<PAGE>
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
OR
[_] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from to
COMMISSION FILE NUMBER 0-28294
SILICON GAMING, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
<TABLE>
<S> <C>
CALIFORNIA 77-0357939
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
</TABLE>
2800 W. BAYSHORE ROAD
PALO ALTO, CA 94303
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
TELEPHONE: (650) 842-9000
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
Indicate the number of shares outstanding of each of the issuer's classes of
Common Stock, as of the latest practicable date.
14,257,482 shares of Common Stock, $.001 par value, were outstanding as of
October 31, 1998.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<PAGE>
SILICON GAMING, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 30, 1998
INDEX
<TABLE>
<CAPTION>
PAGE
----
<C> <S> <C>
PART I FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Balance Sheets--September 30, 1998 and December 31,
1997............................................................ 3
Consolidated Statements of Operations--Three months and nine
months ended September 30, 1998 and September 30, 1997.......... 4
Consolidated Statements of Cash Flows--Nine months ended
September 30, 1998 and September 30, 1997....................... 5
Notes to Consolidated Financial Statements....................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations........................................... 9
PART II OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds........................ 21
Item 6. Exhibits and Reports on Form 8-K................................. 21
Signature........................................................ 22
</TABLE>
2
<PAGE>
PART I--FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SILICON GAMING, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- ------------
(UNAUDITED)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and equivalents............................... $ 12,423 $ 16,352
Short-term investments............................. -- 4,705
Accounts receivable (net of allowances of $1,155 in
1998 and $50 in 1997)............................. 7,241 4,930
Inventories........................................ 15,247 6,335
Prepaids and other................................. 1,419 1,334
-------- --------
Total current assets............................. 36,330 33,656
PROPERTY AND EQUIPMENT, NET......................... 8,774 8,844
PARTICIPATION UNITS, NET............................ 2,592 4,825
OTHER ASSETS, NET................................... 1,469 1,713
-------- --------
$ 49,165 $ 49,038
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIENCY)
CURRENT LIABILITIES:
Accounts payable................................... $ 3,086 $ 3,151
Accrued liabilities................................ 7,584 2,983
Deferred revenue................................... 1,453 1,478
Line of credit..................................... 1,000 --
Current portion of long-term obligations........... 1,260 1,453
-------- --------
Total current liabilities........................ 14,383 7,897
OTHER LONG-TERM LIABILITIES......................... 1,307 1,007
LONG-TERM OBLIGATIONS............................... 39,561 22,637
REDEEMABLE CONVERTIBLE PREFERRED STOCK--6,884,473
shares authorized at September 30, 1998; shares
outstanding: September 30, 1998-- 1,474,641;
December 31, 1997--2,769,424....................... 1,666 3,065
SHAREHOLDERS' EQUITY (DEFICIENCY)
Common Stock, $.001 par value; 50,000,000 shares
authorized; shares Outstanding: September 30,
1998--14,279,400; December 31, 1997--13,149,737... 57,349 54,131
Warrants........................................... 4,573 3,107
Notes receivable from shareholders................. (179) (207)
Unrealized gain on investments..................... -- 1
Accumulated deficit................................ (69,495) (42,600)
-------- --------
Total shareholders' equity (deficiency).......... (7,752) 14,432
-------- --------
$ 49,165 $ 49,038
======== ========
</TABLE>
See notes to consolidated financial statements.
3
<PAGE>
SILICON GAMING, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------- ---------------
1998 1997 1998 1997
------- ------ ------- -------
<S> <C> <C> <C> <C>
REVENUE:
Hardware..................................... $ 3,313 $2,214 $11,199 $ 3,756
Software..................................... 849 151 3,510 182
Participation................................ 827 482 2,567 574
------- ------ ------- -------
Total revenue.............................. $ 4,989 $2,847 $17,276 $ 4,512
OPERATING EXPENSES:
Cost of sales and related manufacturing
expenses.................................... 8,553 3,151 17,579 6,414
Research and development..................... 3,193 2,388 8,748 6,824
Selling, general and administrative.......... 6,224 3,777 14,097 9,022
------- ------ ------- -------
Total costs and expenses..................... 17,970 9,316 40,424 22,260
------- ------ ------- -------
Loss from operations....................... 12,981 6,469 23,148 17,748
Interest (income)/expense, net............... 1,721 $ (125) 3,747 $ (805)
------- ------ ------- -------
NET LOSS...................................... $14,702 $6,344 $26,895 $16,943
======= ====== ======= =======
Basic and diluted net loss per share.......... $ 1.06 $ 0.58 $ 1.98 $ 1.64
======= ====== ======= =======
Shares used in computation.................... 13,930 10,965 13,584 10,343
======= ====== ======= =======
</TABLE>
See notes to consolidated financial statements.
4
<PAGE>
SILICON GAMING, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
------------------
1998 1997
-------- --------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss.................................................. $(26,895) $(16,943)
Reconciliation to net cash used in operating activities:
Depreciation and amortization............................ 3,713 1,430
Accrued interest......................................... 2,470 --
Accretion of debt discount............................... 1,316 --
Provision for bad debt................................... 1,105 --
Stock compensation expense............................... 676 --
Deferred rent............................................ 159 145
Gain from disposal of property........................... (27) --
Changes in assets and liabilities:
Accounts receivable...................................... (3,416) (1,645)
Inventories.............................................. (8,912) (5,047)
Prepaid and other........................................ (73) (807)
Participation units...................................... 1,538 (3,328)
Accounts payable......................................... (65) 1,949
Accrued liabilities...................................... 2,272 2,398
Deferred revenue......................................... (25) 915
-------- --------
Net cash used in operating activities................... (26,164) (20,933)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment..................... (2,730) (6,008)
Proceeds from disposal of property and equipment.......... 118 --
Purchase of short-term investments........................ -- (3,230)
Sales and maturities of short-term investments............ 4,704 9,115
Other assets, net......................................... (27) (192)
-------- --------
Net cash provided by (used in) investing activities..... 2,065 (315)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from debt financing and issuance of warrants, net
of costs................................................. 14,950 23,055
Proceeds from term loans and line of credit............... 4,586 --
Sale of Common Stock, net of notes receivable............. 1,143 797
Collection of note receivable............................. 28 10
Repayment of term loans................................... (326) --
Repayment of capital lease obligations.................... (211) (142)
-------- --------
Net cash provided by financing activities............... 20,170 23,720
-------- --------
NET INCREASE (DECREASE) IN CASH AND EQUIVALENTS............ (3,929) 2,472
Beginning of period....................................... 16,352 25,583
-------- --------
End of period............................................. $ 12,423 $ 28,055
======== ========
SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for interest................... $ 203 $ 80
======== ========
Issuance of common warrants................................ $ 1,466 $ 3,082
======== ========
Conversion of preferred stock to Common Stock.............. $ 1,399 $ 1,864
======== ========
</TABLE>
See notes to consolidated financial statements.
5
<PAGE>
SILICON GAMING, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The accompanying consolidated balance sheet as of September 30, 1998, the
consolidated statements of operations for the three and nine months ended
September 30, 1998 and 1997, and the consolidated statements of cash flows for
the nine months ended September 30, 1998 and 1997, are unaudited. In the
opinion of management, these financial statements have been prepared on the
same basis as the audited financial statements and include all adjustments,
consisting only of normal recurring adjustments and accruals, necessary for
the fair presentation of the financial position and operating results as of
such dates and for such periods. The unaudited information should be read in
conjunction with the audited consolidated financial statements of Silicon
Gaming, Inc. ("Silicon Gaming" or the "Company") and the notes thereto for the
year ended December 31, 1997 included in the Company's Annual Report on Form
10-K filed with the Securities and Exchange Commission.
Certain prior year amounts have been reclassified to conform to the current
year presentation.
