SPECIAL
NOTE REGARDING FORWARD-LOOKING STATEMENTS
This
Quarterly Report on Form 10-Q contains “forward-looking statements” within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended. These forward-looking
statements are made in good faith and are based on current expectations,
estimates, forecasts and projections about the industry in which we operate,
management’s beliefs and management’s assumptions. These statements relate to
future events or to our future financial performance and involve known and
unknown risks, uncertainties and other factors that may cause our actual
results, levels of activity, performance or achievements to be materially
different from any future results, levels of activity, performance or
achievements expressed or implied by these forward-looking statements.
Statements
expressing expectations regarding our future (including gaming regulatory
approvals) and projections related to products, sales, revenues and earnings
are
typical of forward-looking statements. In some cases you can identify
forward-looking statements by the use of words such as “may,” “could,” “expect,”
“intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,” “predict,”
“potential” or “continue” or the negative of these terms or other comparable
terminology. You should not place undue reliance on forward-looking statements
because they involve known and unknown risks, uncertainties, and other factors
that are, in some cases, beyond our control and that could materially affect
actual results, levels of activity, performance or achievements. You should
read
carefully the risk factors in “Part II - Other Information, Item 1A. Risk
Factors” of this report and the risk factors set forth in our Annual Report on
Form 10-K for the year ended December 31, 2005 for a description of risks
that
could cause actual results to differ from these forward-looking
statements.
If
any of
these risks or uncertainties materialize, or if our underlying assumptions
prove
to be incorrect, actual results may vary significantly from what we projected.
Forward-looking statements speak only as of the date they are made. Any
forward-looking statement you read in this Quarterly Report reflects our
current
views with respect to future events and is subject to these and other risks,
uncertainties and assumptions relating to our operations, results of operations,
growth strategies and liquidity. Except as required under federal securities
laws and the rules and regulations of the Securities and Exchange Commission,
we
assume no obligation to publicly update or revise these forward-looking
statements for any reason, or to update the reasons actual results could
differ
materially from those anticipated in these forward-looking statements, even
if
new information becomes available in the future.
PART
I FINANCIAL INFORMATION
ITEM
1. FINANCIAL
STATEMENTS
CONDENSED
CONSOLIDATED BALANCE SHEETS
(Unaudited)
| |
|
March
31,
|
|
|
|
| |
|
|
|
2005
|
|
|
Assets:
|
|
|
|
|
|
|
Current
Assets:
|
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
25,641,971
|
|
$
|
511,517
|
|
|
Accounts
Receivable, net of
|
|
|
|
|
|
|
|
|
allowance
for doubtful accounts
|
|
|
1,230,140
|
|
|
1,311,849
|
|
|
Inventories
|
|
|
1,421,831
|
|
|
1,270,445
|
|
|
Prepaid
Expenses
|
|
|
1,179,464
|
|
|
957,889
|
|
|
Deferred
tax asset
|
|
|
113,990
|
|
|
82,604
|
|
|
Total
current assets
|
|
|
29,587,396
|
|
|
4,134,304
|
|
|
Property
and Equipment, net of
|
|
|
|
|
|
|
|
|
accumulated
depreciation
|
|
|
4,816,609
|
|
|
5,016,573
|
|
|
Other
assets, net of accumulated
|
|
|
|
|
|
|
|
|
amortization
|
|
|
377,988
|
|
|
1,176,671
|
|
|
Deferred
tax asset
|
|
|
711,943
|
|
|
720,955
|
|
|
Total
assets
|
|
$
|
35,493,936
|
|
$
|
11,048,503
|
|
| |
|
|
|
|
|
|
|
|
Liabilities
and stockholders' equity:
|
|
|
|
|
|
|
|
|
Current
Liabilities
|
|
|
|
|
|
|
|
|
Accounts
Payable
|
|
$
|
310,489
|
|
$
|
330,564
|
|
|
Commissions
Payable
|
|
|
336,274
|
|
|
184,863
|
|
|
Accrued
Expenses
|
|
|
275,383
|
|
|
184,496
|
|
|
Income
Taxes Payable
|
|
|
168,575
|
|
|
158,446
|
|
|
Notes
payable, current portion
|
|
|
392,603
|
|
|
536,495
|
|
|
Total
current liabilities
|
|
|
1,483,324
|
|
|
1,394,864
|
|
|
Stockholders'
equity:
|
|
|
|
|
|
|
|
|
Common
stock (.001 par value
|
|
|
|
|
|
|
|
|
|
|
|
11,342
|
|
|
8,350
|
|
|
Additional
paid in capital
|
|
|
29,477,550
|
|
|
4,702,039
|
|
|
Contra-Equity
|
|
|
(612,129
|
)
|
|
-
|
|
|
Retained
earnings
|
|
|
5,133,849
|
|
|
4,943,250
|
|
|
Total
stockholders equity
|
|
|
34,010,612
|
|
|
9,653,639
|
|
|
Total
liabilities and
|
|
|
|
|
|
|
|
|
stockholders'
equity
|
|
$
|
35,493,936
|
|
$
|
11,048,503
|
|
See
notes
to condensed consolidated financial statements.
FORTUNET,
INC.
