
of our activities could be subject to regulatory challenges, litigation, and
enforcement actions by multiple regulatory bodies. Any such action could
materially and adversely affect our ability to install and operate our player
stations and games, could be costly to defend and could divert management's time
and attention away from our operations.
We cannot assure you that new laws and regulations relating to our business will
not be enacted or that existing laws and regulations will not be amended or
reinterpreted in a manner adverse to our business. Any regulatory change could
materially and adversely affect the installation and use of existing and
additional player stations, games and systems and our ability to generate
revenues from some or all of our Class II games. Regulatory uncertainty also
increases our cost of doing business. We dedicate significant time and incur
significant expense on new game development without any assurance that the NIGC
or other federal, state and local agencies or Native American governments will
agree that each of our games meets applicable regulatory requirements. We also
devote significant time and expense in dealing with federal, state and Native
American agencies having jurisdiction over Native American gaming and in
complying with the various regulatory regimes that govern our business.
If the NIGC continues to assert that the MegaNanza family of games are Class III
games, we could be required to replace those games and our business could be
adversely affected.
In January 2001, we introduced the first of a family of new Class II games
called MegaNanza65. The MegaNanza family of games generates a significant
portion of our revenues and earnings.
On April 15, 2002, we received an advisory opinion from the Deputy General
Counsel of the NIGC, stating that MegaNanza and its related family of games were
Class III games as defined by IGRA. The advisory opinion relied heavily upon two
factors in reaching its conclusion. First, that the ball draw for each MegaNanza
bingo game occurred prior to, rather than after, the sale of bingo cards to
players and, second, upon proposed rules published by the NIGC on March 22, 2002
that would have changed the definitions of legally permissible technological
aids and illegal electronic facsimiles used in the play of Class II gaming in a
manner adverse to our method of operating our games.
On April 18, 2002, we filed a lawsuit in the United States District Court for
the Northern District of Oklahoma against the NIGC seeking a judicial
declaration that two versions of MegaNanza are Class II games. Both versions
operate in what is called "nonstandard sequence," meaning that the ball draw
occurs before bingo cards are sold to players. On June 14, 2002, the NIGC,
represented by and acting through the Department of Justice, or DOJ, filed a
motion to dismiss the case, claiming the Court lacked jurisdiction on various
procedural grounds. On July 11, 2002, we responded to the DOJ's motion to
dismiss. The Court has yet to rule on the DOJ's motion.
On June 17, 2002, the NIGC adopted final rules on the definitions of legally
permissible technological aids and illegal electronic facsimiles used in the
play of Class II gaming. This action was based on a two-to-one vote of the
Commission, with the NIGC Chairman in the minority. These new rules differed
significantly from the rules initially proposed by the NIGC on March 22, 2002
and that had been relied upon by the Deputy General Counsel of the NIGC in her
April 15, 2002, advisory opinion finding MegaNanza to be Class III gaming. We
believe the final rules support our current method of game operation, including
the MegaNanza family of games. Nevertheless, under the rules of IGRA
-21-
that grant the Chairman exclusive authority to bring enforcement actions against
tribes believed by the Chairman to be conducting illegal gaming, on June 17,
2002, the Chairman issued a Notice of Violation, or NOV, to our largest
customer, threatening the tribe with significant fines and penalties unless it
immediately ceased the play of MegaNanza.
In view of the threat raised by the NOV, our largest customer immediately ceased
play of MegaNanza and, together with two of our other major tribal customers,
sought to join us in our pending action against the NIGC. We and the tribes
further sought an injunction against the NIGC from pursuing the existing NOV or
taking any other enforcement actions against these tribes or any of our other
Native American customers. On June 24, 2002, the Court granted the relief we
requested and enjoined the NIGC "from issuing or further pursuing any notices of
violation, penalties, or closure orders with respect to the MegaNanza family of
games." The injunction will remain in effect until further order of the Court.