2. INVENTORIES
Inventories are stated at lower of cost (first-in, first-out) or market and
consist of the following (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- ------------
<S> <C> <C>
Raw materials..................................... $ 4,710 $3,028
Work in process................................... 905 468
Finished goods.................................... 9,632 2,839
------- ------
$15,247 $6,335
======= ======
</TABLE>
3. CONCENTRATION OF CREDIT RISK
Financial instruments which potentially subject the Company to
concentrations of credit risk consist primarily of cash equivalents, short-
term investments, and trade accounts receivable. The Company invests only in
high credit quality short-term debt. The Company performs ongoing credit
evaluations of its customers' financial condition and limits the amount of
credit extended when deemed necessary but generally requires no collateral.
The Company maintains reserves for estimated potential credit losses. As of
September 30, 1998, two customers accounted for 26% and 24% of accounts
receivable, including one for which a reserve of $930,000 was provided during
the quarter ended September 30, 1998. As of December 31, 1997, two customers
accounted for 32% and 21% of accounts receivable. For the three months ended
September 30, 1998, one customer accounted for 40% of revenue and for the nine
months ended September 30, 1998, two customers accounted for 12% and 11% of
revenue. For the three months ended September 30, 1997, one customer accounted
for 30% of revenue and for the nine months ended September 30, 1997, three
customers accounted for 23%, 19%, and 10% of revenue.
4. ACCRUED LIABILITIES
In October 1998, the Company reached an agreement to pay royalties on all
installations existing in casinos as of September 30, 1998 for its Lucky Draw
Poker game. This agreement is based on actual usage over a limited number of
units and time period in which payments of royalties are required. The maximum
obligation relating to units sold as of September 30, 1998 was $2,187,000 and
has been recorded in Accrued Liabilities.
6
<PAGE>
SILICON GAMING, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
5. BORROWING ARRANGEMENTS
In April 1998, the Company entered into a $10 million secured revolving line
of credit agreement based on the Company's eligible accounts receivable, which
expires December 31, 1999. Borrowings bear interest at the bank's prime rate
(8.25% at September 30, 1998) plus 1%. As of September 30, 1998, the Company
had $1,000,000 outstanding under this agreement. The line of credit requires
the Company to comply with certain financial covenants. For the quarter ended
September 30, 1998, the Company was in compliance with all financial
covenants, excluding one covenant for minimum quarterly net income, for which
the Company has received a waiver from the lending institution.
Borrowing arrangements consist of the following (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- ------------
<S> <C> <C>
Senior Discount Notes ($47.25 and $30 million
principal obligation, respectively)........... $37,127 $22,277
Capital lease obligations...................... 434 645
Other long-term obligations.................... 3,260 0
------- -------
40,821 22,922
Current obligation............................. (1,260) (285)
------- -------
Long-term portion.............................. $39,561 $22,637
======= =======
</TABLE>
Future minimum debt commitments at September 30, 1998 are as follows:
<TABLE>
<CAPTION>
OTHER
LONG TERM CAPITAL TOTAL
OBLIGATIONS LEASES DEBT
----------- ------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Fourth Quarter 1998............................ $ 327 $ 84 $ 411
1999........................................... 7,215 327 7,542
2000........................................... 7,215 56 7,271
2001........................................... 14,546 -- 14,546
2002........................................... 43,158 -- 43,158
Thereafter..................................... -- -- --
-------- ---- --------
Total minimum payments....................... $ 72,461 $467 $ 72,928
Amount representing interest................... (32,074) (33) (32,107)
-------- ---- --------
Present value of debt payments................. $ 40,387 $434 $ 40,821
Current portion................................ 953 307 1,260
-------- ---- --------
Long-term portion............................ $ 39,434 127 $ 39,561
======== ==== ========
</TABLE>
In July 1998, the Company completed the private placement of $17.25 million
principal obligation Senior Discount Notes ("Notes") due September 30, 2002.
Commencing January 1, 1999 the Notes bear interest at 12.5% per annum, payable
semi-annually. The Company is required to redeem $3 million in principal on
September 30, 2001. The Company is permitted to raise additional proceeds from
debt or equity securities of up to $40 million before mandatory redemption of
the Notes. The Notes are callable at the option of the Company
7
<PAGE>
SILICON GAMING, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
at any time, with an initial redemption price of 93.13% of the aggregate
amount, increasing to 100% over 9 months. In connection with the offering,
purchasers of the Notes were issued warrants to purchase 250,000 shares of the
Company's Common Stock at a per-share price of $8.00. Additionally, the
exercise price of the 375,000 warrants issued in connection with the September
1997 $30 million Senior Discount Notes was also adjusted from a per-share
price of $15.4375 to a per-share price of $8.00. The value ascribed to the
warrants and to the repricing of the September 1997 warrants was $1,466,000.
The Company is required, after approval is received by the necessary gaming
regulatory authorities, to register the Common Stock underlying the warrants
with the Securities and Exchange Commission, no later than January 1, 1999.
Gross proceeds to the Company before fees and other expenses were $14.95
million. Offering costs of $50,000 are included in other assets and are
amortized as an adjustment to interest expense over the term of the Notes. The
Notes require the Company to comply with certain financial covenants, with
which the Company was in compliance as of September 30, 1998.
In June 1998, the Company entered into a secured equipment term loan with
available credit up to $3 million. Borrowings bear interest at 14% per annum
for a term of 42 months. As of September 30, 1998, the Company had $1,562,000
outstanding under this agreement. The agreement requires the Company to comply
with certain financial covenants, with which the Company was in compliance as
of September 30, 1998.
In March 1998, the Company entered into a secured equipment term loan with
available credit up to $2 million. Borrowings bear interest at 11% per annum
for a term of 36 months. As of September 30, 1998, the Company had $1,698,000
outstanding under this agreement. The agreement requires the Company to comply
with certain financial covenants, with which the Company was in compliance as
of September 30, 1998.
6. EQUITY
On September 10, 1998, the Company's Board of Directors approved the
repricing of certain employee stock options with an exercise price in excess
of the fair market value of the Company's common stock on September 11, 1998.
The exercise price for 1,615,505 shares of employee stock options was reset to
$4.00, the closing market price on September 11, 1998. All such options retain
their original vesting schedules but are subject to a six-month period in
which exercises are prohibited.
7. RECENTLY ISSUED ACCOUNTING STANDARDS
In the first quarter of 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income" which requires
an enterprise to report, by major components and as a single total, the change
in net assets during the period from non-owner sources. Comprehensive loss,
which is comprised of the Company's net loss for the periods and unrealized
gains (losses) on investments, was $14,702,000 and $6,334,000 for the quarters
ended September 30, 1998 and 1997, respectively, and $26,896,000 and
$16,910,000 for the nine months ended September 30, 1998 and 1997,
respectively.
In June 1997, the FASB issued Statement of Financial Accounting Standards
No. 131, "Disclosures about Segments of an Enterprise and Related
Information," which establishes annual and interim reporting standards for an
enterprise's business segments and related disclosures about its products,
services, geographic areas and major customers. Adoption of this statement
will not impact the Company's consolidated financial position, results of
operations or cash flows. The Company will adopt this statement in its
financial statements for the year ending December 31, 1998.
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities." This
statement requires companies to record derivatives on the balance sheet as
assets or liabilities measured at fair value. Adoption of this statement will
not impact the Company's consolidated financial position, results of
operations or cash flows as the Company does not currently have any derivative
financial instruments covered under this standard.
8
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THIS DISCUSSION INCLUDES A NUMBER OF FORWARD-LOOKING STATEMENTS WHICH
REFLECT THE COMPANY'S CURRENT VIEWS WITH RESPECT TO FUTURE EVENTS AND
FINANCIAL PERFORMANCE. THESE FORWARD-LOOKING STATEMENTS ARE SUBJECT TO CERTAIN
RISKS AND UNCERTAINTIES, INCLUDING THOSE REFERRED TO IN THE RISK FACTORS
SECTION BELOW AND ELSEWHERE HEREIN AND CONTAINED IN THE COMPANY'S PREVIOUSLY
FILED ANNUAL REPORT ON FORM 10-K, THAT COULD CAUSE ACTUAL RESULTS TO DIFFER
MATERIALLY FROM HISTORICAL RESULTS OR THOSE ANTICIPATED. IN THIS DISCUSSION,
THE WORDS "ANTICIPATES," "BELIEVES," "EXPECTS," "INTENDS," "FUTURE" AND
SIMILAR EXPRESSIONS IDENTIFY FORWARD-LOOKING STATEMENTS. READERS ARE CAUTIONED
NOT TO PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH SPEAK
ONLY AS OF THE DATE HEREOF.