CONDENSED
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
| |
|
|
|
|
|
|
|
|
2005
|
|
| |
|
|
|
|
|
|
Sales
Revenue
|
|
$
|
3,978,783
|
|
$
|
3,890,212
|
|
|
Cost
of Revenue
|
|
|
497,556
|
|
|
612,422
|
|
|
Gross
Profit
|
|
|
3,481,227
|
|
|
3,277,790
|
|
|
Operating
Costs & Expenses
|
|
|
|
|
|
|
|
|
General
& Administrative
|
|
|
1,685,178
|
|
|
981,469
|
|
|
Sales
& Marketing
|
|
|
1,297,925
|
|
|
1,139,975
|
|
|
Research
& Development
|
|
|
258,209
|
|
|
228,649
|
|
|
Total
Operating Expenses
|
|
|
3,241,312
|
|
|
2,350,093
|
|
|
Income
from operations
|
|
|
239,915
|
|
|
927,697
|
|
| |
|
|
|
|
|
|
|
|
Other
Income
|
|
|
87,556
|
|
|
26,170
|
|
|
Interest
Expense
|
|
|
(6,056
|
)
|
|
(8,551
|
)
|
|
Income
Before Taxes
|
|
|
321,415
|
|
|
945,316
|
|
|
Provision
for income taxes
|
|
|
130,816
|
|
|
326,445
|
|
|
Net
Income
|
|
$
|
190,599
|
|
$
|
618,871
|
|
|
|
|
|
|
|
|
|
|
|
Weighted
average shares - basic
|
|
|
10,169,151
|
|
|
8,350,000
|
|
|
Earnings
per share - basic
|
|
$
|
0.02
|
|
$
|
0.07
|
|
|
Weighted
average shares - diluted
|
|
|
10,233,297
|
|
|
8,350,000
|
|
|
Earnings
per share - diluted
|
|
$
|
0.02
|
|
$
|
0.07
|
|
See
notes
to condensed consolidated financial statements.
FORTUNET,
INC.
CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
| |
|
|
|
| |
|
|
|
2005
|
|
|
Cash
flows from operating activities
|
|
|
|
|
|
|
Net
Income
|
|
$
|
190,599
|
|
$
|
618,871
|
|
|
Adjustments
to reconcile net income to net cash provided by operating
activities:
|
|
|
|
|
|
|
|
|
Depreciation
|
|
|
432,170
|
|
|
510,589
|
|
|
Amortization
|
|
|
113,535
|
|
|
113,535
|
|
|
Stock
issued for services
|
|
|
437,379
|
|
|
|
|
|
Change
in operating assets and liabilities:
|
|
|
|
|
|
|
|
|
Accounts
receivable
|
|
|
81,709
|
|
|
245,039
|
|
|
Inventories
|
|
|
(151,386
|
)
|
|
258,995
|
|
|
Prepaid
expenses
|
|
|
(221,575
|
)
|
|
(418,943
|
)
|
|
Deferred
Tax
|
|
|
(22,374
|
)
|
|
(281,020
|
)
|
|
Other
assets
|
|
|
(574
|
)
|
|
(8
|
)
|
|
Accounts
payable
|
|
|
(20,075
|
)
|
|
49,394
|
|
|
Accrued
expenses
|
|
|
90,887
|
|
|
168,721
|
|
|
Commissions
payable
|
|
|
151,411
|
|
|
31,967
|
|
|
Income
tax payable
|
|
|
10,129
|
|
|
420,878
|
|
|
Net
cash provided by operating activities
|
|
|
1,091,835
|
|
|
1,718,018
|
|
| |
|
|
|
|
|
|
|
|
Cash
flows from investing activities:
|
|
|
|
|
|
|
|
|
Purchase
of equipment and property
|
|
|
(232,206
|
)
|
|
(855,491
|
)
|
|
Net
cash used in investing activities
|
|
|
(232,206
|
)
|
|
(855,491
|
)
|
| |
|
|
|
|
|
|
|
|
Cash
flows from financing activities
|
|
|
|
|
|
|
|
|
Dividends
|
|
|
-
|
|
|
(30,000
|
)
|
|
Sale
of Stock
|
|
|
24,710,625
|
|
|
-
|
|
|
Cost
of issuing stock
|
|
|
(295,908
|
)
|
|
-
|
|
|
Payments
on note payable
|
|
|
(143,892
|
)
|
|
(136,888
|
)
|
|
Net
cash used in (provided by) financing activities
|
|
|
24,270,825
|
|
|
(166,888
|
)
|
| |
|
|
|
|
|
|
|
|
Net
increase in cash and cash equivalents
|
|
|
25,130,454
|
|
|
695,639
|
|
| |
|
|
|
|
|
|
|
|
Cash
and cash equivalents, beginning
|
|
|
511,517
|
|
|
1,379,925
|
|
|
Cash
and cash equivalents, ending
|
|
$
|
25,641,971
|
|
$
|
2,075,564
|
|
| |
|
|
|
|
|
|
|
|
Supplemental
disclosure of cash flow information:
|
|
|
|
|
|
|
|
|
Interest
|
|
$
|
6,056
|
|
$
|
8,552
|
|
|
Cash
paid for income taxes
|
|
$
|
143,060
|
|
$
|
274,690
|
|
|
Non-cash
financing activities, dividends accrued
|
|
$
|
-
|
|
$
|
30,000
|
|
See
notes
to condensed consolidated financial statements.
FORTUNET,
INC.
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
| 1. |
Nature
of Business and Interim Basis of Presentation:
|
Nature
of business:
FortuNet, Inc. (FortuNet or the Company) was incorporated in 1989 in Nevada.
FortuNet is engaged primarily in the business of designing, manufacturing
and
leasing electronic bingo and entertainment systems throughout North America.
FortuNet derives substantially all revenues from the gaming industry in the
United States and Canada. Changes in laws and regulations related to gaming
in
each state or province can affect the Company’s revenues in any given state or
province.