We cannot predict what the outcome of the pending litigation against the NIGC
will be, including whether the Court will grant the NIGC's pending motion to
dismiss for lack of jurisdiction. A successful challenge to the Class II status
of the MegaNanza game could materially and adversely affect our business. Even
if we are successful on the merits, litigation is time-consuming, very costly
and distracts management's attention away from operations.
There is no assurance that new laws and regulations relating to our business
will not be enacted or that existing laws and regulations will not be amended or
reinterpreted in a manner adverse to our business. Any regulatory change could
materially and adversely affect the installation and use of existing and
additional player stations, games and systems, and our ability to generate
revenues from some or all of our Class II games. Regulatory uncertainty also
increases our cost of doing business. We dedicate significant time and incur
significant expense for new game development without any assurance that the NIGC
or other federal, state and local agencies or Native American governments will
agree that new or enhanced games meet applicable regulatory requirements. We
also devote significant time and expense to dealing with federal, state and
tribal agencies having jurisdiction over Native American gaming, and in
complying with the various regulatory regimes that govern our business.
Our business is subject to various licensing regimes imposed by gaming
regulatory authorities.
We have obtained all state licenses, lottery board licenses, Native American
gaming commission licenses, findings of suitability, registrations, permits and
approvals necessary for the operation of our gaming activities. These include a
license from the State of Washington to sell Class III video lottery systems,
licenses from the lottery boards of the State of Texas and the District of
Columbia and licenses from all applicable Native American gaming commissions. We
cannot assure you that new licenses, permits and approvals that may be required
in the future will be granted to us. The suspension, revocation, non-renewal or
limitation of any of our licenses would have a material adverse effect on our
business, financial condition and results of operations.
We are dependant upon a few customers who are based in Oklahoma.
For the year ended September 30, 2001, the Chickasaw Nation of Oklahoma and the
Cherokee Nation of Oklahoma accounted for approximately 28% and 14% of our
gaming revenues, respectively.
The significant concentration of our customers in Oklahoma means that:
. local economic changes may adversely affect our customers, and therefore
our business, more suddenly and disproportionately than would changes in
national economic conditions; and
. our business would be materially and adversely affected if Oklahoma were
to adopt Class III gaming by compacts with our Oklahoma customers.
The loss of any of these tribes as our customers would have a material and
adverse effect upon our financial condition and results of operations. We do not
operate under a written agreement with the Chickasaw Nation of Oklahoma. See
"Risk Factors - We do not rely upon the term of our customer contracts to retain
the business of our customers."
-22-
Our future performance will depend on our ability to introduce new games and
enhancements that are widely accepted and played.
Our recent revenue growth has been driven primarily by our technological
innovations and the increased number and use of our installed base of player
stations. Our New-Generation gaming platform allows us to produce games that
play faster than our Legacy games and generate increased revenues for our
customers and for us. In January 2001, we introduced MegaNanza, our first game
based on the New-Generation platform. In June 2002, we introduced Reel Time
Bingo, a high-speed standard sequence bingo game.
Our future performance will depend on our ability to successfully and
cost-effectively develop and introduce new and enhanced games that will be
widely accepted both by our tribal customers and their end users. Our
New-Generation platform enables us to more effectively launch new games that we
believe are more entertaining for end users, thus providing us and our customers
with greater revenues.
However, we may experience delays in game development in the future, or we may
not be successful in developing, introducing and marketing new games or game
enhancements on a timely and cost effective basis. In addition, our new games
may be subject to challenge by the NIGC or the DOJ based on the IGRA, the
Johnson Act or some other regulatory scheme. If we are unable, for technological
or other reasons, to develop and introduce new games or enhancements of existing
products in a timely manner in response to changing regulatory, legal or market
conditions or customer requirements, or if new products or new versions of
existing products do not achieve market acceptance, our business would be
seriously harmed.