The following discussion should be read in conjunction with the unaudited
consolidated financial statements and notes thereto included in Part I--Item 1
of this Report and the audited consolidated financial statements and notes
thereto included in the Company's Annual Report on Form 10-K filed with the
Securities and Exchange Commission.
OVERVIEW
Silicon Gaming, Inc. ("SGI" or "the Company") is engaged in the design,
development, production, marketing and sale of what it believes will be the
next generation of interactive slot machines for use in casinos and other
gaming establishments. The Company's first product, Odyssey, combines an
advanced multimedia gaming platform with software-based games that the Company
believes to be more engaging and entertaining than other gaming devices
currently available and will, as a result, generate increased win per machine
for the casino operator. The Company recently announced its new product,
Quest(TM), which is designed as a lower-priced, single-game product to further
meet the needs of casino operators, add flexibility to the Company's product
line, and allow further penetration and expansion of new and existing markets.
Odyssey and Quest feature high-resolution video presented across the full
surface of a large touchscreen display. The games feature high-quality
animation, video clips, digital sound and a level of visual appeal and
interactivity that the Company believes is unattainable by the current
generation of slot machines. The majority of today's slot machines are
"hardware dominant", consisting of a fixed and unvarying game played on
spinning reels or a small video screen mounted within a large metal box. By
contrast, the Company's machines are "software dominant", in that the
attraction and entertainment value of its machines is created by software
programs that run SGI's games. Odyssey offers a selection of a suite of up to
six different games on a single machine, while Quest is designed as a single-
game machine. The Company expects that casino operators will be able to
quickly and easily upgrade SGI's machines simply by installing new software,
rather than replacing an entire slot machine.
The Company commenced commercial sale of Odyssey in May 1997, prior to which
it was in the development stage. Since introducing Odyssey the Company has
focused its efforts on entering new markets and jurisdictions, introducing its
product and ramping up its sales in such markets. As of September 30, 1998 the
Company had an installed base of over 3,000 machines. The Company shipped 505
machines to customers during the quarter ended September 30, 1998, increasing
its installed base by 12%. Odyssey is licensed for sale in Nevada, Missouri,
Mississippi, Iowa, Indiana, Connecticut, Alberta, Canada and to casinos
operated by certain native American tribes in Louisiana, Mississippi, Iowa,
Minnesota, Michigan and New Mexico. The Company has received its corporate
license in these jurisdictions as well as New Jersey, and is in the process of
gaining licenses in additional jurisdictions. The Company offers multiple-
denomination machines to its customers and in June 1998 began operating its
"game factory" concept which intends to introduce new game titles to customers
9
<PAGE>
on a monthly basis. In recent months the Company introduced Arabian
Riches,(TM) Riddle of the Sphinx,(TM) Banana-Rama(TM), and Lucky Draw Poker,
and in November 1998 introduced its multi-line, multi-coin game Vacation
USA(TM).
The Company generates revenue from machine sales direct to customers as well
as from software license and participation revenue. The Company installs units
on casino floors through direct sales, as well as on a trial basis, consistent
with industry practice. The Company's initial sales of Odyssey include the
hardware platform bundled with a suite of six games, play stoppage
entertainment and the Machine Management System(TM), while, its new product
Quest, is a single-game product. The Company offers two alternative purchase
programs, consisting of the sale of hardware bundled with either (1) a single-
game or a suite of games or (2) a renewable one-year software license,
including access to the Company's entire game library for the term of the
license. In addition, the Company offers a revenue participation plan that
allows the Company to share with casino operators the aggregate win generated
by the machines, with 20% going to the Company. Under this plan, the casino
accumulates credits that may be applied to the purchase of the machines after
a 90-day, minimum evaluation period. The Company expects to introduce a multi-
site progressive product in December 1998, which is also under a program of
revenue participation.
The Company was incorporated in California on July 27, 1993. Its principal
offices are located at 2800 W. Bayshore Road, Palo Alto, California 94303. The
Company also maintains sales and support offices in Las Vegas and Reno,
Nevada, and in Gulfport and Tunica, Mississippi.
RESULTS OF OPERATIONS
The Company had a net loss of $14,702,000 in the quarter ended September 30,
1998, an increase of $8,358,000, or 132%, from $6,344,000 for the quarter
ended September 30, 1997. Revenue increased to $4,989,000 in the quarter ended
September 30, 1998, an increase of $2,142,000, or 75%, from $2,847,000 for the
quarter ended September 30, 1997, however revenue decreased $3,272,000, or
40%, from $8,261,000 in the quarter ended June 30, 1998. The Company commenced
sale of its product in May 1997 and since that time has increased revenue by
introducing its product, entering new markets and jurisdictions, and ramping
up its sales in such markets. This increase in revenue is coupled with
increases in resources the Company has devoted to manufacturing development
and production, research and development, building a sales, support and
administrative infrastructure, hiring additional administrative staff, ramping
up the Company's marketing activities, and financing its operations. However,
because the Company's sales are dependent on a few large orders in each
period, quarterly sales have been and are expected to remain volatile. In the
current quarter, the Company recorded approximately $7,700,000 in charges
consisting of the costs for certain licensing arrangements, the adjustment of
inventory costs to current market values, reserves for doubtful accounts, and
costs in connection with management reorganization following the resignation
of the Chief Executive Officer in August 1998. This resulted in an increase of
costs, expenses and net interest expense to $19,691,000 for the quarter ended
September 30, 1998 from $9,191,000 for the quarter ended September 30, 1997.
The Company had a net loss of $26,895,000 for the nine months ended
September 30, 1998 an increase of $9,952,000, or 59%, from $16,943,000 for the
nine months ended September 30, 1997. The Company was in the development
stage, without revenue, until its first sales in May 1997. Accordingly, the
Company recorded only five months of revenue during the nine moths ended
September 30, 1997, and the prior period may not be comparable to current or
future periods. The Company had revenue of $17,276,000 for the nine months
ended September 30, 1998, an increase of $12,764,000, or 283%, from $4,512,000
for the nine months ended September 30, 1997. This increase in revenue was
offset by increases in costs, expenses and net interest expense to $44,170,000
in the nine months ended September 30, 1998 from $21,455,000 for the nine
months ended September 30, 1997.
The Company sold its first machines in Nevada in May 1997. Since that time
the Company has been broadening the markets in which it sells its product and
expanding its game software library. The Company's quarterly and annual
operating results have been, and will continue to be, affected by a wide
variety of factors
10
<PAGE>
that could have a material adverse effect on revenue and profitability during
any particular period. This includes such factors as the level of orders which
are received and can be shipped in a quarter, the rescheduling or cancellation
of sales or trial orders by its customers, the timing and/or ability of the
Company to obtain the licenses necessary to conduct its business, the
Company's ability to introduce new software or hardware products and
technologies on a timely basis, new product introductions by the Company's
competitors, and the level of expenditures in manufacturing, research and
development, and sales, general and administrative functions. Accordingly, it
is not possible to estimate future revenue and operating expenses based upon
historical operating performance.
The Company's products, Odyssey and Quest, are significantly different from
the products offered by its competitors. Because revenues from Odyssey, Quest
and their related software will comprise the Company's only source of revenue
for the foreseeable future, the Company's quarterly and annual operating
results will depend on the success of these single products that are subject
to the new product risks described in the preceding paragraph. In addition,
the success of Odyssey and Quest will also depend upon the Company's ability
to generate new and successful software-based games which are readily accepted
in the marketplace. Historically, the Company has generally recognized a
substantial portion of its revenue in the last month of a given quarter. A
significant portion of the Company's expenses are fixed in the short term, and
the timing of increases in expenses is based in large part on the Company's
forecast of future revenue. As a result, if revenue does not meet the
Company's expectations, it may be unable to quickly adjust expenses to levels
appropriate to actual revenue, which could have a material adverse effect on
the Company's business and results of operations.