Interim
Basis of Presentation:
The
accounting policies followed in the preparation of the financial information
herein are the same as those summarized in the Company’s 2005 Annual Report on
Form 10-K, except for the Company’s adoption of Statement of Financial
Accounting Standards (“SFAS”) No. 123R on January 1, 2006 (see Notes 3
and 4). The condensed consolidated balance sheet at December 31, 2005 was
derived from audited consolidated financial statements at that date. The
interim
condensed consolidated financial information is unaudited and should be read
in
conjunction with the Company’s 2005 Annual Report on Form 10-K. In the opinion
of management, all adjustments, consisting of normal and recurring adjustments
that are necessary to fairly present the financial condition of the Company
as
of March 31, 2006 and the results of its operations and its cash flows for
the three months ended March 31, 2006 and 2005 have been included. Interim
results of operations are not necessarily indicative of the results of
operations for the full year due to seasonality and other factors.
In
accordance with the provisions of SFAS No. 128, Earnings
Per Share, basic
net
income is computed by dividing net income by the weighted average number
of
common shares outstanding during the period. Diluted earnings per common
share
is calculated by dividing the amount of income available to common shareholders
by the number of diluted weighted average shares of common stock outstanding
during each period. Potentially dilutive securities include common shares
purchasable upon exercise of stock options and any non-vested
stock.
The
following table sets forth the computations for basic and dilutive earnings
per
common share:
| |
|
Three
months ended
|
|
| |
|
|
|
2005
|
|
|
Net
Income
|
|
$
|
190,599
|
|
$
|
618,871
|
|
|
Weighted
average shares outstanding
|
|
|
10,169,151
|
|
|
8,350,000
|
|
|
Dilutive
non-vested shares
|
|
|
64,146
|
|
|
-
|
|
|
Dilutive
weighted average number of shares outstanding
|
|
|
10,233,297
|
|
|
8,350,000
|
|
|
Basic
Earnings Per Share
|
|
$
|
0.02
|
|
$
|
0.07
|
|
|
Dilutive
Earnings Per Share
|
|
$
|
0.02
|
|
$
|
0.07
|
|
| 3. |
Adoption
of Recently Issued Accounting Pronouncements:
|
On
January 1, 2006, we were required to apply the provisions of Financial
Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard
No. 123 (revised 2004) (“SFAS 123R”), “Share-Based Payment”, and SEC Staff
Accounting Bulletin No. 107 (“SAB 107”), “Share-Based Payment”, requiring
the measurement and recognition of all share-based compensation under the
fair
value method. Under the fair value recognition provisions of this statement,
share-based compensation cost is estimated at the grant date based on the
value
of the award and is recognized as expense over the vesting period. Option
valuation models require the input of highly subjective assumptions, and
changes
in the assumptions used can materially affect the fair value estimate.
Additionally, judgment is required in estimating stock price volatility,
expected dividends, and expected term for options that remain outstanding.
Actual results, and future estimates, may differ substantially from our current
estimates.
In
November 2004, FASB issued SFAS No. 151 “Inventory
Costs,”
which
amends the guidance in ARB No. 43, Chapter 4 “Inventory
Pricing,”
to
clarify the accounting for abnormal amounts of idle facility expense, freight,
handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43,
Chapter 4, previously stated that under some circumstances, items such as
idle facility expense, excessive spoilage, double freight, and rehandling
costs
may be so abnormal as to require treatment as current period charges. SFAS
No.
151 requires that those items be recognized as current-period charges regardless
of whether they meet the criterion of “so abnormal.” In addition, SFAS No. 151
requires that allocation of fixed production overheads to the costs of
conversion be based on the normal capacity of the production facilities.
SFAS
No. 151 became effective for our inventory costs incurred since January 1,
2006.
The application of SFAS No. 151 has not had a material effect on our condensed
consolidated financial statements.
| 4. |
Stock
Based Compensation:
|
On
January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based
Payments” (“SFAS No. 123R”), which requires companies to measure the cost
of employee services received in exchange for an award of equity instruments
based on the grant date fair value of the award. The Company has equity
incentive plans that provide for the issuance of stock options, restricted
stock
and other equity incentives.
On
January 30, 2006, the Company issued 61,112 shares of restricted stock to
two of
its officers. One-sixth of these shares will vest upon completion of each
month
thereafter. On January 30, 2006, the Company issued 5,500 shares of
restricted stock to independent members of the board of directors. Upon
completion of each fiscal quarter of the current fiscal year, 25% of these
shares will vest.
The
Company recognizes stock-based compensation expense over the requisite service
period of the individual grants.
Compensation
cost related to vested restricted stock for the three months ended
March 31, 2006, including costs referred to in Note 5, was $437,379. Costs
associated with these expenses are included in general and administrative
expenses. A total of $612,129 of unrecognized compensation costs related
to
nonvested restricted stock is recorded in contra-equity and is expected to
be
recognized over future periods.
| 5. |
Commitments
and contingencies:
|
At March 31, 2006, the Company has entered into non-cancelable purchase
commitments for certain inventory components used in its normal operations.
The
purchase commitments covered by these agreements are for less than one year
and
in the aggregate amount to approximately $1,940,000.
The Company has engaged the services of Spiegel Partners, LLC to provide
advisory services associated with preparation for the Company’s initial public
offering. In consideration of these services, the Company paid approximately
$182,000 in cash, at the close of the initial public offering, less any prior
payments made in monthly installments of $10,000 - $30,000 per
month.