Our expansion into non-Indian gaming activities will present new challenges and
risks that could adversely affect our business or results of operations.
Our growth strategy includes selling our games and technology into segments of
the gaming industry other than Native American gaming, principally the charity
bingo market and new Class III video lottery jurisdictions. In May 2002, the New
York Lottery notified us that it had selected us as the winning vendor in a
competitive procurement to provide the central system for video lottery games to
be operated at New York state racetracks.
We do not believe that these activities are currently subject to a nationwide
regulatory system such as the one created by the Indian Gaming Regulatory Act,
and regulation is on a state-by-state basis. In addition, federal laws relating
to gaming, such as the Johnson Act, which regulates slot machines and similar
gambling devices, would also apply to new video lottery jurisdictions absent
authorized state law exemptions. If we were to expand into these new markets, we
would expect to encounter legal and regulatory uncertainties similar to those we
face in our Native American gaming business. Successful growth in accordance
with this strategy may require us to make certain changes to our games to ensure
that they comply with applicable regulatory regimes and may require us to obtain
additional licenses. Importantly, in certain jurisdictions and for certain
venues our ability to enter these markets will depend on changes to existing
laws and regulatory regimes. These changes are subject to a great degree of
uncertainty and may never be achieved. We cannot assure you that we will be
successful in entering into other segments of the gaming industry.
Generally, our selling games and technology into new segments involves a number
of uncertainties, including:
. whether our resources and expertise will enable us to effectively operate
and grow in such new markets;
. whether our internal processes and controls are mature enough to function
effectively within these segments;
. whether we have enough experience to accurately predict revenues and
expenses in these new segments; and
. whether entering such segments will divert management attention and
resources from our traditional business.
If we are unable to effectively develop and operate within these segments, then
entering into these new segments could have a material adverse effect on our
business, operating results and financial condition. Moreover, we may not be
able to obtain the anticipated or desired benefits of such new lines of
business.
We compete for both customers and end users with other vendors of Class II and
Class III games. We also compete for end users with other forms of
entertainment. To remain competitive, we must continue to develop new game
themes and systems that appeal to end users.
We compete with other Class II vendors for customers, primarily on the basis of
the amount of profit our gaming products generate for our customers in relation
to gaming products offered by other vendors. We believe that the most important
factor influencing our customers' product selection is the appeal of those
products to end users. This
-23-
appeal has a direct effect on the volume of play by end users, and drives the
amount of revenues generated for and by our customers. Our ability to remain
competitive depends primarily on our ability to continuously develop new game
themes and systems that appeal to end users and to introduce those game themes
and systems in a timely manner. In addition, our new or modified gaming products
that are intended for the Class II market must be designed and operated to meet
the requirements of Class II gaming. We cannot assure you that we will continue
to develop and introduce appealing new game themes and systems that meet the
requirements of Class II gaming in a timely manner, or at all. In addition,
there can be no assurance that others will not independently develop games
similar to our Class II games.
If the Class II market expands and the legal and regulatory uncertainties
regarding Class II gaming are resolved, we could see increased competition in
the Class II market from Class III vendors, many of whom have significantly
greater financial resources than we do. Increased competition could have a
materially adverse affect on our ability to sell our products, generate revenue
and maintain our profit margins.
Given the limitations placed on Class II gaming, we may not be able to
successfully compete in gaming jurisdictions and facilities where slot machines,
table games and other forms of Class III gaming are permitted. Furthermore,
increases in the popularity of, and competition from, an expansion of Class III
gaming or Internet and other account wagering gaming services, which allow end
users to wager on a wide variety of sporting events and to play traditional
casino games from home, could have a material adverse effect on our business,
financial condition, operating results and prospects.
Changes in regulation or regulatory interpretations could require us to modify
the terms of our contracts with customers.
The NIGC has considered the provisions of the agreements under which we provide
our Class II games, equipment and services and has determined that these
agreements are "service contracts" and are not "management contracts."