As a result of the foregoing, the Company's operating results and stock
price may be subject to significant volatility, particularly on a quarterly
basis. Any shortfall in net revenue or operating results from levels expected
by securities analysts could have an immediate and significant adverse effect
on the trading price of the Company's Common Stock.
The market price of the Company's Common Stock has fluctuated significantly
since its initial public offering in July 1996. The market price of the Common
Stock could be subject to significant fluctuations in the future based on
factors such as announcements of new products or game titles by the Company or
its competitors, quarterly fluctuations in the Company's financial results or
other gaming machine manufacturing companies' financial results, changes in
analysts' estimates of the Company's financial performance, general conditions
in the gaming or gaming machine manufacturing industries, conditions in the
financial markets and general conditions in the political or business
environment which might adversely affect the gaming industry. In addition, the
stock market in general has experienced extreme price and volume fluctuations,
which have particularly affected the market prices for many high technology
companies and which have often been unrelated to the operating performance of
the specific companies. The market price of the Company's Common Stock has
declined substantially from its historic highs and may continue to experience
significant fluctuations in the future.
Revenue
As of September 30, 1998 the Company had an installed base of over 3,000
machines, as compared to 955 machines as of September 30, 1997. During the
quarter ended September 30, 1998, the Company shipped 505 machines, increasing
its installed base by 12%. Revenue was recognized on 241 and 478 units for the
quarters ended September 30, 1998 and 1997, respectively, with the remaining
units (net of returns) subject to an initial evaluation period. Revenue was
recognized on 1,157 and 713 units for the nine months ended September 30, 1998
and 1997, respectively. The Company had 644 units with customers under
participation arrangements as of September 30, 1998, compared to 374 units as
of September 30, 1997. As of September 30, 1998, the Company recognized
revenue in ten jurisdictions across the United States and Canada.
Revenue for the quarter ended September 30, 1998 was $4,989,000, an increase
of $2,142,000, or 75%, from $2,847,000 for the quarter ended September 30,
1997. Revenue for the quarter ended September 30, 1998 consisted of
$3,313,000, or 66%, in hardware sales, $849,000, or 17%, in software license
revenue and $827,000, or 17%, in participation revenue. Revenue for the
quarter ended September 30, 1997 consisted of $2,214,000, or
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78%, in hardware sales, $151,000, or 5%, in software license revenue and
$482,000, or 17%, in participation revenue. Revenue decreased $3,272,000, or
40%, from $8,261,000 in the quarter ended June 30, 1998. Because the Company's
sales are dependent on a few large orders in each period, quarterly sales have
been and are expected to remain volatile.
Revenue for the nine months ended September 30, 1998 was $17,276,000, an
increase of $12,764,000, or 283%, from $4,512,000 for the nine months ended
September 30, 1997. Revenue for the nine months ended September 30, 1998
consisted of $11,199,000, or 65%, in hardware sales, $3,510,000, or 20%, in
software license revenue and $2,567,000, or 15%, in participation revenue.
Revenue for the nine months ended September 30, 1997 consisted of $3,756,000,
or 83%, in hardware sales, $182,000, or 4%, in software license revenue and
$574,000, or 13%, in participation revenue. In both the three and nine month
periods between 1997 and 1998, hardware sales have decreased as a percentage
of total revenue and software sales have increased as a percentage of total
revenue. These changes are the result of a decrease in the average price per
unit to stimulate higher sales levels, as well as and an increase in software
revenue resulting from the change in customer preference from annual licenses
to paid-up licenses.
The large increases between the periods are primarily due to the fact that
the Company was in the development stage, without revenue, until its first
sales in May 1997. Since that time the Company has increased revenue by
introducing its product, entering new markets and jurisdictions, and ramping
up its sales in such markets. Because the Company was without revenue in four
of the nine months ended September 30, 1997, the prior period differs from,
and may not be comparable to, current or future periods, and it is not
possible to estimate future revenue and operating expenses based upon
historical data. The Company believes the revenue generated from sales will
increase in the current year as the Company's base of installed units
continues to increase, and the Company believes license and participation
revenue will increase as a percentage of total revenue and in absolute
dollars. Anticipated increases in revenue, however, are subject to a number of
risks and uncertainties. See "Risk Factors Uncertain Market Acceptance; Risk
of Technical Errors; Single Product", "--Competition", "--Rapidly Changing
Technology" "--Slow Trend in Legalized Gambling", and "--Regulatory Approval."
Cost of Sales and Related Manufacturing Expenses
Cost of sales and related manufacturing expenses include direct costs of
product sales, payroll and related costs for manufacturing personnel, overhead
costs and depreciation of participation units. Cost of sales and related
manufacturing expenses were $8,553,000, or 171% of revenue, as compared to
$3,151,000, or 111% of revenue, for the quarters ended September 30, 1998 and
1997, respectively. Cost of sales and related manufacturing expenses were
$17,579,000, or 102% of revenue, as compared to $6,414,000, or 142% of
revenue, for the nine months ended September 30, 1998 and 1997, respectively.
For the three and nine months ended September 30, 1998 cost of sales and
related manufacturing expenses included $3,266,000 in cost of sales expense
for the revision of inventory standards and related costs to adjust the
Company's inventory to reflect current market value. The decrease in per-unit
product costs are a result of reductions in cost of materials and buying
quantities, as well as redesigns from tooling certain hardware components.
Cost of sales during the three and nine months ended September 30, 1998 also
included $2,187,000 in royalty expense for an agreement the Company reached in
the September quarter covering existing installations of its Lucky Draw Poker
game. The Company was in the development stage until May 1997, without
revenue, and manufacturing expenses for the three and nine months ended
September 30, 1997 did not include direct costs of product sales. As such, the
Company experienced negative gross margins in the three and nine months ended
September 30, 1997 and 1998.
Cost of sales and manufacturing expenses are expected to increase through
1998 as the Company increases sales of its product, while gross margins are
expected to remain volatile due to the products' sensitivity to volume levels.
The Company is currently experiencing a position of excess manufacturing
capacity and expects that, while aggregate manufacturing costs will increase
as sales volume increases, per unit costs are expected to decrease. The
anticipated manufacturing expenses are subject to a number of risks and
uncertainties. See "Risk Factors Limited Manufacturing Experience."
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Research and Development
Research and development ("R&D") expenses include payroll and related costs
of employees engaged in ongoing design and development activities, fees to
outside contractors, prototype development expenses, overhead costs, equipment
depreciation and costs of supplies. To date, the Company has expensed all
costs associated with the research, design and development of its product. R&D
expenses were $3,193,000, or 64% of revenue, as compared to $2,388,000, or 84%
of revenue, for the quarters ended September 30, 1998 and 1997, respectively.
R&D expenses were $8,748,000, or 51% of revenue, as compared to $6,824,000, or
151% of revenue for the nine months ended September 30, 1998 and 1997,
respectively. Increases in R&D expenses over these periods have resulted from
the incremental hiring of personnel, development of new games and products,
including Quest and a wide area progressive system, increased use of
engineering consultants and license fees and similar costs associated with the
acquisition of outside technologies. The Company believes that a significant
level of R&D expense is required due to the technical nature of its product
and the elaborate requirements of the game development process. Accordingly,
the Company anticipates devoting substantial resources, including additional
personnel, to R&D and expects that these costs will increase in absolute
dollars in future periods; however, these costs are expected to decrease as a
percentage of revenue and as a percentage of total costs and expenses.