The Company has engaged future services of Spiegel Partners, LLC to provide
advisory services following the completion of the offering. In consideration
of
these services, the Company issued 50,000 shares of Company stock, which
will
vest monthly per the provision of such continued service agreement for a
six
month period following the initial public offering. In addition, we expect
to
pay approximately $130,000 to Spiegel Partners, LLC in cash in equal monthly
installments over such six month period.
| 6. |
Research
and development:
|
Research and development costs are primarily for costs of software and hardware
development and continued enhancements for the electronic bingo systems that
the
Company leases to customers. The total amount of research and development
was
$228,649 and $258,209 during the three months ended March 31, 2005 and 2006,
respectively.
| 7. |
Legal
and patent settlements:
|
The
Company is pursuing a patent infringement lawsuit against two of its
competitors, Planet Bingo, LLC and Melange Computer Services, Inc. The lawsuit
involves two of the Company’s patents. The Company alleges that one of its
patents is being infringed by both defendants and the other patent is being
infringed by Planet Bingo, LLC only. The Company filed this action in May
2004
in the United States Federal Court, District of Nevada. The Company is seeking
unspecified monetary damages and injunctive relief. The defendants have
counter-claimed that our patents are invalid and one of the defendants, Planet
Bingo, LLC, has claimed that our operations infringe one of its own patents.
The
patent that Planet Bingo, LLC claims that we have infringed has been invalidated
in a separate lawsuit. This decision is on appeal.
The
Company recently filed a lawsuit against GameTech International Incorporated
and
its subsidiary, GameTech Arizona Corporation. The complaint alleges that
GameTech has violated the Nevada deceptive trade practices act and the Lanham
Act by manufacturing, distributing, selling and advertising gaming devices
without first complying with Nevada gaming laws. We are seeking both injunctive
relief and monetary damages in the lawsuit.
The
Company believes that the final resolution of any such threatened or pending
litigation, individually or in the aggregate, is not likely to have a material
adverse effect on the Company’s business, cash flow, results of operations or
financial position.
We
recorded our income tax provision at an effective rate of 40.7% for the three
months ended March 31, 2006. The
temporary increase in the effective tax rate reflects the effect of executive
bonuses granted
in connection with our initial public offering and state tax
liabilities.
| 9. |
Initial
Public Offering:
|
In
January 2006 the Company sold 2,500,000 shares of its’ common stock in an
underwritten initial public offering raising proceeds of approximately $21.5
million, net of underwriters commission. In February 2006, the underwriter
exercised their right to purchase 375,000 shares of the over allotment resulting
in proceeds of approximately $3.2 million, net of underwriters commission.
The
Company has incurred costs of $981,630 in connection with the initial public
offering.
In
early
April, 2006 the Company submitted a comprehensive compliance report for its
system based mobile gaming platform to the Nevada Gaming Control Board or
NGCB.
The compliance report includes hardware drawings and software listings for
our
stationary and mobile wireless gaming terminals controlled by system game
servers. The compliance report is the initial step by which the Technology
Division of the NGCB begins the rigorous task of reviewing new gaming products
for sale in the Nevada market. There is no assurance as to the timing of
the
review process or that our mobile gaming platform will be approved by the
NGCB.
On
April
13, 2006, the NGCB published a draft of policies to further clarify certain
areas of Technical Standard number 4 addressing mobile gaming systems. The
Company has submitted comments in response to the NGCB’s solicitation for
comments from those in the industry. We believe the Company’s mobile gaming
platform is readily adaptable to comply with these standards and
policies.
| ITEM
2. |
MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATION
|
Overview
We
are an
established and profitable manufacturer of multi-game and multi-player
server-based gaming platforms. Our gaming platforms include networks of both
wireless and stationary player terminals, cashier-based point-of-sale terminals,
self-service point-of-sale kiosks and game file servers that conduct and
control
bingo games. Our gaming platforms have been adapted to conduct traditional
casino games, such as keno, poker and slots, in addition to bingo.
We
believe that our field-proven mobile gaming platform will be readily adaptable
to the regulations promulgated by the Nevada Gaming Commission on March 23,
2006 and
policies published by Nevada Gaming Commission on April 13, 2006.
Our
gaming platforms currently enable patrons to play bingo using either our
wireless or our stationary player terminals. Our gaming platforms also enable
patrons to play traditional casino games using our stationary player terminals.
We have successfully completed the field testing of our wireless player
terminals that enable patrons to play traditional casino games on a limited
basis on cruise lines. Upon anticipated
approval
of our wireless gaming devices by the Nevada gaming authorities, Nevada casino
patrons will be able to play traditional casino games using our wireless
player
terminals. There
is
no assurance however as to the timing of the review process or that our mobile
gaming platform will be approved by the Nevada
Gaming Control Board or NGCB.
As
a
result of the adoption of the regulations, the NGCB
is
positioned to finalize specific policies and procedures governing the process
of
reviewing, testing and approving mobile gaming systems. On April 13, 2006,
the
NGCB published a draft of policies to further clarify certain areas of Technical
Standard number 4 addressing mobile gaming systems. We have submitted comments
in response to the NGCB’s solicitation for comments from those in the industry.
We believe our mobile gaming platform is readily adaptable to comply with
these
policies.
In
early
April 2006 we submitted a comprehensive compliance report for our system
based
mobile gaming platform to the NGCB. The compliance report includes hardware
drawings and software listings for our stationary and mobile wireless gaming
terminals controlled by system game servers. The compliance report is the
initial step by which the Technology Division of the NGCB begins the rigorous
task of reviewing new gaming products for sale in the Nevada market. There
is no
assurance as to the timing of the review process or that our mobile gaming
platform will be approved by the NGCB.
Since
our
inception, we have been a technology innovator in the gaming equipment industry.