Management contracts are subject to additional regulatory requirements and
oversight. Our contracts could be subject to further review at any time. Any
further review of these agreements by the NIGC could require substantial
modification to our agreements and result in their redesignation as management
contracts, which could materially and adversely affect the terms on which we
conduct our business.
We may seek to expand our business through acquisitions or by jointly developing
or expanding gaming and related facilities with our customers. We have limited
experience with these activities and may not realize a satisfactory return, if
any, on our investment, and we could lose some or all of our investment.
If appropriate opportunities present themselves, we may acquire other
complementary businesses, technologies, services or products. We are exploring
the possibility of the joint development of gaming and related facilities on
Native American land where we can install our games and player stations. We also
may seek to enter into strategic relationships and provide financing and
development services for new or expanded gaming and related facilities for our
customers. We currently have no binding agreements to acquire any third party or
to provide any financing to our customers for the development or expansion of
their facilities. We cannot assure you that the anticipated benefits of any
acquisition, strategic relationship or financing would be realized. We may not
be able to complete or integrate future acquisitions successfully.
In connection with one or more of those transactions, we may:
. issue additional equity securities which would dilute stockholders;
. extend secured and unsecured credit which may not be repaid;
. incur debt on terms unfavorable to us or that we are unable to repay;
. incur contingent liabilities;
. integrate additional employees and fixed assets that we must maintain; and
. incur amortization expenses related to goodwill and other intangible
assets.
We have limited experience in these types of activities. Accordingly, an
acquisition or a strategic relationship, development effort or financing may
result in unforeseen operating difficulties, financial risks or required
expenditures that could adversely affect our liquidity. It may also divert the
time and distract the attention of our management that would otherwise be
available for ongoing development of our business. If we provide financing or
development services to our customers, we may not realize a satisfactory return,
if any, on our investment and we could lose some or all of our investment.
-24-
We may not be successful in protecting our intellectual property rights or
avoiding claims that we are infringing upon the intellectual property rights of
others.
We rely upon patent, copyright, trademark and trade secret laws, license
agreements and employee nondisclosure agreements to protect our proprietary
rights and technology, but these laws and contractual provisions provide only
limited protection. We rely to a greater extent upon proprietary know-how and
continuing technological innovation to maintain our competitive position.
Insofar as we rely on trade secrets, unpatented know-how and innovation, there
is no assurance that others will not independently develop similar technology or
that secrecy will not be breached. The issuance of a patent does not necessarily
mean that our technology does not infringe upon the intellectual property rights
of others. Accordingly, we cannot assure you that we will not be subject to
infringement claims from other parties. Problems with patents or other rights
could increase the cost of our products or delay or preclude new product
development and commercialization. If infringement claims against us are valid,
we may seek licenses that might not be available to us on acceptable terms or at
all. Litigation could be costly and time-consuming, but may be necessary to
protect our proprietary rights or to defend against infringement claims. We
could incur substantial costs and diversion of management resources in the
defense of any claims relating to the proprietary rights of others or in
asserting claims against others.
We rely on software licensed from third parties and technology provided by
third-party vendors, the loss of which could increase our costs and delay
software shipments. We also rely on technology provided by third-party vendors
which, if disrupted, could suspend play at some of our player stations.
We integrate various third-party software products as components of our
software. Our business would be disrupted if this software, or functional
equivalents of this software, were either no longer available to us or no longer
offered to us on commercially reasonable terms. In either case, we would be
required to either redesign our software to function with alternate third-party
software or develop these components ourselves, which would result in increased
costs and could result in delays in our software shipments. Furthermore, we
might be forced to limit the features available in our current or future
software offerings.
We also rely on the technology of third-party vendors, such as telecommunication
providers, to operate our "Betnet" network. A serious or sustained disruption to
the provisions of these services could result in some of our player stations
being non-operational for the duration of the disruption, which would adversely
affect our ability to generate revenue from those player stations.
