<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 March 31, 1999
OR
______ Transition Report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934 for the transition period from to
Commission File Number 0-28294
SILICON GAMING, INC.
(Exact name of Registrant as specified in its charter)
CALIFORNIA 77-0357939
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
2800 W. Bayshore Road
Palo Alto, CA 94303
(Address of principal executive offices)
Telephone: (650) 842-9000
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
------ ------
Indicate the number of shares outstanding of each of the issuer's classes of
Common Stock, as of the latest practicable date.
14,287,795 shares of Common Stock, $.001 par value, were outstanding as
of April 30, 1999.
<PAGE>
SILICON GAMING, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 1999
INDEX
<TABLE>
<CAPTION>
Page
<S> <C> ----
Part I Financial Information
Item 1. Financial Statements:
Consolidated Balance Sheets--March 31, 1999 and December 31, 1998................................... 3
Consolidated Statements of Operations--Three months ended March 31, 1999 and 1998................... 4
Consolidated Statements of Cash Flows--Three months ended March 31, 1999 and 1998................... 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 1. Legal Proceedings................................................................................... 20
Exhibits and Reports on Form 8-K.................................................................... 20
Signature........................................................................................... 21
</TABLE>
2
<PAGE>
PART I--FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SILICON GAMING, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
<TABLE>
<CAPTION>
March 31, December 31,
1999 1998
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
(unaudited)
ASSETS
CURRENT ASSETS:
Cash and equivalents............................................................. $ 4,097 $ 8,399
Accounts receivable (net of allowances of $1,552 in 1999 and $1,650 in 1998)..... 4,043 5,340
Inventories...................................................................... 11,471 12,024
Investments to fund jackpot winners.............................................. 319 288
Prepaids and other............................................................... 1,376 1,410
----------------------------------------
Total current assets.......................................................... 21,306 27,461
PROPERTY AND EQUIPMENT, NET........................................................ 8,808 12,922
OTHER ASSETS, NET.................................................................. 1,254 1,361
----------------------- --------------
$ 31,368 $ 41,744
========================================
LIABILITIES AND SHAREHOLDERS' DEFICIENCY
CURRENT LIABILITIES:
Accounts payable................................................................. $ 951 $ 1,480
Accrued liabilities.............................................................. 8,994 8,154
Deferred revenue................................................................. 1,481 1,766
Line of credit................................................................... 2,132 4,000
Current portion of long-term obligations......................................... 1,281 1,289
----------------------------------------
Total current liabilities..................................................... 14,839 16,689
OTHER LONG-TERM LIABILITIES........................................................ 2,051 2,032
LONG-TERM OBLIGATIONS.............................................................. 40,105 39,809
REDEEMABLE CONVERTIBLE PREFERRED STOCK--6,884,473 shares
authorized at March 31, 1999; shares outstanding: March 31, 1999--1,474,641;
December 31, 1998--1,474,641..................................................... 1,666 1,666
SHAREHOLDERS' DEFICIENCY
Common Stock, $.001 par value; 50,000,000 shares authorized; shares
Outstanding: March 31, 1999--14,287,598; December 31, 1998--
14,242,313..................................................................... 57,588 57,398
Warrants......................................................................... 4,548 4,548
Notes receivable from shareholders............................................... (119) (128)
Accumulated deficit.............................................................. (89,310) (80,270)
Accumulated other comprehensive income........................................... -- --
----------------------------------------
Total shareholders' deficiency................................................ (27,293) (18,452)
----------------------- --------------
$ 31,368 $ 41,744
========================================
</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 Ended
March 31,
1999 1998
---------------- -------------
REVENUE:
<S> <C> <C>
Hardware.................................................................. $ 3,672 $ 2,424
Software.................................................................. 1,387 720
Participation............................................................. 602 882
------- -------
Total revenue............................................................. $ 5,661 $ 4,026
OPERATING EXPENSES:
Cost of sales and related
manufacturing expenses.................................................. 4,219 3,190
Research and development.................................................. 2,348 2,716
Selling, general and
administrative.......................................................... 2,896 3,951
Restructuring charges..................................................... 3,312 --
------- -------
Total costs and expenses.................................................. 12,775 9,857
------- -------
Loss from operations................................................. 7,114 5,831
Interest expense, net..................................................... 1,926 933
------- -------
NET LOSS.................................................................... $ 9,040 $ 6,764
======= =======
Basic and diluted net loss per share $ 0.64 $ 0.51
======= =======
Shares used in computation 14,115 13,150
======= =======
</TABLE>
See notes to consolidated financial statements.