We helped to define the core concepts of modern gaming technologies including
server-based networks, concurrent multi-gaming, cashless gaming, downloadable
gaming and notably, mobile gaming. We continue to focus on research and
development and have recently upgraded our fourth generation wireless player
terminal to serve as a multi-game platform that enables patrons to play
traditional casino games in casino public areas in addition to playing bingo.
We
also recently introduced a new advanced bingo flashboard that utilizes long-life
color light emitting diods instead of conventional incadecent lamps. We have
sold our first set of the new flashboards to a customer in Nevada. We intend
to
continue to introduce other new products for the conventional bingo market
segment.
Almost
all our revenues are currently generated by placing electronic bingo systems
in
bingo halls under contracts based on (a) a fixed fee per use per session,
(b) a
fixed weekly fee per terminal or (c) a percentage of the revenue generated
by
each terminal. Revenue growth is affected by player acceptance of electronic
bingo as an addition or an alternative to paper bingo in our existing customer
establishments, our ability to expand operations into new markets and our
ability to increase our market share in the existing market. Our stationary
bingo player terminals generate greater revenue per player terminal than
our
wireless bingo player terminals, but also require a greater initial capital
investment. As our customer base changes from period to period through the
addition of new customers or the occasional loss of existing customers, we
experience an increase in rental revenue due to the addition of customers
and a
decrease in rental revenue due to the loss of customers. Our rental revenue
is
also affected from period to period as a result of changes in operations
at our
existing customer locations, which result from numerous factors over which
we
have little or no control.
We
typically install our electronic bingo systems at no charge to our customers
and
we capitalize all direct costs. We record depreciation of bingo equipment
over a
five-year estimated useful life using the straight-line method of
depreciation.
We
anticipate that at some point we will begin selling our gaming platforms
for use
in conducting traditional casino games, instead of entering into lease contracts
as we do now. At that time, our revenue will include product revenue from
sales
of equipment, in addition to our leasing revenue. At such time, our product
revenue will be determined by the then current price for our products and
our
unit-volume sales.
We
envision that if we develop product revenue sales, we will also see a recurring
revenue component develop for both software upgrades and maintenance of the
software components of our sold products.
Our
expenses currently consist of:
(a)
cost
of revenue, depreciation of bingo terminals and other capitalized equipment
under lease to customers, maintenance, repair and refurbishment of bingo
terminals and related support equipment, and cost of shipping. Installation
costs and initial shipment expenses associated with new customer lease contracts
are expensed as cost of revenue in the period in which the equipment is
deployed. Expenses related to maintenance, repair and refurbishment of our
existing equipment that has been deployed at customer locations are expensed
as
cost of revenue in the period in which the maintenance, repair or refurbishment
is performed. These expenses are incurred to, among other things, maintain
our
existing equipment in working order, provide our customers with updated
equipment, fix software bugs, if any, provide new functionality and minimize
the
number of different installation configurations that we must support. We
are not
obligated to perform maintenance, repair or refurbishment under the terms
of our
rental agreements with our customers, but do so in order to improve the quality
and reliability of our products;
(b)
general and administrative, consisting of activities associated with management
of our company and related support, which includes all payroll and benefits
other than payroll in connection with research and development activities,
amortization of our noncompetition agreements, travel, professional fees,
facility expenses and bad debt expense reserves;
(c)
sales
and marketing, consisting predominately of commissions paid to distributors
for
promoting and supporting our products and related marketing costs;
and
(d)
research and development, internal research and development activities geared
to
the further development of our gaming platform, including labor and hardware
and
software testing, prototyping and development.
We
envision that the development of our product revenue will require us to record
cost of revenue that include materials, labor, and direct and indirect
manufacturing costs and associated warranty costs.
Millennium,
our wholly owned subsidiary, holds
equipment placement contracts for our
bingo
products in selected territories in the United States. All of our other
operations, including the operation and maintenance of our bingo products
in
all
territories and
the
exclusive distribution of our bingo products in Nevada, Texas and Washington,
are conducted by FortuNet. Prior to November 2003, Yuri Itkis held approximately
72% of the voting control over Millennium. In November 2003 Millennium purchased
its outstanding shares held by stockholders other than Yuri Itkis. In January
2004, we became the 100% owner of Millennium through Yuri Itkis’ contribution to
us of the remaining outstanding shares. This enabled us to consolidate our
worldwide distribution rights and enabled significant expense reduction in
our
overall distribution and operational costs. As part of this consolidation
of our
distribution channel, we undertook a review of Millennium’s receivables, and
determined that certain receivables were delinquent or uncollectible based
on
our policies. As a result, we wrote off $212,011 of receivables and restructured
accounts in 2005. In addition, we dropped a substantial number of former
Millennium customers during the three months ended March 31, 2005 because
they
did not meet our payment policies. During this same period, we also lost
customers that were apparently dissatisfied with the customer service previously
provided by Millennium. During the three months ended March 31, 2005 these
former Millennium customers represented $31,240 of our total
revenue.
During
the three months ended March 31, 2006, we incurred $130,897 in legal expenses
primarily due to ongoing patent infringement litigation against defendants
Planet Bingo, LLC and Melange Computer Services, Inc., and additional costs
associated with being a public company. Our legal expenses increased
substantially when compared with the $29,564 in legal expenses for the three
months ended March 31, 2005. We expect similar or increasing levels of
litigation and other legal expenses in the future.