We do not rely upon the term of our customer contracts to retain the business of
our customers.
Our contracts with our customers are on a year-to-year or multi-year basis and
we have no written contract with our largest customer, the Chickasaw Nation of
Oklahoma. We do not rely upon the stated term of our customer contracts to
retain the business of our customers. We rely instead upon providing
competitively superior player stations, games and systems to give our customers
the incentive to continue to do business with us. At any point in time, a
significant portion of our business is subject to non-renewal, which could
materially and adversely affect our earnings and financial condition.
If our key personnel leave us, our business will be significantly adversely
affected.
We depend on the continued performance of the members of our senior management
team and our technology team. Gordon T. Graves, our Chairman and Chief Executive
Officer, has extensive experience in the Native American gaming business and has
contributed significantly to the growth of our business. If we lose the services
of Mr. Graves, Clifton E. Lind, our President and Chief Operating Officer, or
any of our other senior officers or our directors or any member of our
technology team, and cannot find suitable replacements for such persons in a
timely manner, it could have a material adverse effect on our business.
Enforcement of remedies or contracts against Native American tribes could be
difficult.
Governing and Native American Law. Federally recognized Native American tribes
are independent governments, subordinate to the United States, with sovereign
powers, except as those powers may have been limited by treaty or by the United
States Congress. Native American power to enact their own laws to regulate
gaming is an exercise of Native American sovereignty, as recognized by IGRA.
Native American tribes maintain their own governmental systems and often their
own judicial systems. Native American tribes have the right to tax persons and
enterprises conducting business on Native American lands, and also have the
right to require licenses and to impose other forms of regulation and regulatory
fees on persons and businesses operating on their lands.
-25-
Native American tribes, as sovereign nations, are generally subject only to
federal regulation. Although Congress may regulate Native American tribes,
states do not have the authority to regulate Native American tribes unless such
authority has been specifically granted by Congress. State laws generally do not
directly apply to Native American tribes and activities taking place on Native
American lands, unless the tribe has a specific agreement or compact with the
state or federal government allowing for the application of state law. In the
absence of a conflicting federal or properly authorized state law, Native
American law governs.
Our contracts with Native American customers provide that the law of the state
in which a tribe is located will be the governing law of those contracts. We
cannot assure you, however, that these choice of law clauses are enforceable.
Sovereign Immunity; Applicable Courts. Native American tribes generally enjoy
sovereign immunity from suit similar to that of the states and the United
States. In order to sue a Native American tribe (or an agency or instrumentality
of a Native American tribe), the Native American tribe must have effectively
waived its sovereign immunity with respect to the matter in dispute.
Our contracts with Native American customers include a limited waiver of each
tribe's sovereign immunity and provide that any dispute regarding
interpretation, performance or enforcement shall be submitted to, and resolved
by, arbitration in accordance with the Commercial Arbitration Rules of the
American Arbitration Association, and that any award, determination, order or
relief resulting from such arbitration is binding and may be entered in any
court having jurisdiction. In the event that such waiver of sovereign immunity
is held to be ineffective, we could be precluded from judicially enforcing any
rights or remedies against a tribe. These rights and remedies include, but are
not limited to, our right to enter Native American lands to retrieve our
property in the event of a breach of contract by the tribe party to that
contract.
If a Native American tribe has effectively waived its sovereign immunity, there
exists an issue as to the forum in which a lawsuit can be brought against the
tribe. Federal courts are courts of limited jurisdiction and generally do not
have jurisdiction to hear civil cases relating to Native Americans. Federal
courts may have jurisdiction if a federal question is raised by the suit, which
is unlikely in a typical contract dispute. Diversity of citizenship, another
common basis for federal court jurisdiction, is not generally present in a suit
against a tribe because a Native American tribe is not considered a citizen of
any state. Accordingly, in most commercial disputes with tribes, the
jurisdiction of the federal courts, which are courts of limited jurisdiction,
may be difficult or impossible to obtain. There can be no assurance that we
could effectively enforce any arbitration decision.