4
<PAGE>
SILICON GAMING, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(unaudited)
<TABLE>
<CAPTION>
Three months Ended
March 31,
1999 1998
------------------ -------------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss.............................................................. $(9,040) $(6,764)
Reconciliation to net cash used in operating activities:
Depreciation and amortization........................................ 1,726 1,176
Accrued interest..................................................... 1,125 672
Accretion of debt discount........................................... 599 364
Provision for bad debt............................................... (98) --
Restructuring charges................................................ 2,566 --
Deferred rent........................................................ 19 53
Changes in assets and liabilities:
Accounts receivable.................................................. 1,395 647
Inventories.......................................................... 553 (4,997)
Prepaid and other.................................................... 10 (83)
Participation units.................................................. 406 (178)
Accounts payable..................................................... (529) 1,047
Accrued liabilities.................................................. (285) (572)
Deferred revenue..................................................... (285) (52)
------- -------
Net cash used in operating activities.............................. (1,838) (8,687)
------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment................................. (311) (1,197)
Sales and maturities of short-term investments........................ -- 2,625
Other assets, net..................................................... (31) (4)
------- -------
Net cash provided by (used in) investing activities................ (342) 1,424
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from term loans and line of credit........................... -- 1,560
Repayment of bank line of credit...................................... (1,868) --
Sale of Common Stock, net of notes receivable......................... 48 561
Collection of note receivable......................................... 9 5
Repayment of term loans............................................... (235) --
Repayment of capital lease obligations................................ (76) (69)
------- -------
Net cash provided by financing activities.......................... (2,122) 2,057
------- -------
NET DECREASE IN CASH AND EQUIVALENTS.................................... (4,302) (5,206)
Beginning of period................................................... 8,399 16,352
------- -------
End of period......................................................... $ 4,097 $11,146
======= =======
SUPPLEMENTARY DISCLOSURES OF CASH FLOW
INFORMATION:
Cash paid during the period for interest.............................. $ 173 $ 15
======= =======
Conversion of preferred stock to Common Stock......................... $ -- $ 1,399
======= =======
</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 March 31, 1999, the
consolidated statements of operations for the three months ended March 31, 1999
and 1998, and the consolidated statements of cash flows for the three months
ended March 31, 1999 and 1998, 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, 1998
included in the Company's Annual Report on Form 10-K filed with the Securities
and Exchange Commission.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. The Company has
incurred operating losses every year since its inception and at March 31, 1999
had an accumulated deficit of $89,310,000 and a shareholders' deficiency of
$27,293,000. The Company has been required to obtain additional financing every
year to be able to fund its ongoing operations. As of March 31, 1999 the Company
was not in compliance with the terms of its line of credit, and its cash and
equivalents had decreased to $4,097,000. Based on historical levels of cash
usage, the above factors raise substantial doubt about the Company's ability to
continue as a going concern. In the fourth quarter of 1998 the Company took
steps to reduce the level of operating expenses and made a number of management
decisions which resulted in a reduction of the Company's workforce by
approximately 20% and cuts in expenditures across the Company. The Company
continued to evaluate further possible ways to reduce operating expenses through
outsourcing of different parts of its business and further downsizing of its
workforce. In March 1999 management reduced the size of the Company's workforce
by an additional 35% and made additional cuts to operating expenses. Management
also announced in March 1999 the relocation of its manufacturing to its Las
Vegas, Nevada facility and the closure of its Mountain View, California
manufacturing facility. Management is currently attempting to renegotiate the
terms of its line of credit with its bank so that additional funds will become
available to the Company. Management is also reviewing financing and other
strategic alternatives available to the Company such as additional share or debt
offerings, joint ventures, alternative distribution channels, conversion of some
or all of its debt to equity and sale of all or part of the Company's assets to
improve the Company's liquidity position. Management believes that these steps
and satisfactory resolution of its financing and strategic alternatives, plus
sales related to proposed new product introductions will provide sufficient cash
and working capital for the Company to meet its ongoing obligations and to allow
it to continue operating as a going concern through at least the end of 1999.
The accompanying consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
Net loss per share - Basic earnings per share excludes dilution and is
computed by dividing net income by the weighted average of common shares
outstanding for the period. Diluted earnings per share reflects the potential
dilution that would occur if securities or other contracts to issue Common Stock
were exercised or converted into Common Stock. Common share equivalents
including stock options, warrants and Redeemable Convertible Preferred Stock
have been excluded from all periods presented, as their effect would be
antidilutive.
The following is a reconciliation of the numerators and denominators of the
basic and diluted net loss per share computations (in thousands except per share
amounts):
<TABLE>
<CAPTION>
Three months ended March 31,
____________________________
1999 1998
---- ----
<S> <C> <C>
Net Loss (Numerator):
Net Loss, basic and diluted........................... $ (9,040) $ (6,764)
========= =========
Shares (Denominator)
Weighted average common shares outstanding............. 14,277 13,644
Weighted average common shares subject to repurchase.. (162) (494)
--------- ---------
Shares used in computation 14,115 13,150
========= =========
Net Loss Per Share, Basic and Diluted................. $ 0.64 $ 0.51
========= =========
</TABLE>
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):
March 31, December 31,
1999 1998
--------- ------------
Raw materials............................ $ 4,884 $ 4,294
Work in process.......................... 900 93
Finished goods........................... 5,687 7,637
------- -------
$11,471 $12,024
======= =======
6
<PAGE>
3. Concentration of Credit Risk
Financial instruments which potentially subject the Company to
concentrations of credit risk consist primarily of cash equivalents and trade
accounts receivable. The Company invests only in high credit quality short-term
debt with its surplus funds. The Company performs ongoing credit evaluations of
its customers' financial condition and limits the amount of credit extended when
deemed necessary but generally requires no collateral. The Company maintains
reserves for estimated potential credit losses. As of March 31, 1999, two
customers accounted for 13% and 11% of accounts receivable. For the three months
ended March 31, 1999, one customer accounted for 15% of revenue. For the three
months ended March 31, 1998, two different customers accounted for 18% and 13%
of revenue.
4. 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 March 31, 1999) plus 1%. As of March 31, 1999, the Company had
$2,132,000 outstanding under this agreement. The line of credit requires the
Company to comply with certain financial covenants. As of March 31, 1999, the
Company was not in compliance with financial covenants relating to working
capital and minimum quarterly net income. See Note 6.
Borrowing arrangements consist of the following (in thousands):
<TABLE>
<CAPTION>
March 31, December 31,
1999 1998
---------- -------------
<S> <C> <C>
Senior Discount Notes ($47.25 and $30 million principal
obligation, respectively)....................................... $38,315 $37,716
Capital lease obligations........................................ 285 360
Other long-term obligations...................................... 2,786 3,022
-------- --------
41,386 41,098
Current obligation............................................... (1,281) (1,289)
-------- --------
Long-term portion $40,105 $39,809
======== ========
</TABLE>
7
<PAGE>
5. Restructuring Charges
In March 1999 the Company announced the closure of its Mountain View,
California manufacturing facility and the relocation of all of its manufacturing
operations to its Las Vegas, Nevada facility. At the same time the Company
announced a reduction in the size of its employee workforce by approximately
35%. These measures have been taken as the Company has sought to reduce its
level of overhead and operating expenses to a level more conducive to
profitability, and as the company refocuses on its core activities. The
restructuring charges include severance costs, lease related costs of excess
facilities, and the write down of specific fixed assets associated with these
facilities and assets rendered surplus as a result of the reduction in force.