Application
of Critical Accounting Policies and Estimates
Our
condensed consolidated financial statements have been prepared in accordance
with United States generally accepted accounting principles. The preparation
of
these financial statements requires us to make estimates and assumptions
that
affect the reported amounts of assets and liabilities and the disclosure
of
contingent assets and liabilities at the reporting date and reported amounts
of
revenue and expenses during the reporting period. On an ongoing basis, we
evaluate our estimates and judgments, including those related to revenue
recognition, bad debts, bingo unit depreciation and litigation. We base our
estimates and judgments on historical experience and on various other factors
that are reasonable under the circumstances, the results of which form the
basis
for making judgments about the carrying values of assets and liabilities
that
are not readily apparent from other sources. Actual results may differ from
these estimates under different assumptions or conditions.
There
has
been no material change in the critical accounting policies that affect our
more
significant judgments and estimates used in the preparation of our condensed
consolidated financial statements described in our Annual Report on Form
10-K
for fiscal year ended December 31, 2005, except for the changes required
with
respect to share-based compensation. See Footnote 4 to our condensed
consolidated financial statements for more information.
We
are
currently involved in various legal claims and legal proceedings. We have
not
accrued any liability for estimated losses related to legal contingencies
at
this time. In management’s opinion, these matters are not expected to have a
significant effect on our financial position or results of operations.
Periodically, we review the status of each significant matter and assess
our
potential financial exposure. If the potential loss from any claim or legal
proceeding is considered probable and the amount can be estimated, we accrue
a
liability for the estimated loss. Significant judgment is required in both
the
determination of probability and the determination as to whether an exposure
can
be reasonably estimated. Because of uncertainties related to these matters,
accruals are based only on the best information available at the time. As
additional information becomes available, we reassess the potential liability
related to our pending claims and litigation and may revise our estimates.
Such
revisions in the estimates of the potential liabilities could have a material
impact on our consolidated results of operations and financial
position.
Results
of Operations
The
following table sets forth our results of operations and as a percentage
of
revenue for each of the periods indicated:
Condensed
Consolidated Income Statement
| |
|
|
|
| |
|
|
|
2005
|
|
|
Revenues
|
|
|
|
|
|
|
|
|
|
|
Sales
Revenue
|
|
|
3,978,783
|
|
|
100.0
|
%
|
|
3,890,212
|
|
|
100.0
|
%
|
|
Cost
of Revenue
|
|
|
497,556
|
|
|
12.5
|
%
|
|
612,422
|
|
|
15.7
|
%
|
|
Gross
Profit
|
|
|
3,481,227
|
|
|
87.5
|
%
|
|
3,277,790
|
|
|
84.3
|
%
|
|
Operating
Costs & Expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
General
& Administrative
|
|
|
1,685,178
|
|
|
42.4
|
%
|
|
981,469
|
|
|
25.3
|
%
|
|
Sales
& Marketing
|
|
|
1,297,925
|
|
|
32.6
|
%
|
|
1,139,975
|
|
|
29.3
|
%
|
|
Research
& Development
|
|
|
258,209
|
|
|
6.5
|
%
|
|
228,649
|
|
|
5.9
|
%
|
|
Total
Operating Expenses
|
|
|
3,241,312
|
|
|
81.5
|
%
|
|
2,350,093
|
|
|
60.5
|
%
|
|
Income
from Operations
|
|
|
239,915
|
|
|
6.0
|
%
|
|
927,697
|
|
|
23.8
|
%
|
|
Other
Income
|
|
|
87,556
|
|
|
2.2
|
%
|
|
26,170
|
|
|
0.7
|
%
|
|
Interest
Expense
|
|
|
(6,056
|
)
|
|
(0.1
|
)%
|
|
(8,551
|
)
|
|
(0.2
|
)%
|
|
Income
Before Taxes
|
|
|
321,415
|
|
|
8.1
|
%
|
|
945,316
|
|
|
24.3
|
%
|
|
Provision
for Income Taxes
|
|
|
130,816
|
|
|
3.3
|
%
|
|
326,445
|
|
|
8.4
|
%
|
|
Net
Income
|
|
|
190,599
|
|
|
4.8
|
%
|
|
618,871
|
|
|
15.9
|
%
|
Sales
revenue.
Rental
revenue was $3,978,783 during the three months ended March 31, 2006, compared
to
$3,890,212 during the three months ended March 31, 2005, an increase of $88,571,
or 2.3%. This increase was due primarily to the deployment of additional
bingo
player units in the fourth quarter of 2005.
For
the
three months ended March 31, 2006, the net change in our revenue as a result
of
changes in our customer base was a decrease in revenue of $3,142 and the
net
change in revenue as a result of changes in operations at our existing customer
locations was an increase of revenue of $91,713.
Cost
of revenue.
Cost of
revenue was $497,556 during the three months ended March 31, 2006, compared
to
$612,422 during the three months ended March 31, 2005, a decrease of $114,866,
or 18.8%. The decrease in cost of revenue was attributable primarily to the
decrease in depreciation, installation and maintenance expenses. Specifically,
the depreciation cost for the three months ended March 31, 2006 was $416,069
as
compared to $491,295 for the three months ended March 31, 2005. Our
installation, maintenance and shipping expense also decreased from $121,127
for
the three months ended March 31, 2005 to $81,488 for the three months ended
March 31, 2006. This decrease was partially attributable to a decrease in
the
rate of new installations of player units in the first quarter of 2006 as
compared to the first quarter of 2005. As a result of this overall decrease
in
costs, our gross margin increased from 84.3% for the three months ended March
31, 2005 to 87.5% for the three months ended March 31, 2006.