Selling, General and Administrative
Selling, general and administrative ("SG&A") expenses include payroll and
related costs for administrative and executive personnel, sales and marketing
personnel, overhead costs, legal and associated costs, costs associated with
obtaining corporate and product licenses in various jurisdictions and fees for
professional services. SG&A expenses were $6,224,000, or 125% of revenue, as
compared to $3,777,000, or 133% of revenue, for the quarters ended September
30, 1998 and 1997, respectively. SG&A expenses were $14,097,000, or 82% of
revenue, as compared to $9,022,000, or 200% of revenue, for the nine months
ended September 30, 1998 and 1997, respectively. For the three and nine months
ended September 30, 1998 SG&A expenses included $1,335,000 for costs in
connection with management reorganization following the resignation of the
Chief Executive Officer in August 1998, as well as $930,000 charge in reserve
for doubtful accounts relating to one customer. Increases in SG&A expenses
over these periods have resulted from the incremental hiring of personnel and
expenses associated with applying for corporate and product licensing in
various jurisdictions and costs associated with establishing a sales and
marketing organization as the Company commenced commercial production and
distribution of its product. SG&A expenses are expected to increase in
absolute dollars as the Company invests in increased sales and marketing-
related activities and in administrative personnel to support its growing
infrastructure; however, these costs are expected to decrease as a percentage
of revenue.
Interest Income and Expense
Net interest expense was $1,721,000 for the quarter ended September 30,
1998, as compared to net interest income of $125,000 for the quarter ended
September 30, 1997. Net interest expense was $3,747,000 for the nine months
ended September 30, 1998, as compared to net interest income of $805,000 for
the nine months ended September 30, 1997. Included in these totals was
interest income of $200,000 and $153,000 for the quarter ended September 30,
1998 and 1997, respectively, and $527,000 and $887,000 for the nine months
ended September 30, 1998 and 1997, respectively. Changes in interest income
over these periods were primarily due to a change in the average cash and
investment balances held compared to prior periods. Interest expense was
$1,921,000 and $28,000 for the quarters ended September 30, 1998 and 1997,
respectively, and $4,274,000 and $82,000 for the nine months ended September
30, 1998 and 1997, respectively. The increases in interest expense over these
periods was primarily due to interest and amortized debt costs recorded in the
periods ended September 30, 1998 for Senior Discount Notes (the "Notes")
issued on September 30, 1997 and on July 8, 1998 and for interest expense
associated with the secured equipment term loans.
Income Taxes
The Company has not been required to pay income taxes due to its net
operating losses in each period since inception. As of December 31, 1997, the
Company had net operating loss carryforwards of approximately
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$40,800,000 and $24,900,000 for federal and state income tax purposes,
respectively. These loss carryforwards will expire beginning in the year 2000,
if not utilized. As of December 31, 1997, the Company also has R&D credit
carryforwards of approximately $480,000 for both federal and state purposes,
which expire beginning 2010. A valuation allowance has been recorded for any
deferred tax assets due to uncertainties regarding the realization of these
assets resulting from the lack of earnings history of the Company. The Tax
Reform Act of 1986 and the California Act of 1987 impose restrictions on the
utilization of net operating loss and tax credit carryforwards in the event of
an "ownership change" as defined by the Internal Revenue Code. The Company's
ability to utilize its net operating loss and tax credit carryforwards is
subject to limitation pursuant to these restrictions. As of December 31, 1997,
approximately $4 million of the Company's net operating loss carryforwards was
subject to such limitation and this limitation is dependent on the Company's
future profitability and the utilization of its net operating loss
carryforwards over a period of time.
LIQUIDITY AND CAPITAL RESOURCES
Cash, cash equivalents and short-term investments were $12,423,000 as of
September 30, 1998, compared to $21,057,000 as of December 31, 1997. This
decrease was primarily due to cash used in operating activities as the Company
ramped up manufacturing, marketing, and selling of its product, as well as
cash used for the purchase of property and equipment, which was partially
offset primarily by increases in cash provided by debt transactions.
The Company's net cash used in operating activities was $26,164,000 and
$20,933,000 for the nine months ended September 30, 1998 and 1997,
respectively. This increase was primarily due to increases in the Company's
net losses, due to the fact that the Company was ramping up operations,
increasing sales, operations and accounts receivable, increasing inventory on
hand to prepare for increased sales volume and increasing interest from
financings obtained in the current year.
Net cash provided by investing activities was $2,065,000 for the nine months
ended September 30, 1998, as compared to the net cash used in investing
activities of $315,000 for the nine months ended September 30, 1997. The
change was primarily due to decreases in the acquisition of fixed assets,
primarily computer equipment and software, and decreases in the net cash
provided by the purchase, sale and maturity of short-term investments.
Net cash provided by financing activities was $20,170,000 for the nine
months ended September 30, 1998. Funds received during this period consisted
primarily of proceeds from issuance of the Notes in July 1998, proceeds from
term loans and the line of credit, proceeds from the sale of Common Stock,
which was partially offset by the repayment of capital lease and term loan
obligations. Net cash provided by financing activities was $23,720,000 for the
nine months ended September 30, 1997. Funds received during this period
consisted primarily of proceeds from issuance of the Notes in September 1997,
proceeds from the sale of Common Stock, which was partially offset by the
repayment of capital lease obligations.
In July 1998, the Company completed the private placement of $17.25 million
principal obligation Senior Discount Notes ("Notes") due September 30, 2002.
Commencing January 1, 1999 the Notes bear interest at 12.5% per annum, payable
semi-annually. The Company is required to redeem $3 million in principal on
September 30, 2001. The Company is permitted to raise additional proceeds from
debt or equity securities of up to $40 million before mandatory redemption of
the Notes. The Notes are callable at the option of the Company at any time,
with an initial redemption price of 93.13% of the aggregate amount, increasing
to 100% over 9 months. In connection with the offering, purchasers of the
Notes were issued warrants to purchase 250,000 shares of the Company's Common
Stock at a per-share price of $8.00. Additionally, the exercise price of the
375,000 warrants issued in connection with the September 1997 $30 million
Senior Discount Notes was also adjusted from a per-share price of $15.4375 to
a per-share price of $8.00. The value ascribed to the warrants and to the
repricing of the September 1997 warrants was $1,466,000. The Company is
required, after approval is received by the necessary gaming regulatory
authorities, to register the Common Stock underlying the warrants with the
Securities and Exchange Commission, no later than January 1, 1999. Gross
proceeds to the Company before fees and other expenses were $14.95 million.
Offering costs of $50,000 are included in other assets and
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are amortized as an adjustment to interest expense over the term of the Notes.
The Notes require the Company to comply with certain financial covenants, with
which the Company was in compliance as of September 30, 1998.
In June 1998, the Company entered into a secured equipment term loan with
available credit up to $3 million. Borrowings bear interest at 14% per annum
for a term of 42 months. As of September 30, 1998, the Company had $1,562,000
outstanding under this agreement. The agreement requires the Company to comply
with certain financial covenants, with which the Company was in compliance as
of September 30, 1998.
In April 1998, the Company entered into a $10 million secured revolving line
of credit agreement based on the Company's eligible accounts receivable, which
expires December 31, 1999. Borrowings bear interest at the bank's prime rate
(8.25% at September 30, 1998) plus 1%. As of September 30, 1998, the Company
had $1,000,000 outstanding under this agreement. The line of credit requires
the Company to comply with certain financial covenants. For the quarter ended
September 30, 1998, the Company was in compliance with all financial
covenants, excluding one covenant for minimum quarterly net income, for which
the Company has received a waiver from the lending institution.
In March 1998, the Company entered into a secured equipment term loan with
available credit up to $2 million. Borrowings bear interest at 11% per annum
for a term of 36 months. As of September 30, 1998, the Company had $1,698,000
outstanding under this agreement. The agreement requires the Company to comply
with certain financial covenants, with which the Company was in compliance as
of September 30, 1998.