The National Gambling Impact Study Commission's recommendations may adversely
affect the gaming industry and our operations.
The National Gambling Impact Study Commission was established by the United
States Congress to conduct a comprehensive study of the social and economic
impact of gaming in the United States. On April 28, 1999, the National Gambling
Impact Study Commission voted to recommend that the expansion of gaming be
curtailed. In June 1999, the National Gambling Impact Study Commission issued a
final report of its findings and conclusions, together with recommendations for
legislative and administrative actions. Highlights of some of those
recommendations include:
. legal gaming should be restricted to those at least 21 years of age;
. betting on college and amateur sports should be banned;
. the introduction of casino-style gaming at pari-mutuel racing facilities
for the primary purpose of saving pari-mutuel facilities that otherwise
may not be financially viable, for the purpose of competing with other
forms of gaming should be prohibited;
. internet gaming should be banned in the United States;
. the types of gaming activities allowed by Native American tribes within a
given state should be consistent with the gaming activities allowed to
other persons in that state; and
. state, local and Native American governments should recognize that casino
gaming provides economic development, particularly for economically
depressed areas, as opposed to stand-alone slot machines (e.g., in
convenience stores), Internet gaming and lotteries, which do not provide
the same economic development.
-26-
Any regulation of the gaming industry which may result from the National
Gambling Impact Study Commission's report may have an adverse effect on the
gaming industry and on our financial condition and results of operations.
We may incur prize payouts in excess of game revenues.
Our contracts with our Native American customers relating to our Legacy platform
games provide that our customers receive, on a daily basis, an agreed percentage
of gross gaming revenues based upon an assumed level of prize payouts, rather
than the actual level of prize payouts. This can result in our paying our
customers amounts greater than our customers' percentage share of the actual
hold per day. In addition, because the prizes awarded in our games are based
upon assumptions as to the number of players in each game and statistical
assumptions as to the frequency of winners, we may experience on any day, or
over short periods of time, a "game deficit" where the total aggregate amount of
prizes paid exceeds aggregate game revenues. If we have to make any excess
payments to customers or experience a game deficit over any statistically
relevant period of time, we are contractually entitled to adjust the rates of
prize payout to end users in order to recover any deficit. We cannot assure you
that, in the future, we will not miscalculate our statistical assumptions or for
other reasons experience abnormally high rates of jackpot prize wins which may
materially and adversely affect our cash flow on a temporary or long-term basis
and which could materially and adversely affect our earnings and financial
condition.
Any disruption in our network or telecommunications services could affect our
ability to operate our games, which would result in reduced revenues and
customer down time.
If we lose the services of one or more of our telecommunications provider for
any reason, we could experience disruption in our network availability and our
games may experience down time as a result. This disruption to our business
could result in a decrease in our revenue from the loss of play.
Our network is susceptible to outages due to fire, floods, power loss, break-ins
and similar events. We have multiple site back-up for our services in the event
of any such occurrence. Despite our implementation of network security measures,
our servers are vulnerable to computer viruses, break-ins, and similar
disruptions from unauthorized tampering with our computer systems. Any such
event could have a material adverse effect on our business, operating results
and financial condition.
Adverse weather conditions in the areas in which we operate could have a
material adverse effect on our results of operations and financial condition.
Adverse weather conditions, particularly flooding, heavy snowfall and other
extreme weather conditions, often deter our end users from traveling or make it
difficult for them to frequent the sites where our games are installed. If any
of the sites where our games are installed were to experience prolonged adverse
weather conditions, or if the sites in Oklahoma where a significant number of
our games are installed were to simultaneously experience adverse weather
conditions, our results of operations and financial condition would be
materially adversely affected.