The Company recorded charges of $3.3 million related to the restructure as
follows:
<TABLE>
<CAPTION>
Accrued Write-down
severance, Facility Of
benefits & other Lease Fixed
(in thousands) costs Obligations Assets Total
<S> <C> <C> <C> <C>
Restructuring provision $ 595 $ 293 $ 2,424 $ 3,312
Non-cash items (142) -- (2,424) (2,566)
Amounts paid (431) -- (431)
------------- ------------- ------------- -------------
Balance at March 31, 1998 $ 22 $ 293 $ -- $ 315
============= ============= ============= =============
The Company anticipates that all accrued severance and benefits will be paid before June 30,
1999.
</TABLE>
6. Subsequent Events
In April 1999 the Company announced the settlement of its patent
infringement litigation with International Game Technology, Inc. ("IGT"). Under
the settlement agreement the Company obtained an exclusive sublicense from IGT
relating to the disputed patents, which will allow the Company to continue to
sell its Lucky Draw Poker and Multi Draw Poker games without any limitations.
The Company's customers who choose to purchase this product will be required to
exercise a separate license agreement with IGT and to pay daily fees for the use
of the game under the terms of the settlement. The Company also cross licensed
certain of its intellectual property to IGT as part of the settlement and in
consideration IGT will pay a per-unit royalty to the Company for each product
sold that incorporates licensed technology upon the occurrence of certain
events. IGT also granted the Company development rights in order to create games
on IGT's current platforms and preferential development and distribution rights
to create and distribute games on IGT's future product platforms. As a result of
settlement of disputed royalties payable to IGT, the Company will record a
favorable adjustment to income in the second quarter of 1999 of approximately
$500,000.
In May 1999 the Company renegotiated the terms of its bank line of credit.
Under the renegotiated line, the Company has a $4 million secured revolving line
of credit arrangement based on the Company's eligible accounts receivable, which
expires on December 31, 1999. Borrowings bear interest at the bank's prime rate
(8.25% at March 31, 1999) plus 3.5%. The renegotiated line requires the company
to comply with certain financial covenants relating to minimum tangible net
worth (as defined), with which the Company is currently in compliance. This line
is still subject to find bank approval before it becomes effective.
Certain holders of the Company's Series A1 and B1 Nonvoting Redeemable
Convertible Preferred Stock ("Nonvoting Preferred") have notified the Company of
their election to convert shares of Nonvoting Preferred to Common Stock. Each
share of Nonvoting Preferred is convertible into 0.6667 shares of Common Stock
upon 75 days' prior written notice. Pursuant to these conversion notices,
approximately 241,000 shares of Common Stock are expected to be issued in May
1999.
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. was incorporated on July 27, 1993 to design, develop,
manufacture and distribute interactive gaming devices that implement advanced
multimedia technologies using state-of-the-art, off-the-shelf components. In
March 1997 the Company introduced its first product, Odyssey/TM/, a multi-game,
video-based slot machine, into the Nevada market. In 1998 the Company introduced
Quest, a single-game platform that utilizes many of the same components as the
Odyssey, to increase its penetration of the casino floor. The Company has since
rolled out Odyssey and Quest into other jurisdictions including Connecticut,
Indiana, Iowa, Louisiana, Michigan, Mississippi, Missouri, New Mexico, certain
Canadian provinces and Uruguay.
The Company's products feature high-resolution video presented across the
full surface of a large touchscreen display. The games feature high-quality
animation, video clips, digital sound and a level of visual appeal and
interactivity that the Company believes is unattainable by the current
generation of slot machines. The Company is attempting to maximize the
entertainment value offered on the video screen by providing multiple levels of
achievement within certain games so that, through successful play over a period
of time, a player may advance to a bonusing sequence and win additional
jackpots. SGI believes that by utilizing these features, it will encourage
longer and more frequent periods of play by existing slot machine customers and
attract new gaming customers who are seeking greater entertainment value than
that offered by the current generation of slot machines. The Company has
designed its machines with a number of unique player features, such as play
stoppage entertainmentTM. In addition, the product's modular components and
Machine Management SystemTM software provide easy-to-use diagnostics designed to
minimize player inconvenience and machine down time. The Company currently
offers several products including OdysseyTM, a multi-game machine that can play
up to six different games on the same machine, and Quest, a single-game machine.
In December 1998, the Company introduced its first wide-area progressive
product, The Big Win. Under a wide-area progressive system, numerous slot
machines are linked by computer networks and share a common top award that is
usually much greater than the award that a single, unlinked machine could
support. The network links machines in different casinos, and can be extended
from its current installed base in Las Vegas to include other locations across
Nevada. The Company receives a predetermined percentage of the amounts wagered
on these machines as revenue and is responsible for payment of the game's
progressive jackpot prizes.
9
<PAGE>
Through March 31, 1999, the Company has installed 3,540 Odyssey and Quest
machines in approximately 198 properties throughout Connecticut, Iowa, Indiana,
Louisiana, Michigan, Minnesota, Mississippi, Missouri, Nevada, New Mexico,
certain Canadian provinces and Uruguay. Of these machines, 3,058 have been sold
outright or placed on a revenue-sharing basis. After returns, 482 machines
remain installed on a trial basis and the casino operators are required to
purchase the machine outright, participate in SGI's revenue sharing plan or
return the machine to the Company within a defined trial period. Included in the
Company's revenue and installed base at March 31, 1999 are 16 machines connected
to the wide-area progressive system. 144 wide-area progressive machines were
returned to the Company in January 1999 following a decision by the Company to
modify the initial game that was released on the wide-area progressive system.
The Company believes that these machines will be reinstalled in casinos during
the second quarter of 1999.
At March 31, 1999 the Company had cash and equivalents of $4,097,000. The
Company has incurred operating losses each year since inception and as of March
31, 1999 had an accumulated deficit of $89,310,000 and a deficiency of
shareholders' equity of $27,293,000. The Company has been required to obtain
additional financing each year to be able to fund its ongoing operations. At
March 31, 1999 the Company was not in compliance with the terms of its line of
credit. Based on historical levels of cash usage, the above factors raise
substantial doubt about the Company's ability to continue as a going concern. In
the fourth quarter of 1998 the Company took steps to reduce the level of
operating expenses and made a number of management decisions which resulted in a
reduction of the Company's work force by approximately 20% and cuts in
expenditures across the Company. The Company continued to evaluate further
possible ways to reduce operating expenses through outsourcing of different
parts of its business and further downsizing of its workforce. In March 1999
management reduced the size of the Company's workforce by a further 35% and made
additional cuts to its operating expenses. Management also announced the
relocation of its manufacturing to its Las Vegas, Nevada facility and the
closure of its Mountain View, California manufacturing facility. The Company was
able to renegotiate the terms of its line of credit with its bank in May 1999
so that this credit facility will remain available to the Company. Management is
currently reviewing financing alternatives available to the Company such as
additional share or debt offerings, joint ventures, alternative distribution
channels, conversion of some or all of its debt to equity and sale of all or a
portion of the Company's assets to improve the Company's liquidity position.