At September 30, 1998 the Company's principal sources of liquidity included
cash and equivalents of $12,423,000 and the Company's $10 million line of
credit, as well as secondary sources of $7,241,000 in accounts receivable and
$15,247,000 in inventory. The Company believes its cash and equivalents,
accounts receivable, cash received from the reduction of current inventory
levels, the Company's revolving line of credit, and proceeds from additional
financing sources which the Company believes are available, will be sufficient
to meet its anticipated cash needs for working capital, capital expenditures
and business expansion until the Company generates positive cash flow from
operations. There can be no assurances that the Company will generate positive
cash flow within the currently anticipated time frame. Additionally, the
Company's revolving line of credit is subject to certain financial covenants
and should the Company fall out of compliance with these covenants, there can
be no assurances that a waiver from the lending institution will be
forthcoming in the future.
Cash flow from the Company's initial commercial sales has been negatively
affected by the revenue participation plan that the Company is offering to its
customers. Under this plan, a customer does not purchase the machine outright,
but pays the Company 20% of the win generated by such machine. The customer
also accumulates credits which may be applied to the purchase of the machines.
The Company also plans to introduce a multi-site progressive product, which is
also offered under program of revenue participation. Although the Company
expects that both plans will generate higher revenue per-unit than
conventional sales, the cash flow generated by sales under the plan occurs
over an extended period.
The Company's capital requirements will depend on many factors, including,
but not limited to, the rate at which the Company can introduce its product,
the market acceptance and competitive position of such product, the response
of competitors to the Company's product, the extent to which the customers
choose the revenue participation plan, the introduction and acceptance of its
multi-site progressive product, and the ability of the Company to satisfy the
licensing requirements in various jurisdictions applicable to the Company, its
product, and in some jurisdictions, its officers, directors, employees or
principal shareholders. In addition to financing recently obtained, the
Company may be required to seek additional financing before it achieves
positive cash flow. In that event, no assurance can be given that additional
financing will be available or that, if available, it will be available on
terms acceptable to the Company or its shareholders. If adequate funds are not
available to satisfy the Company's short-term or long-term capital
requirements, the Company may be required to limit its operations
significantly.
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YEAR 2000 ISSUES
The inability of computers and software programs to recognize and properly
process data fields containing a two-digit year is commonly known as the Year
2000 issue. As the year 2000 approaches, such computer systems may be unable
to accurately process certain date-based information. This could result in
system failures or miscalculations causing disruption of operations including,
among other things, a temporary inability to process transactions, send
invoices or engage in similar normal business activities.
During 1997, the Company implemented an enterprise-wide management
information system which supports all of the Company's major business
applications including sales and customer service, manufacturing and
distribution, and finance and accounting. Management has determined that the
Year 2000 issue will not pose significant operational problems for its
computer systems. As a result, any costs attributable to the purchase and
implementation of new software will be capitalized and any other costs
incurred in connection with Year 2000 compliance will be expensed as incurred.
The Company expects that any systems or application changes or upgrades
connected with Year 2000 compliance will be completed before December 31,
1998. The Company expects to use both internal and external resources to
replace and test software for Year 2000 compliance. The total cost to the
Company for these Year 2000 compliance activities has not been and is not
anticipated to be material to its financial position or results of operations.
These costs are not expected to be substantially different from normal costs
that are incurred for systems development and implementation, in part due to
the reallocation of internal resources. The total cost of Year 2000 compliance
is not expected to exceed $500,000, the majority of which will be spent on the
purchase and implementation of new software and upgrades during 1998. These
costs and the date by which management expects to complete the Year 2000
compliance are based on management's best estimates, which were derived
utilizing numerous assumptions of future events including the availability of
certain resources, third party product and modification programs and other
factors. However, there can be no assurance that these estimates will be
achieved and actual results could differ materially from those anticipated.
The Company is in the process of obtaining assurances from vendors that
timely updates will be made available to ensure that all purchased software
will be Year 2000 compliant. The Company is also in the process of initiating
formal communications with all of its significant suppliers to determine the
extent to which the Company is vulnerable to Year 2000 issues. However, there
can be no guarantee that if the systems of other companies on which the
Company's systems rely are not timely converted, or if another company fails
to convert, this would not have a material adverse effect on the Company.
The Company currently obtains a significant amount of its revenue from
relatively few customers. There can be no assurance that the Year 2000 issue
will not pose significant problems for the computer systems of these
customers, which could in turn affect the customers' ability to purchase
machines and generate revenue for the Company. The Company is currently
reviewing its own products to determine that its software and hardware will be
Year 2000 compliant. Accordingly, there can be no assurance revenue generated
for the Company will not be affected by the Year 2000 issues that these
customers might have or that we might encounter with our own product. The
Company cannot predict the nature of any such changes or their impact on the
Company.
RISK FACTORS
UNCERTAIN MARKET ACCEPTANCE; RISK OF TECHNICAL ERRORS; SINGLE PRODUCT. To
achieve commercial success, the Company's product must be accepted both by
casino operators and gaming patrons. Because acceptance of the product by
casino operators will ultimately depend on win per machine, the Company
believes that its ultimate success will depend on player acceptance. The
Company's first gaming platform, Odyssey, has only been installed in casinos
for a limited period and the Company has only limited market studies and
player data to support its belief that Odyssey or the Company's new product,
Quest, will be accepted by slot players. There can be no assurance that
Odyssey or Quest will be accepted by casino patrons. Initial player interest
in the product may be affected by its novel design in addition to any inherent
advantages it may have over competing
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platforms and may therefore not be indicative of the long-term success of
Odyssey or Quest in the marketplace. Player preferences are highly subjective,
vary substantially among geographic and demographic markets and are subject to
unpredictable change. Because the Company's product offers features not found
on traditional slot machines, it may not appeal to players for whom
familiarity and predictability are important considerations.
The Company sells its machines at prices that are substantially higher than
the prices of most competing products. In light of these higher sale prices,
coupled with the Company's status as a new and relatively small entrant in a
market dominated by larger companies, the success of Odyssey and Quest will
require that it demonstrate superior, as opposed to merely comparable, win per
machine when compared to traditional slot machines and other gaming platforms
offered by more established competitors. Although a number of casinos have
purchased or installed the Company's product, any additional purchases of the
product by these casinos, or others that may conduct similar evaluations in
the future, will be subject to the superior performance of the product on the
casino floor. Because of the limited opportunity for the Company to test its
gaming platform under long-term play conditions, there can be no assurance
that a substantial technical difficulty with, or an undetected error in, the
Company's software or hardware will not arise, possibly resulting in
unanticipated costs, installation and production delays or delays in product
licensing.
The Company's success currently depends on the success of a single product.
Because sales of its slot machine and related software will comprise the
Company's only source of revenue in the foreseeable future, any interruption
in these sales due to a technical problem will prevent the Company from
earning revenue unless and until the cause of such interruption can be
remedied. As the Company moves into new jurisdictions, including potential
international markets, the Company may be required to make certain
modifications to its product to comply with local regulatory or market
conditions. There can be no assurance that such modifications will be
successful, or that these modifications will be performed in a timely or cost
effective manner. Moreover, should Odyssey or Quest fail to win broad
acceptance in the market, the Company's business, financial condition and
results of operations would be materially and adversely affected, and
investors would be exposed to the loss of all or a substantial portion of
their investment.
EXPECTATION OF LOSSES; NEGATIVE CASH FLOWS. As of September 30, 1998, the
Company has had net losses since inception, and the Company expects to
continue to incur operating losses and negative cash flows at least through
mid 1999. There can be no assurance that the Company will become profitable or
cash flow positive at any time in the future. The likelihood of the success of
the Company must be considered in light of the expenses, difficulties and
complications that may affect the Company's ability to achieve profitable
operations and the competitive and regulatory environment in which the Company
must operate. To date, the Company's operations have focused primarily on
product development, and the Company has had limited experience in the areas
of manufacturing, sales, product distribution and customer support.
Accordingly, it is not possible to estimate future revenue and operating
expenses based upon historical operating performance. Operating results will
depend, in part, on matters over which the Company has little or no control,
including, without limitation, the ability of the Company to obtain the
licenses necessary to conduct its business, competition, the actual number of
orders for its product, gaming regulations and taxes.