General
and Administrative. General
and administrative expenses were $1,685,178, or 42.4% of revenue, for the
three
months ended March 31, 2006 compared to $981,469, or 25.2% of revenue, for
the
three months ended March 31, 2005, an increase of $703,709, or 71.7%. This
cost
increase was associated with our transition from being a private company
to
being a public company and was primarily attributable to consulting services
provided by Spiegel Partners LLC (with a first quarter cost of $193,200)
and the
costs associated with the stock grants to certain of our executives (in the
amount of $275,004) and to our directors (in the amount of $12,375). We expect
to have costs similar to the costs incurred with respect to the stock grants
to
Spiegel Partners LLC in the second quarter of 2006,
and for
one month only of the third quarter, but
not
thereafter. We
also
expect to incur similar costs associated with the executive bonuses referenced
above in the second quarter of 2006 but not thereafter.
We
will
have costs similar to the costs associated with the stock grants to our
directors in each of the remaining quarters of 2006. We will also have costs
associated with the grant to our employees of stock options to purchase 67,000
shares of our stock on April 1, 2006. The increase was also due in part to
additional costs associated with becoming a public company in the amount
of
$93,170 consisting of director and officer’s insurance, license fees and
additional audit costs. Our litigation and other legal expenses increased
from
$29,564 during the three months ended March 31, 2005 to $130,897, or 342.8%,
during the three months ended March 31, 2006.
Sales
and marketing.
Sales
and marketing expenses were $1,297,925, or 33% of revenue, for the three
months
ended March 31, 2006, compared to $1,139,975, or 29% of revenue, for the
three
months ended March 31, 2005, an increase of $157,950, or 13.9%. This increase
was attributable primarily to the expansion of our distribution channel through
our distributors.
Research
and development.
Research
and development expenses were $258,209, or 6% of revenue, for the three months
ended March 31, 2006, compared to $228,649, or 6% of revenue, for the three
months ended March 31, 2005, an increase of $29,560, or 12.9%. The increase
in
research and development expenses was primarily the result of our increased
investment in new hardware and software development tools and additional
labor
cost to enable us to accelerate development of upgrades to our hardware and
software components of our gaming platform.
Provision
for income taxes.
An
income tax provision of $130,816 with an effective tax rate of 40.7% was
recorded for the three months ended March 31, 2006, compared to $326,445
with an
effective tax rate of 34.5% for the three months ended March 31, 2005, a
decrease of $195,629, or 59.9%. This decrease was primarily due to a decrease
in
taxable income during the three months ended March 31, 2006.
The
temporary increase in the effective tax rate reflects the effect of executive
bonuses granted
in connection with our initial public offering and certain permanent differences
between financial accounting principles and tax accounting principles related
to
depreciation and state tax liabilities.
Liquidity
and Capital Resources
Since
inception, we have financed our operations primarily with revenue generated
from
the leasing of our bingo products. In January 2006 we successfully completed
our
initial public offering of our common stock. As of March 31, 2006, our principal
sources of liquidity were cash and cash equivalents of $25,641,971 and accounts
receivable net of allowance for doubtful accounts of $1,230,140. We anticipate
that our leasing revenue, which is our principal source of revenue today,
will
be sufficient to fund our operating expenses in the short term. Long term
cash
is expected to be generated from existing operations and also through selling
or
leasing of our products in new markets.
We
expect
to incur significant additional expenses in connection with the procurement
of
equipment and components and the manufacture of additional stationary and
wireless player terminals to take advantage of business opportunities. We
anticipate that these expenses will consume a substantial portion, if not
all,
of our recurring lease revenues. Except to the extent we become obligated
under
supply contracts that we enter into to procure equipment and components,
our
fixed payment commitments are limited to our facilities lease and payments
under
long term debt obligations incurred in connection with becoming the 100%
owner
of Millennium. Payments to Spiegel Partners, LLC for
advisory services are expected to continue through July
2006, and the remaining balance of the long term debt associated with an
acquisition of Millennium is expected to be fully repaid by December of
2006.
We
believe that our cash flow from operations will be adequate to meet our
anticipated future requirements for working capital and capital expenditures
for
the next 12 months and for the foreseeable future. Although no additional
financing is currently contemplated, we may seek, if necessary or otherwise
advisable, additional financing through bank borrowings or public or private
debt or equity financings. Additional financing, if needed, may not be available
to us, or, if available, the financing may not be on terms favorable to us.
The
terms of any financing that we may obtain in the future could impose additional
limitations on our operations and management structure. Our estimates of
our
anticipated liquidity needs may not be accurate or new business development
opportunities or other unforeseen events may occur, resulting in the need
to
raise additional funds.
Summary
of Condensed Consolidated Statements of Cash Flow
| |
|
Three
Months
Ended
March 31
|
|
| |
|
2005
|
|
2006
|
|
|
Net
Cash provided by operating activities
|
|
$
|
1,718,017
|
|
$
|
1,091,835
|
|
|
Net
cash used in investing activities
|
|
|
(855,491
|
)
|
|
(232,206
|
)
|
|
Net
cash used in financing activities
|
|
|
(166,888
|
)
|
|
24,270,825
|
|
|
Net
increase (decrease) in cash and cash equivalents
|
|
|
695,638
|
|
|
25,130,454
|
|
|
Cash
and cash equivalents, beginning
|
|
|
1,379,925
|
|
|
511,517
|
|
|
Cash
and cash equivalents, ending
|
|
$
|
2,075,563
|
|
$
|
25,641,971
|
|
Operating
Activities
For
the
three months ended March 31, 2006, net cash of $1,091,835 provided by operating
activities was primarily due to net income of $190,599, depreciation and
amortization of $539,705, stock issued for services of $437,379 and change
in
operating assets and liabilities of $(75,858). For the three months ended
March
31, 2005, net cash of $1,718,017 provided by operating activities was primarily
due to net income of $618,871, depreciation and amortization of $618,124
and
change in operating assets and liabilities of $481,023. The decrease in net
cash
provided by operating activities during the three months ended March 31,
2006 as
compared to the three months ended March 31, 2005 was primarily due to cash
flow
used to cover the costs associated with our operating as a publicly held
company
after our initial public offering in January 2006.