Management believes that these steps, satisfactory resolution of its financing
and strategic alternatives, plus sales related to new product introductions will
provide sufficient cash and working capital for the Company to meet its ongoing
obligations and to allow it to continue operating as a going concern through at
least the end of 1999.
Prior to March 1997 the Company was in the development stage and its primary
activities were focussed on product development, including system hardware and
software, game concept development and software coding. Towards the end of 1996
the Company began manufacturing slot machines for commercial distribution. The
Company sold its first product in May 1997 following completion of a customer
evaluation period. Prior to this time the Company did not generate any revenues
from product sales. Once the Company started generating revenue from product
sales, the focus of its expenditures changed from product development to
building its infrastructure to support the sale and distribution of its
products.
Silicon Gaming is headquartered in Palo Alto, California and has sales
offices in Reno and Las Vegas, Nevada, and in Gulfport, Mississippi. The
Company's products are now manufactured at the Company's location in Las Vegas,
Nevada. At March 31, 1999 the Company had 100 employees.
Results of Operations
The Company had a net loss of $9,040,000 in the quarter ended March 31,
1999, an increase of $2,276,000, or 34%, from $6,764,000 for the quarter ended
March 31, 1988. In the current quarter, the Company recorded approximately
$3,300,000 in charges relating to the 35% reduction in its workforce and for
costs associated with the closure of its Mountain View, California manufacturing
facility. Revenue increased to $5,661,000 in the quarter ended March 31, 1999,
an increase of $1,635,000, or 41%, from $4,026,000 for the quarter ended March
31, 1998 and increased by $656,000 or 13% from $5,005,000 in the quarter ended
December 31, 1998. The Company commenced sale of its product in May 1997 and
since that time has increased revenue by introducing its product and new game
titles, 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,
10
<PAGE>
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.
Revenue
The Company generates revenue from the sale of its products and related
parts and accessories. All products are sold with licensed software and
customers have the choice of either of a paid-up or renewable annual license.
The Company places product in casinos under a participation program whereby it
receives 20% of the net win generated by the product as revenue. The Company
also places machines in casinos that are linked to a wide-area progressive
system in exchange for a predetermined share of the gross amount wagered on the
machine. Amounts received from the participation program and the wide-area
progressive system are recorded as participation revenues. Total revenue units
include machines sold outright as well as machines placed under the
participation programs.
The Company generated revenues as follows:
<TABLE>
<CAPTION>
Three Months Ended March 31,
----------------------------------------------------
1999 1998
----------------------- ----------------------
(in $'000, except for machine numbers)
-----------------------------------------------------
<S> <C> <C> <C> <C>
Hardware sales $3,672 65% $2,424 60%
Software sales 1,387 24% 720 18%
Participation revenue 602 11% 882 22%
------ --- ------ ---
Total revenue $5,661 100% $4,026 100%
====== ======
Total revenue units 407 310
</TABLE>
As can be seen in the above table, the Company was able to increase total
revenue in the three-month period ended March 31, 1999 by $1,635,000 or 41% to
$5,661,000 from the $4,026,000 recorded in the three-month period ended March
31, 1998. This also represented an increase of $656,000 or 13% from the
$5,005,000 recorded in the three-month period ended December 31, 1998. This
increase was accomplished on a lower number of revenue units and reflects an
increase in direct sales rather than placing units on participation as happened
in the prior year and the benefit of sales to new jurisdictions. The average
selling price on machines sold outright decreased to $9,022 in 1999 from the
$10,540 in 1998 reflecting the increased levels of competition in the industry
and a resulting higher level of discounts given to strategic corporate customers
compared to the prior year period.
The increase in software sales in 1999 compared to the prior year reflects
both an increase in the proportion of machines that are sold with paid-up
licenses, and the larger installed base of machines in 1999 from which the
Company derives software license revenue. Software revenues increased by
$667,000 or 93% because of these factors. Participation revenues decreased by
$280,000 or 32% compared to the comparable period in the prior year due largely
to a reduction in the number of machines on the participation program as
customers have either purchased those machines outright or returned them to the
Company. Participation revenues were also negatively impacted in the current
quarter by the Company's decision to recall the majority of its wide-area
participation machines so that the Company could modify the initial game that
was released on this system.
During the three-month period ended March 31, 1999, one customer accounted
for 15% of revenue. In the three-month period ended March 31, 1998 two different
customers accounted for 18% and 13% of revenues. The Company expects that a
significant portion of its revenues will remain concentrated within a limited
number of strategic customers within the gaming industry due to the increasing
consolidation that is taking place among casino operators. As an equipment
vendor to the gaming industry, the Company sells infrequently to many customers
and the volume of sales to any particular customer may vary significantly from
period to period. As a result, there can be no assurance that the above
strategic customers will continue to account for a significant percentage of the
Company's revenue in the future. The loss of any strategic customer would
adversely affect the Company's business and results of operations.
The Company believes the revenue generated from sales will increase in the
current year 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
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subject to a number of risks and uncertainties. See "Factors Affecting Future
Results -- Management of Changing Business; "Liquidity", "Customer Retention" ,
"Changing Legislative Environment", "Intellectual Property Rights", and "Rapidly
Changing Technology".