CAPITAL REQUIREMENTS. The Company believes that its cash and equivalents,
short-term investments, cash received from the reduction of current inventory
levels, accounts receivable, the Company's revolving line of credit, and
proceeds from additional financing sources which the Company believes are
available, will be sufficient to fund its capital and operating requirements
until the Company generates positive cash flow from operations. The Company
recently obtained debt financing to fund its product rollout, expand
operations, and fund its revenue sharing plan and the development and
implementation of its wide area progressive system. The cash flow generated by
sales under the revenue sharing plan is recognized over an extended period, as
the aggregate win per day is earned, and therefore has an adverse effect on
the Company's working capital compared to other pricing options. Additionally,
the Company's revolving line of credit is subject to certain financial
covenants and should the Company fall out of compliance with these covenants,
there can be no assurances that a waiver from the lending institution will be
forthcoming in the future. In addition to the financings recently obtained,
the Company may be required to seek additional financing before it achieves
positive cash flow. There
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can be no assurance that the Company will be able to obtain such financing, or
that, if it is able to obtain such financing, it will be able to do so on
satisfactory terms or on a timely basis. If additional funds are raised
through the issuance of equity, convertible debt or similar securities,
shareholders may experience substantial dilution, and such securities may have
rights or preferences senior to those of Common Stock. Moreover, if adequate
funds are not available to satisfy the Company's short-term or long-term
capital requirements, the Company may be required to limit or discontinue its
revenue sharing plan or its multi-site progressive system, scale back its
product rollout, or limit its operations significantly. The Company's capital
requirements will depend on many factors, including, but not limited to, the
rate at which the Company can introduce its product, the market acceptance and
competitive position of such product, the response of competitors to the
Company's product, the extent to which the customers choose the revenue
participation plan, the introduction and acceptance of its multi-site
progressive product, and the ability of the Company to satisfy the licensing
requirements in various jurisdictions.
DEPENDENCE ON KEY PERSONNEL; ABSENCE OF FULL-TIME CEO. The operations of the
Company depend to a great extent on the management efforts of its officers and
other key personnel and on the ability to attract new key personnel and retain
existing key personnel. Competition is intense for highly skilled product
development employees in particular. There can be no assurance that the
Company will be successful in attracting and retaining such personnel or that
it can avoid increased costs in order to do so. In addition, the Company's
officers and key employees are not bound by noncompetition agreements that
extend beyond their employment at the Company, and there can be no assurance
that employees will not leave the Company or compete against the Company. The
Company's failure to attract additional qualified employees or to retain the
services of key personnel could have a material adverse effect on the
Company's operating results and financial condition. In August 1998, Donald J.
Massaro resigned as President and CEO. Since then, the Company has been
without a full-time CEO and has utilized the services of David B. Morse, a
member of its Board of Directors, as acting CEO while the search for a full-
time CEO continues. The Company currently maintains a "key-man" life insurance
policy in the amount of $3 million on the life of Andrew S. Pascal, the
Company's Executive Vice President-Marketing and Game Development.
COMPETITION. The gaming machine industry is characterized by intense
competition that is based on, among other things, a device's ability to
generate win per machine through product appeal to players, and knowledge of
customer requirements such as ease of use, quality of service, support and
training, distribution, name recognition and price. In recent years, the
gaming machine market has been dominated by International Game Technology
("IGT") which, according to industry sources, captured approximately 75% of
the market in 1997. IGT's presence as a competitor is bolstered by its
extensive market presence, distribution capacity, player acceptance and
financial, technological and other resources. Several other companies,
including Bally Gaming International, Inc. ("Bally Gaming"), are established
in, or are seeking to enter, the gaming machine business. Companies in
historically unrelated industries, such as Sega Enterprises Ltd. ("Sega"),
have technological resources that could offer them a competitive advantage in
developing multimedia-based gaming machines. In general, the Company's
existing competitors, as well as many potential new competitors, have
significantly greater financial and technical resources than the Company, as
well as more established customer bases and distribution channels, any of
which could afford them a competitive advantage in developing multimedia-based
gaming machines. Any success the Company might have may benefit existing
competitors and induce new competitors to enter the market. If Odyssey or
Quest displays a potential to capture a significant share of the gaming
machine market, the Company's competitors can be expected to employ a variety
of tactics to limit erosion of their market share, including price reductions,
acceleration of new product development or acquisition of new, competitive
technologies. In the face of such tactics, there can be no assurance that the
Company will be a successful competitor in the gaming machine industry.
SLOWING IN TREND TO LEGALIZE GAMING. Growth in demand for slot machines
historically has been driven by the opening of new casinos, including casinos
in jurisdictions where gaming has recently been legalized. However, in recent
years, the legalization of gaming in new jurisdictions has been significantly
reduced; therefore, demand based on new openings will be largely limited to
new projects in existing markets. Certain
18
<PAGE>
jurisdictions which currently permit gaming are contemplating legislation to
limit, reduce, or eliminate gaming. If successful, such legislation could
limit growth opportunities for the Company. As a result of these factors,
there can be no assurance that the slot machine industry will sustain the rate
of growth that was possible in the first half of this decade.
MANAGEMENT OF GROWTH. Execution of the Company's plan of operation will
require significant growth. The Company's current plans for growth will place
a significant strain on the Company's financial, managerial and other
resources. The Company's ability to manage its growth effectively will require
it to continue to improve its operational, financial and management
information systems and to attract, motivate and train key employees. Should
the Company's executives be unable to manage growth effectively, the Company's
business, operating results and financial condition would be materially and
adversely affected.
LIMITED PROTECTION OF INTELLECTUAL PROPERTY RIGHTS; RISK OF LITIGATION. The
Company regards its product as proprietary and relies primarily on a
combination of patent, trademark, copyright and trade secret laws and employee
and third-party nondisclosure agreements to protect its proprietary rights.
Defense of intellectual property rights can be difficult and costly, and there
can be no assurance that the Company will be able to effectively protect its
technology from misappropriation by competitors. In addition, the protections
offered by trademark, copyright and trade secret laws would not prevent a
competitor from designing games having appearance and functionality that
closely resemble the Company's games. At present, the Company's principal
proprietary technology consists of its game authentication algorithm, which is
designed to prevent tampering with the game software that is resident in its
product, and its random number generator algorithm, which determines the
outcome of each gaming proposition. While the Company believes that these
algorithms are unique at present, there can be no assurance that a competitor
of the Company will not succeed in developing an authentication algorithm or a
random number generator algorithm that performs as well as, or better than,
the Company's. Moreover, although the Company has applied for and received
certain patents and trademarks for its intellectual property, there can be no
assurance that such patents and trademarks will not be successfully challenged
in subsequent litigation.
As the number of software products in the industry increases and the
functionality of these products further overlaps, software developers and
publishers may increasingly become subject to infringement claims. The Company
may also become subject to infringement claims, with or without merit, that
are brought by competitors who are motivated by a desire to disrupt the
Company's business. Although the Company is not currently aware of any claim
that it is infringing upon any intellectual property rights, there can be no
assurance that the Company will not face claims, with or without merit, in the
future. Any such claims or litigation could be costly and could result in a
diversion of management's attention, which could have a material adverse
effect on the Company's business and financial condition. Any settlement of
such claims or adverse determinations in such litigation could also have a
material adverse effect on the Company's business, operating results and
financial condition.
RAPIDLY CHANGING TECHNOLOGY. The Company's product utilizes hardware
components that have been developed primarily for the personal computer and
multimedia industries. These industries are characterized by rapid
technological change and product enhancements. The Company's ability to remain
competitive and retain any technological lead may depend in part upon its
ability to continually develop new slot machine games that take full advantage
of the technological possibilities of state-of-the-art hardware. Should any
current or potential competitor of the Company succeed in developing a
competing software-based gaming platform, such competitor could be in a
position to outperform the Company in its ability to exploit developments in
microprocessor, video or other multimedia technology. The emergence of a suite
of slot machine games that is superior to the Company's in any respect could
substantially diminish the Company's product sales and thereby have a material
adverse effect on the Company's operating results.