Investing
Activities
For
the
three months ended March 31, 2006, $232,206 of net cash was used for investing
activities, with $208,785 being used to fund the manufacture of additional
equipment for lease to our customers and the balance spent on other capital
expenditures.
For
the
three months ended March 31, 2005, $855,491 of net cash was used for investing
activities, with $836,329 being used to fund the manufacture of additional
equipment for lease to our customers and the balance spent on other capital
expenditures.
Financing
Activities
For
the
three months ended March 31, 2006, $24,270,825 of net cash was raised through
financing activities associated with $24,710,625 raised as a result of the
sale
of our stock in our initial public offering less cost of issuing stock of
$295,908.
For
the
three months ended March 31, 2005, $166,888 of net cash was used for financing
activities, with $136,888 used for payments on a non-compete
agreement.
Off-Balance
Sheet Arrangements
As
of
March 31, 2006, we have no off-balance sheet arrangements as defined in Item
303(a)(4) of the Securities and Exchange Commission’s Regulation
S-K.
| ITEM
3. |
QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
|
Market
risk is the risk of loss arising from adverse changes in market rates and
prices, including interest rates, foreign currency exchange rates, credit
risk,
commodity prices and equity prices. Our primary exposure to market risk is
due
to the fact that certain parts, components and subassemblies for our products
are manufactured outside of the United States, which exposes us to the risk
of
foreign currency fluctuations, political and economic instability and diluted
protection of intellectual property. We are most affected by fluctuations
in the
value of currencies in southeast Asia. We are also subject to significant
credit
risk resulting from the fact that a significant portion of our accounts
receivable are owed to us by relatively few of our customers. One customer
made
up 26.7% and 29.2% of rental revenues for the three months ended March 31,
2005
and 2006, respectively. Furthermore, one other customer made up 8.7% and
9.8% of
the accounts receivable balance for the three months ended March 31, 2005
and
2006, respectively. If these few customers fail to perform their obligations
to
us, we may lose a significant portion of our revenue. We do not require
collateral to extend credit to our customers but we do perform ongoing credit
evaluations of our customers’ financial condition.
We
do not
believe we are subject to any material variable interest risk or similar
market
risks.
| ITEM
4. |
CONTROLS
AND PROCEDURES
|
Evaluation
of Disclosure Controls and Procedures
We
are
required to maintain disclosure controls and procedures that are designed
to
provide reasonable assurance that information required to be disclosed in
our
reports under the Securities Exchange Act is recorded, processed, summarized
and
reported within the time period specified in the Securities and Exchange
Commission’s rules and forms and that such information is accumulated and
communicated to our management, including our Chief Executive Officer and
Chief
Financial Officer, as appropriate, to allow timely decisions regarding required
disclosure.
As
required by Rule 13a-15(b) promulgated under the Securities Exchange Act,
our
management, with the participation of our Chief Executive Officer and Chief
Financial Officer, evaluated the design and operating effectiveness as of
March
31, 2006 of our disclosure controls and procedures, as defined in Rule 13a-15(e)
promulgated under the Securities Exchange Act. Based on this evaluation our
Chief Executive Officer and Chief Financial Officer concluded that, as of
March
31, 2006 our disclosure controls and procedures were effective to enable
the
company to record, process, summarize and report information required under
the
Securities and Exchange Commission’s rules in a timely fashion.
Changes
in Internal Controls
There
were no significant changes in the Company’s internal control over financial
reporting identified in management’s evaluation during the three months ended
March 31, 2006 that have materially affected, or are reasonably likely to
materially affect, the Company’s internal control over financial reporting.
PART
II OTHER INFORMATION
ITEM
1. LEGAL
PROCEEDINGS
We
are
pursuing a patent infringement lawsuit against two of our competitors, Planet
Bingo, LLC and Melange Computer Services, Inc. The lawsuit involves two of
our
patents. We allege that one of our patents is being infringed by both defendants
and the other patent is being infringed by Planet Bingo, LLC only. We filed
this
action in May 2004 in the United States Federal Court, District of Nevada.
We
are seeking unspecified monetary damages and injunctive relief. The defendants
have counter-claimed that our patents are invalid and one of the defendants,
Planet Bingo, LLC, has alleged that our operations infringe on one of its
own
patents. The patent that Planet Bingo, LLC alleges that we have infringed
has
been invalidated by a Federal District Court in unrelated litigation. This
decision is on appeal. If either of the counter-claims is successful, our
patents may be invalidated, or limited in scope, or we may be forced to modify
or discontinue some of our operations or pay substantial damages.
In
late
March 2006 we filed a lawsuit in the United States District Court of Nevada
against GameTech International Incorporated and its subsidiary, GameTech
Arizona
Corporation. The complaint alleges that GameTech has violated the Nevada
deceptive trade practices act and the Lanham Act by manufacturing, distributing,
selling and advertising gaming devices without first complying with Nevada
gaming laws. We are seeking both injunctive relief and monetary damages in
the
lawsuit.
We
believe that the final resolution of any such threatened or pending litigation,
individually or in the aggregate, is not likely to have a material adverse
effect on our business, cash flow, results of operations or financial
position.