Cost of Sales
Cost of sales includes the direct costs of product sales as well as the
unabsorbed costs of the Company's manufacturing operations. Cost of sales also
includes license fees and royalties paid to third parties, depreciation on
machines placed on the participation programs as well as the costs directly
associated with running the wide-area progressive system, including payment of
jackpot awards. Cost of sales were $4,219,000, or 75% of revenue, as compared to
$3,190,000, or 79% of revenue, for the quarters ended March 31, 1999 and 1998,
respectively. The relative decrease in cost of sales as a percentage of revenue
reflects lower manufacturing overhead costs offset by the higher fixed costs
from the participation machines and the wide-area progressive system, as well as
the effects of lower average selling prices of product compared to the prior
year period. The Company has been able to realize a 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 which offsets this
impact. The Company does not anticipate that this rate of cost reduction will
continue into future periods. The Company believes that as it introduces more
unique, fully integrated specialty products, per-unit costs may actually
increase in future periods.
Cost of sales and manufacturing expenses are expected to increase in
absolute terms through 1999 as the Company increases sales volume for its
product, while gross margins are expected to remain volatile due to the
products' sensitivity to volume levels. The Company is currently experiencing a
position of excess manufacturing capacity but expects that it will be able to
decrease aggregate manufacturing costs with the relocation of its manufacturing
activities to its Las Vegas, Nevada location during the second quarter of 1999,
which will lower the level of excess overhead costs. The anticipated
manufacturing expenses are subject to a number of risks and uncertainties.
Research and Development
Research and development ("R&D") expenses include payroll and related costs
of employees engaged in ongoing design and development activities of the
Company, costs paid to outside contractors and specialists, prototype
development expenses, overhead costs, equipment depreciation and costs of
supplies. To date, the Company has expensed all costs associated with the
research, design and development of its product. R&D expenses were $2,348,000,
or 41% of revenue, as compared to $2,716,000, or 67% of revenue, for the
quarters ended March 31, 1999 and 1998, respectively.
The decrease in R&D expenses are largely the result of lower personnel
costs, attributable to the Company's reductions in its workforce and lower use
of engineering consultants, offset by higher license fees and similar costs
associated with the acquisition of outside technologies. Since the comparable
period in 1998, the focus of the Company's R&D activities has changed to
emphasize new game development, the introduction of new product platforms, and
the introduction of new game types, such as the wide-area progressive system.
The Company is focussed on offering additional features in its products that
will fully utilize the underlying technology used. This is expected to require a
continued heavy investment in R&D resources to continue the development of the
product platform and new platforms to facilitate the elaborate requirements of
the game development process. With the reductions in its workforce, the Company
anticipates that the level of R&D activity will decrease in absolute dollars in
future periods.
Selling, General and Administrative
Selling, general and administrative ("SG&A") expenses include payroll and
related costs for administrative and executive personnel, sales and customer-
support organization personnel, marketing and licensing personnel, overhead
costs, legal and associated costs, costs associated with obtaining and retaining
corporate and product licenses in various jurisdictions and fees for
professional services. Approximately 50% of SG&A expenses are headcount
related. SG&A expenses were $2,896,000, or 51% of revenue, as compared to
$3,951,000, or 98% of revenue, for the quarters ended March 31, 1999 and 1998,
respectively.
The decrease in SG&A expenses over these periods is largely attributable to
the reduction in personnel and associated costs from the reduction in workforce,
offest by higher costs associated with applying for corporate and
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product licenses as the Company began selling product into new jurisdictions.
The Company also incurred costs compared to the prior period as it created and
established a customer-support organization to support the rollout of its
product into new markets, and as it established a marketing organization upon
the commercial distribution of its products. The costs of these organizations
are reflected in the 1999 expense levels. SG&A expenses also were affected in
the current quarter due to higher legal costs associated with a patent
infringement dispute and due to higher product licensing costs as the Company
has increased the number of new game types and platforms for which it is
currently seeking approval. The reductions in the Company's workforce are
expected to result in lower absolute levels of SG&A expenses in future periods,
although there can be no guarantee that such reductions will be realized.
Interest Income and Expense
Net interest expense was $1,926,000 for the quarter ended March 31, 1999,
as compared to $933,000 for the quarter ended March 31, 1998. Included in these
totals was interest income of $50,000 and $220,000 for the quarter ended March
31, 1999 and 1998, respectively. Changes in interest income over these periods
are directly attributable to fluctuations in the level of average cash and
investments balances that the Company holds. The timing of share offerings,
issuance of Senior Discount Notes, and the rate of spending on operations have
impacted the average level of cash and investments.
Interest expense was $1,976,000 and $1,153,000 for the quarters ended March
31, 1999 and 1998, respectively. The increases in interest expense over these
periods are due to increases in the Company's level of long-term indebtedness
over the period. The Company raised $25 million in September 1997 from the
issuance of Senior Discount Notes (the 1997 Notes) and raised an additional $15
million in July 1998 from the issuance of additional Senior Discount Notes (the
1998 Notes). The Company also raised approximately $3.6 million from equipment
financing borrowing during 1998. The substantial increase in interest expense in
1999 compared to the prior year period reflects the interest costs associated
with the 1998 Notes, repricing of stock warrants and the equipment financing.
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, 1998, the
Company had net operating loss carryforwards of approximately $69,100,000 and
$35,800,000 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, 1998, the Company also has R&D credit carryforwards of
approximately $815,000 and $720,000 for federal and state income tax 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 March 31, 1998, 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
The Company's financial condition has deteriorated substantially since
March of 1998. Cash and equivalents had decreased to $4,097,000 at March 31,
1999 compared to $8,399,000 at December 31, 1998 and $11,146,000 at March 31,
1998. The decrease in cash in the current period is due to losses from
ongoing operations that the Company has incurred and due to the repayment of an
overdrawn amount of $1,868,000 from the Company's revolving line of credit
arrangement in February 1999.