Worsening economic conditions may adversely affect our business.
The demand for entertainment and leisure activities tends to be highly sensitive
to consumers' disposable incomes, and thus a decline in general economic
conditions may lead to our end users having less discretionary income with which
to wager. This could cause a reduction in our revenues and have a material
adverse effect on our operating results.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are not subject to any interest rate, exchange rate, or commodity price
risks.
-27-
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In January 2001, we introduced a new Class II game called MegaNanza. MegaNanza
generated approximately $47.5 million, or 36%, of total revenues for our fiscal
year ended September 30, 2001, and approximately $158.8 million, or 74%, of
total revenues for the nine months ended June 30, 2002. On April 15, 2002, we
received an advisory opinion from the Deputy General Counsel of the NIGC stating
that MegaNanza and its related family of games were Class III games as defined
by IGRA. The advisory opinion relied heavily upon two factors in reaching its
conclusion. First, that the ball draw for each MegaNanza bingo game occurred
prior to, rather than after, the sale of bingo cards to players and, second,
upon proposed rules published by the NIGC on March 22, 2002 that would have
changed the definitions of legally permissible technological aids and illegal
electronic facsimiles used in the play of Class II gaming in a manner adverse to
us and to the method of operating our games.
On April 18, 2002, we filed a lawsuit in the United States District Court for
the Northern District of Oklahoma against the NIGC seeking a judicial
declaration that two versions of MegaNanza are Class II games. Both versions
operate in what is called "nonstandard sequence," meaning that the ball draw
occurs before bingo cards are sold to players. On June 14, 2002, the NIGC,
represented by and acting through the DOJ, filed a motion to dismiss the case,
claiming the Court lacked jurisdiction on various procedural grounds. On July
11, 2002, we responded to the DOJ's motion to dismiss. The Court has yet to rule
on the DOJ's motion.
On June 17, 2002, the NIGC adopted final rules on the definitions of legally
permissible technological aids and illegal electronic facsimiles used in the
play of Class II gaming. This action was based on a two-to-one vote of the
commission, with the NIGC Chairman in the minority. These new rules differed
significantly from the rules initially proposed by the NIGC on March 22, 2002
and that had been relied upon by the Deputy General Counsel of the NIGC in her
April 15, 2002, advisory opinion finding MegaNanza to be Class III gaming. We
believe the final rules support our current method of game operation, including
the MegaNanza family of games. Nevertheless, under the rules of IGRA that grant
the Chairman exclusive authority to bring enforcement actions against tribes
believed by the Chairman to be conducting illegal gaming, on June 17, 2002, the
Chairman issued an NOV to our largest customer, threatening the tribe with
significant fines and penalties unless it immediately ceased the play of
MegaNanza.
In view of the threat raised by the NOV, our largest customer immediately ceased
play of MegaNanza, and together with two other major tribal customers, sought to
join in with us in our pending action against the NIGC. Along with us, the
tribes further sought an injunction against the NIGC from pursuing the existing
NOV or taking any other enforcement actions against these tribes or any other of
our Native American customers. On June 24, 2002, the Court granted the relief
requested by us and enjoined the NIGC "from issuing or further pursuing any
notices of violation, penalties, or closure orders with respect to the MegaNanza
family of games." The injunction will remain in effect until further order of
the Court.
We cannot predict what the outcome of the pending litigation against the NIGC
will be, including whether the Court will grant the NIGC's pending motion to
dismiss for lack of jurisdiction. A successful challenge to the Class II status
of the MegaNanza game could materially and adversely affect our business. Even
if we are successful on the merits, litigation is time-consuming, very costly
and distracts management's attention away from operations.