LIMITED MANUFACTURING EXPERIENCE. In order for the Company to be successful,
its product must be manufactured to meet high-quality standards in commercial
quantities at competitive prices. The Company has a limited history of
manufacturing Odyssey and Quest for commercial distribution and has had no
prior experience
19
<PAGE>
in large-scale manufacturing of gaming machines. The transition to large-scale
manufacturing of Odyssey and Quest will involve various risks and
uncertainties including unforeseen costs or assembly difficulties and the
possibility that anticipated efficiencies or economies of scale will fail to
materialize as the Company begins manufacturing in greater volumes. A failure
by the Company to successfully manage this transition would have a material
adverse affect on the Company's business, operating results or financial
condition.
DEPENDENCE ON SINGLE-SOURCE SUPPLIERS. The Company currently obtains a
number of its system's components from single-source suppliers. In particular,
the touchscreen and picture tube that comprise the video display are supplied
by MicroTouch Systems, Inc. and Philips Display Components Company,
respectively. The Company does not have long-term supply contracts with these
suppliers but rather obtains these components on a purchase order basis.
Although the design of these components is not unique or proprietary and the
Company believes that it could identify alternative sources of supply, if
necessary, there can be no assurance that the Company would be able to
procure, substitute or produce such components without a significant
interruption in its assembly process in the event that these single sources
were unable to supply these components. Even where the Company has multiple
sources of supply for a component, industry-wide component shortages, such as
those that have occurred with various computer components, could significantly
delay productivity, increase costs or both. The failure or delay by any
supplier to furnish the Company with required components would have a material
adverse effect on the Company's business, financial condition and results of
operations.
REGULATORY APPROVAL. The Company will be required to obtain and maintain the
necessary licenses, approvals, findings of suitability and product approvals
in all jurisdictions in which it intends to distribute its product. The
licensing and approval processes can involve extensive examination of the
Company and its officers, directors, employees, principal shareholders and
product and can require significant expenditures of time and resources by the
Company. Distribution of gaming devices in U.S. gaming jurisdictions generally
requires both corporate approval and product approval. In addition to the
initial product approval, the Company is required to submit all software and
hardware modifications to the various regulatory laboratories. These
modifications normally take between 30 and 45 days to process. The regulations
relating to company and product licensing are subject to change, and other
jurisdictions, including the federal government, may elect to regulate or tax
gaming activities. The Company cannot predict the nature of any such changes
or their impact on the Company.
Any beneficial holder of the Company's Common Stock may be subject to
investigation by any gaming authority in any jurisdiction in which the Company
does business if such authorities have reason to believe that such ownership
may be inconsistent with the gaming policies of that jurisdiction. Persons who
acquire beneficial ownership of more than certain designated percentages of
the Common Stock may be subject to certain reporting and qualification
procedures. In addition, changes in control of the Company and certain other
corporate transactions may not be effected without the prior approval of
gaming authorities in other jurisdictions in which the Company plans to do
business. Such provisions could adversely affect the marketability of the
Company's Common Stock or prevent certain corporate transactions, including
mergers or other business combinations.
NO DIVIDENDS. The Company has not paid any cash dividends in the past and
does not expect to do so in the foreseeable future.
20
<PAGE>
PART II--OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
In July 1998, the Company completed the private placement of $17.25 million
principal obligation Senior Discount Notes ("Notes") due September 30, 2002.
Commencing January 1, 1999 the Notes bear interest at 12.5% per annum, payable
semi-annually. The Company is required to redeem $3 million in principal on
September 30, 2001. The Company is permitted to raise additional proceeds from
debt or equity securities of up to $40 million before mandatory redemption of
the Notes. The Notes are callable at the option of the Company at any time,
with an initial redemption price of 93.13% of the aggregate amount, increasing
to 100% over 9 months. In connection with the offering, purchasers of the
Notes were issued warrants to purchase 250,000 shares of the Company's Common
Stock at a per-share price of $8.00. Additionally, the exercise price of the
375,000 warrants issued in connection with the September 1997 $30 million
Senior Discount Notes was also adjusted from a per-share price of $15.4375 to
a per-share price of $8.00. The value ascribed to the warrants and to the
repricing of the September 1997 warrants was $1,466,000. Gross proceeds to the
Company before fees and other expenses were $14.95 million. The Notes and the
Warrants were sold to institutional investors in reliance upon Section 4(2) of
the Securities Act of 1933.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
<TABLE>
<CAPTION>
NUMBER EXHIBIT DESCRIPTION
------ -------------------
<C> <S>
4.1* Amendment No. 1 to Securities Purchase Agreement, dated as by and
between the Company and B III Capital Partners, L.P., a Delaware
limited partnership dated as of July 8, 1998.
4.2* Form of Senior Discount Note (Series B) due September 30, 2002 dated
as of July 8, 1998.
4.3* Registration Rights Agreement dated as of July 8, 1998, by and
between the Company and B III Capital Partners, L.P., a Delaware
limited partnership.
4.4* Amended and Restated Warrant Agreement including form of Common Stock
Purchase Warrant Certificate No. W-2 dated as of July 8, 1998, by and
between the Company and B III Capital Partners, L.P., a Delaware
limited partnership.
10.36 See exhibit 4.1
10.37 See exhibit 4.2
10.38 See exhibit 4.3
10.39 See exhibit 4.4
11.1 Statement Regarding Computation of Loss Per Share
27.1 Financial Data Schedule
</TABLE>
- --------
* Incorporated by reference to the Company's Form 8-K filed with the
Commission on July 21, 1998.
(b) Reports on Form 8-K.
On July 21,1998, the Company filed a Current Report on Form 8-K to report
under Item 5, "Other Events," the issuance of $17.25 million principal
amount of senior discount notes, the issuance of warrants to purchase
250,000 shares of the Company's Common Stock at an exercise price of $8.00
per share and an adjustment to the exercise price of warrants to purchase
375,000 shares, which the Company had issued previously, to $8.00 per
share.
21
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Silicon Gaming, Inc.
/s/ Thomas E. Carlson
By __________________________________
THOMAS E. CARLSON
VICE PRESIDENT--CHIEF FINANCIAL
OFFICER
(PRINCIPAL FINANCIAL AND CHIEF
ACCOUNTING OFFICER)
Date: November 16, 1998
22
<PAGE>
EXHIBIT 11.1
SILICON GAMING, INC.
STATEMENT REGARDING COMPUTATION OF NET LOSS PER SHARE
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS
THREE MONTHS ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- ----------------
1998 1997 1998 1997
--------- --------- ------- -------
<S> <C> <C> <C> <C>
Net loss.............................. $ 14,702 $ 6,344 $26,895 $16,943
========= ========= ======= =======
Weighted average common shares
outstanding.......................... 14,240 11,649 13,986 11,133
Weighted average common shares subject
to Repurchase........................ (310) (684) (402) (790)
--------- --------- ------- -------
Weighted average common and
Equivalent shares.................. 13,930 10,965 13,584 10,343
========= ========= ======= =======
Net loss per share................ $ 1.06 $ .58 $ 1.98 $ 1.64
========= ========= ======= =======
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 12,423
<SECURITIES> 0
<RECEIVABLES> 8,396
<ALLOWANCES> 1,155
<INVENTORY> 15,247
<CURRENT-ASSETS> 36,330
<PP&E> 14,210
<DEPRECIATION> 5,436
<TOTAL-ASSETS> 49,165
<CURRENT-LIABILITIES> 14,383
<BONDS> 37,127
0
1,666
<COMMON> 57,349
<OTHER-SE> (65,101)
<TOTAL-LIABILITY-AND-EQUITY> 49,165
<SALES> 17,276
<TOTAL-REVENUES> 17,276
<CGS> 17,579
<TOTAL-COSTS> 17,579
<OTHER-EXPENSES> 22,845
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 4,274
<INCOME-PRETAX> (26,878)
<INCOME-TAX> 17
<INCOME-CONTINUING> (26,895)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (26,895)
<EPS-PRIMARY> 1.98
<EPS-DILUTED> 1.98
</TABLE>