As of March 31, 1999 the Company had an accumulated deficit of $89,310,000
and a shareholder's deficiency of $27,293,000 and has had operating losses every
year since its inception. The Company has been required to obtain additional
financing each year to be able to fund its ongoing operations. At March 31, 1999
the Company was not in compliance with the terms of its line of credit. Based on
historical levels of cash usage, the above factors
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raise substantial doubt about the Company's ability to continue as a going
concern. In the fourth quarter of 1998 the Company took steps to reduce the
level of operating expenses and made a number of management decisions which
resulted in a reduction of the Company's work force by approximately 20% and
cuts in expenditures across the Company. The Company continued to evaluate
further possible ways to reduce operating expenses through outsourcing of
different parts of its business and further downsizing of its workforce. In
March 1999 management reduced the size of the Company's workforce by a further
35% and made additional cuts to its operating expenses. Management also
announced the relocation of its manufacturing to its Las Vegas, Nevada facility
and the closure of its Mountain View, California manufacturing facility. The
Company was able to renegotiate the terms of its line of credit with its bank in
April 1999 so that this credit facility will remain available to the Company.
Management is currently reviewing financing alternatives available to the
Company such as additional share or debt offerings, joint ventures, alternative
distribution channels, conversion of some or all of its debt to equity and sale
of all or a portion of the Company's assets to improve the Company's liquidity
position. Management believes that these steps, satisfactory resolution of its
financing and strategic alternatives, plus sales related to new product
introductions will provide sufficient cash and working capital for the Company
to meet its ongoing obligations and to allow it to continue operating as a going
concern through at least the end of 1999.
The net cash used in operating activities was $1,838,000 and $8,687,000
for the quarters ended March 31, 1999 and 1998, respectively. This decrease in
cash used in operating activities reflects the higher amount of non-cash items
such as depreciation and amortization, accretion of debt discount and accrued
interest, the non-cash restructuring related charges, and a reduction in cash
used for working capital. The Company was able to reduce its investments in
receivables and inventory and increase its level of payables as it has improved
its asset management and focussed on converting its existing assets into cash to
improve its liquidity situation.
Net cash used for investing activities was $342,000 for the three months
ended March 31, 1999 compared to net cash provided by investing activities of
$1,424,000 for the three months ended March 31, 1998. 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 as the Company's available cash
balances decreased.
Net cash used in financing activities was $2,122,000 for the three months
ended March 31, 1999 compared to net cash provided by financing activities of
$2,057,000 for the three months ended March 31, 1998. The decrease is related
to the timing of additional borrowings in the 1998 period when the Company
received proceeds from term loans and the sale of common stock, but received no
new term financing in the current period, and from repayments against the
Company's bank line of credit in the current period.
In April 1999 the Company announced the settlement of its patent
infringement litigation with International Game Technology, Inc. ("IGT"). Under
the settlement agreement the Company obtained an exclusive sublicense from IGT
relating to the disputed patents, which will allow the Company to continue to
sell its Lucky Draw Poker and Multi Draw Poker games without any limitations.
The Company's customers who choose to purchase this product will be required to
exercise a separate license agreement with IGT and to pay daily fees for the use
of the game under the terms of the settlement. The Company also cross licensed
certain of its intellectual property to IGT as part of the settlement and in
consideration IGT will pay a per-unit royalty to the Company for each product
sold that incorporates licensed technology upon the occurrence of certain
events. IGT also granted the Company development rights in order to create games
on IGT's current platforms and preferential development and distribution rights
to create and distribute games on IGT's future product platforms. As a result of
settlement of disputed royalties payable to IGT, the Company will record a
favorable adjustment to income in the second quarter of 1999 of approximately
$500,000.
In May 1999 the Company renegotiated the terms of its bank line of
credit. Under the renegotiated line, the Company has a $4 million secured
revolving line of credit arrangement based on the Company's eligible accounts
receivable, which expires on December 31, 1999. Borrowings bear interest at the
bank's prime rate (8.25% at March 31, 1999) plus 3.5%. The renegotiated line
requires the company to comply with certain financial covenants with which the
Company is currently in compliance. This line is still subject to final bank
approval before it becomes effective.
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
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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 based on Oracle applications software, which supports all of
the Company's major business applications including sales and customer service,
manufacturing and distribution, and finance and accounting. The Company
completed an upgrade of this system in November 1998 to ensure that this system
is Year 2000 compliant. As a result, management believes that the Year 2000
issue will not pose any significant operational problems for its computer
systems.
During 1998 the Company established a Year 2000 committee comprised of
senior management to provide leadership and direction to the Year 2000 effort
throughout the Company. The committee is using a multi-step approach in managing
the Year 2000 project. The major steps include an inventory of all systems and
devices with potential Year 2000 problems, assigning priority to identified
items, assessing the Year 2000 compliance of all items deemed material to the
Company, repairing or replacing material items that are deemed not to be Year
2000 compliant, testing material items, and designing and implementing
contingency and business continuation plans. The Company has completed the
inventory of its critical systems, made an assessment of Year 2000 compliance
and has identified all systems to be upgraded or replaced. The Company commenced
the upgrading and replacing of certain systems during the quarter ended March
31, 1999. The Company expects to have this process completed by June , 1999. The
Company is still in the process of communicating with the suppliers with which
it has a material contract to determine the extent to which the Company is
vulnerable to those third parties failure to remediate their own Year 2000
issues. The Company cannot accurately predict the outcome of other companies'
remediation efforts.
The Company utilizes third-party vendors for processing data such as
payroll, 401(k) administration and medical benefits processing. The Company has
not yet determined the status of Year 2000 readiness of these vendors. Should
these vendors not be Year 2000 ready in a timely manner, the Company may be
required to process transactions manually or delay processing until such time
the vendors are Year 2000 compliant. No contingency plan has yet been developed,
however it is expected that contingency plans could be developed, if needed, on
short notice.
A number of the Company's customers have contacted the Company to determine
if the Company's products are Year 2000 compliant. The Company has tested its
products and believes that the products will correctly process data such that
the Year 2000 issue will not affect the operation of its products. However,
because the Company's product must run on third party slot management and
tracking systems, there is still a risk that the Company's products will not
work properly with such third party software. This risk is exacerbated because
the Company's products continue to display date fields as a two-digit rather
than a four-digit field. The Company has developed a solution to this problem
that is currently undergoing review by industry regulators that will overcome
this display problem. Upon regulatory approval, the Company intends to offer a
platform upgrade to all of its customers that will fix the current version of
product, and expects this to be delivered and installed to all customers before
June 1999. As a result, it does not anticipate any significant problem with its
products being Year 2000 compliant. There can still be no guarantee that the
Company's product will be able to run with third party software after December
31, 1999 however.