There is no assurance that new laws and regulations relating to our business
will not be enacted or that existing laws and regulations will not be amended or
reinterpreted in a manner adverse to our business. Any regulatory change could
materially and adversely affect the installation and use of existing and
additional player stations, games and systems, and our ability to generate
revenues from some or all of our Class II games. Regulatory uncertainty also
increases our cost of doing business. We dedicate significant time and incurs
significant expense for new game development without any assurance that the NIGC
or other federal, state and local agencies or Native American governments will
agree that new or enhanced games meet applicable regulatory requirements. We
also devote significant time and expense to dealing with federal, state and
tribal agencies having jurisdiction over Native American gaming, and in
complying with the various regulatory regimes that govern our business.
Other Litigation. On June 11, 2002, we were named a defendant in a complaint
filed in the Los Angeles County Superior Court alleging breach of contract. The
complaint alleges that in July 1995, the plaintiff acquired the
-28-
perpetual right to purchase at any time in the future 28,125 shares of our
common stock at $2.64 per share. The warrant certificate issued to the plaintiff
at the time of purchase expressly stated that the plaintiff's right to purchase
common stock expired on July 31, 1998, on which date, the market price of our
common stock was less than $2.64 per share and the plaintiff's warrant was not
exercised. Plaintiff alleges that representations made to plaintiff at the time
of purchase caused him to believe that there was no expiration date to the
warrants, and seeks damages in an amount equal to the profit plaintiff could
have realized by exercising the warrants and selling the common stock at the
highest sale price during the period from February 16, 2002 (the date plaintiff
first demanded that we honor the plaintiff's request to exercise the warrants)
and the date the case comes to trial. In July 2002, we answered the complaint
and denied any liability. The case is in a very preliminary stage and no
discovery has been taken. We intend to vigorously defend the case and expect the
cost of our defense to be expensive. We cannot predict what the outcome of the
case will be.
On June 22, 2002, we were named a defendant in a complaint filed by the Oneida
Indian Nation in the United States District Court for the Western District of
Washington alleging patent infringement. The plaintiff alleges infringement of
two patents, both entitled "Cashless Computerized Video Game System and Method,"
and seeks damages in an unspecified amount and an injunction against us for any
future infringement. We intend to vigorously defend the case and expect the cost
of our defense to be expensive. We cannot predict what the outcome of the case
will be.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On May 29, 2002, we held our 2002 Annual Stockholder Meeting. The meeting
involved the election of eight nominees to be Directors, and the following
persons were elected, constituting all of the members of our Board of Directors:
Gordon T. Graves, Martin A. Keane, Thomas W. Sarnoff, John M. Winkelman, and
Clifton E. Lind.
A separate tabulation with respect to each nominee is as follows:
FOR AGAINST ABSTAIN
Gordon T. Graves 10,922,748 0 166,616
Martin A. Keane 10,454,264 0 166,616
Thomas W. Sarnoff 10,454,264 0 166,616
John M. Winkelman 10,454,264 0 166,616
Clifton E. Lind 10,454,264 0 166,616
A proposal to ratify and approve the appointment of BDO Seidman LLP as our
independent auditors was also voted upon at the meeting and received the
requisite number of votes necessary to pass, as follows:
FOR AGAINST ABSTAIN
10,768,889 305,160 15,315
In addition to the above, a proposal to ratify and approve the 2001 Stock Option
Plan was voted upon at the meeting and received the requisite number of votes
necessary to pass, as follows:
FOR AGAINST ABSTAIN
3,557,672 2,033,921 20,276
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Two exhibits are filed as part of this Quarterly Report on Form 10-Q:
Exhibit 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(b) We filed a report on Form 8-K on May 30, 2002, reporting remarks by Gordon
T. Graves when addressing the annual shareholders' meeting on May 29, 2002.
(c) We filed a report on Form 8-K on April 22, 2002, reporting a presentation
to security analysts and investors.
-29-
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Dated August 14, 2002 Multimedia Games, Inc.
By: /s/ Craig S. Nouis .
---------------------
Craig S. Nouis
Chief Financial and Principal Accounting
Officer
-30-