The total cost associated with required product and systems modifications to
become Year 2000 compliant is not expected to be material to the Company's
financial position. The Company spent approximately $450,000 during 1998 in
getting its major business systems upgraded and Year 2000 compliant. The Company
plans on using both internal and external resources during 1999 to continue to
replace and test hardware and software for Year 2000 compliance. Currently the
Company does not anticipate spending more than $400,000 in connection with its
Year 2000 projects during 1999. The majority of this will be spent on the
purchase of new or replacement hardware and software and upgrades, and on
updating software code for its products, and this will be funded from
operations. The anticipated costs and scope of the Year 2000 project are based
on management's best estimates using information currently available and
numerous assumptions about future events. However, there can be no guarantee
that these estimates will be achieved and actual results could differ materially
from these plans.
The failure to correct a material Year 2000 problem could result in an
interruption in, or failure of, certain normal business activities or
operations. Such failures could materially and adversely affect the Company's
results
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of operations, liquidity and financial condition. Due to the general uncertainty
inherent in the Year 2000 problem, resulting in part from the uncertainty of the
Year 2000 readiness of third-party suppliers and customers, the Company is
unable to determine at this time whether the consequences of Year 2000 failures
will have a material impact on the Company's results of operations, liquidity or
financial condition. The Year 2000 project is expected to reduce the Company's
level of uncertainty about the Year 2000 problem, and in particular, about the
Year 2000 compliance and readiness of its products
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. 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. The Company cannot predict the nature of any such
changes or their impact on the Company.
Outlook
This outlook section contains a number of forward-looking statements that
reflect the Company's current views with respect to future events and future
financial performances. Because they relate to future activities, there is a
high degree of risk that such events will not materialize and readers should not
place undue influence upon them as actual results may differ materially.
Historically, the Company focused many of its resources on creating a
business based on high-volume manufacturing and placement of slot machines in
casinos and other gaming establishments, with a goal of capturing market share.
The Company has struggled in its endeavors against many competitors who are
significantly larger and who have much greater resources than the Company. The
Company has emphasized selling game platforms and sought to penetrate the market
through frequent software releases of new game titles. Changes in the
competitive landscape since the Company was formed have forced the Company to
reevaluate its basic business strategy. The Company has incurred significant
expenses in developing a fully-integrated, high overhead business that assumed a
much higher level of unit sales than the Company has been able to achieve,
resulting in unacceptable levels of profitability for the Company.
Management has spent time in the latter half of 1998 and the first quarter
of 1999 reviewing the basic business strategy of the Company and intends to
reorganize the business around the core competencies that it believes it has
created. At the same time management intends to simplify the business and focus
resources so that it can significantly reduce the level of corporate overhead,
minimize the level of cash usage, transition the business to one that takes
advantage of revenue-sharing opportunities and focus on achieving profitability.
The Company has sold over 3,500 machines to date and understands the need to
continue to support its products and the needs of its existing customers. At the
same time, the Company needs to focus on how to best exploit the technology
inherent in its game platforms so that it can provide game experiences and game
features that are unique to the Company and that cannot be easily exploited or
imitated by its competitors. By emphasizing the quality of the wagering
attraction, including the game itself, rather than the volume of new game
titles, the Company hopes to be able to command premium floor locations in its
customers' casinos, and as a result achieve a premium level of performance.
Where necessary, the Company intends to partner with outside parties, including
casino operators and or other slot manufacturers, in order to accomplish these
goals. The announced joint-product development and marketing agreement with
Anchor Gaming is the first example of where the Company will seek external
skills to complement its own resources.
The Company intends to leverage its investment in the infrastructure that it
has already put in place. To this end, the Company intends to aggressively
introduce new products that can be deployed on its wide-area progressive system
and to expand the geographical coverage of its wide-area progressive systems
during the remainder of 1999 including into the Native American marketplace.
The Company intends to introduce new game title releases for sale and to
refresh the game offerings on its installed base of Odyssey and Quest machines
during the remainder of 1999. The Company intends to change its focus from one
of frequent game releases to one that emphasizes the quality and feature content
of new game titles. It also expects to offer product extensions and variations
of existing, successful game titles. The Company also understands that it must
emphasize more than selling a platform that has a variety of game applications
upon it. The Company hopes to partner with casino operators to provide a unique,
fully integrated gaming experience which encompasses packaging, merchandising,
signage systems and, in some cases, unique platform packaging as well. By doing
this,
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the Company aims to provide a more complete and feature rich experience for the
gaming patron that is unique to the Company. By partnering with casino operators
the Company hopes to achieve premium placement of its product.
During the remainder of 1999 the Company also intends to continue to further
reduce its level of corporate overhead. The reduction in personnel and
relocation of the manufacturing operations to Nevada are expected to
significantly reduce operating expenses compared to previous levels. Management
is currently reviewing a number of proposals to outsource or relocate additional
non-critical business functions and is attempting to sublease excess facilities
in an attempt to reduce costs. Management is also taking steps to reduce the
level of investment that the Company has in inventories and accounts receivable
so that it can operate the business with a lower level of working capital. If
the Company achieves its objectives for 1999, the volume of manufacturing and
product sales is not expected to increase significantly from 1998 levels.
The Company's future results of operations and the other forward-looking
statements contained in this outlook in particular the statements regarding
potential partnerships with casino operators or third parties, expansion of the
wide-area progressive system and anticipated cost reductions involve a number
of risks and uncertainties. In addition to the factors discussed above, among
the other factors that could cause actual results to differ materially are the
following: the success of the Company's game titles that it introduces into the
market, changes in customer order patterns, competitive factors such as new
competitor product or game introductions or changes in pricing strategies,
reluctance of casino operators to use participation-based products, the
Company's level of financial resources and adequate cash flows, the stability of
the Company's management team and workforce, and the ability of the Company to
meet all initial and ongoing licensing requirements in the jurisdictions in
which it sells products.
The Company believes that it has the product offerings, facilities,
personnel, and competitive resources needed for business success, but future
revenue, costs, margins and profits are all influenced by a number of factors,
including those discussed above and the need for the Company to raise additional
funds, all of which are inherently difficult to predict.
Factors Affecting Future Results
Management of Changing Business - The Company is planning to shift its
business strategy from one of high-volume manufacturing and placement of slot
machines with a goal of capturing market share, to a strategy that emphasizes
the quality and feature content of new game titles and takes advantage of
revenue-sharing opportunities. It will offer product extensions and variations
of successful existing games, however the emphasis will shift from volume-based
to one of providing a unique, fully-integrated gaming experience. The Company is
also relocating its manufacturing operations from California to Nevada. This
transition represents a significant challenge for the Company and its management
and employees, and places increased demand on its systems and controls. The
Company's ability to manage this change will require the Company to continue to
change, expand and improve its operational, management and financial systems and
controls to manage any outsourcing or relocation of existing activities. Some of
the keys to effecting this change are the ability of the Company to sell its
existing inventory of Odyssey and Quest products in a timely manner and to
resolve outstanding collections issues with customers in order to provide
sufficient working capital during this transition process. If the Company is not
able to generate adequate funds from its working capital in a timely manner, the
Company's business, operating results and financial condition could be adversely
affected.
Liquidity - The Company has funded its operations to date primarily through
private and public offerings of its equity securities, the issuance of Senior
Discount Notes, term and equipment loans and from bank borrowings. At March 31,
1999 the Company had an accumulated deficit of $89,310,000 and a deficiency of
shareholders' equity of $27,293,000 and was not in compliance with the terms of
its line of credit. Management was able to renegotiate the terms of its line of
credit with its bank in April 1999 so that this credit facility will remain
available to the Company. Management is currently reviewing financing
alternatives available to the Company such as additional share or debt
offerings, joint ventures, alternative distribution channels, conversion of some
or all of its debt to equity and sale of all or a portion of the Company's
assets. If the plans that management has undertaken to improve the Company's
liquidity position are not successfully completed in a timely manner it is
probable that insufficient funds will exist to satisfy the Company's operating
requirements. The Company will be required to make adjustments to its operating
activities to operate within the restrictions of its liquidity and this could
adversely affect the Company's business, operating results and financial
condition. To the extent that the Company sells additional shares or issues any
convertible debt securities, or converts any existing debt into equity,
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this could result in additional dilution to existing shareholders. There can be
no assurance that the Company will be able to successfully renegotiate its
existing credit facility or be able to raise additional funds when and if
needed.
Volatility of Stock - The market price of the Company's stock has been
highly volatile and subject to large fluctuations. The Company's stock price may
be affected by factors such as actual or unanticipated fluctuations in the
Company's results of operations, new product or technical introductions by the
Company or any of its competitors, developments with respect to patents,
copyrights or proprietary rights, conditions or trends in the gaming industry,
changes in or failure by the Company to meet securities analysts' expectations,
continued listing of the Company's stock on the Nasdaq National Market, general
market conditions and other factors. In February 1999, the Company's common
stock was removed from the Nasdaq National Market, a distinct tier of the Nasdaq
stock market, as the Company was no longer in compliance with the minimum
requirements relating to tangible net worth and share price. The Company's stock
now trades on the Over The Counter (OTC) Bulletin Board. This is likely to
reduce the level of trading activity in the Company's stock, result in higher
bid/ask spreads, and increase the cost of raising additional equity for the
Company.
Retention of Personnel - The operations of the Company depend to a great
extent on the management efforts of its officers and other key personnel, and on
the ability to attract new key personnel and retain existing key personnel. The
Company experienced high turnover among its senior management during the second
half of 1998 and in the first quarter of 1999. In February 1999 the Company
announced the appointment of a new Chief Executive Officer and in March 1999
announced the resignation of its Chief Financial Officer. The Company also
reduced its workforce by approximately 20% in December 1998 and by a further 35%
in March 1999. These factors, combined with the Company's poor operating results
and the significant decrease in the price of the Company's Common Stock may have
an adverse affect on the Company's ability to retain and motivate its key
employees. Competition is intense for highly skilled product development
employees in particular. In addition, the Company's officers and key employees
are not bound by non-competition agreements that extend beyond their employment
at the Company, and there can be no assurance that employees will not leave the
Company or compete against the Company. The Company's failure to attract
additional qualified employees or to retain its existing employees could have a
material adverse affect on the Company's operating results and financial
condition. Should the Company offer additional stock option grants to its
existing employees to encourage them to continue their employment at the
Company, this may result in additional dilution to existing shareholders.
Customer Retention - The Company's ability to sell product may be hampered
due to the financial position of the Company which presents risks to customers
that the Company may not be able to fulfill its obligations under license
agreements or be available to provide warranty, repair or upgrade services on
products that it has already sold. The Company has experienced negative reaction
from customers who have had these views during the first quarter of 1999 and who
have indicated that they may not purchase additional product from the Company.
Certain of the Company's competitors who have significantly greater financial
and marketing resources than the Company are also trying to take advantage of
the Company's financial position. To the extent that this results in the loss of
any of the Company's strategic customers or results in a loss of sales
opportunities, the Company's business, operating results and financial condition
may be adversely affected.
Intellectual Property Rights - The Company regards its product as
proprietary and relies primarily on a combination of patent, trademark,
copyright and trade secret laws and employee and third-party nondisclosure
agreements to protect its proprietary rights. Defense of intellectual property
rights can be costly, and there can be no assurance that the Company will be
able to effectively protect its technology from misappropriation by competitors.
As the number of software products in the gaming industry increases and the
functionality of these products further overlaps, software developers and
publishers or competitors may increasingly become subject to infringement
claims. The Company may also become subject to infringement claims, with or
without merit, that are brought by competitors who are motivated with a desire
to disrupt the Company's business. The Company was notified by one of its
competitors of a potential infringement claim during September of 1998 that
resulted in the Company entering into a license and royalty agreement with the
competitor and incurring an expense of $2,200,000. The Company was also notified
in February 1999 that another of its new game titles might potentially infringe
the same intellectual property rights and filed a lawsuit against this
competitor seeking a declaration of noninfringement and invalidity of the
competitor's patent. The competitor responded by filing a complaint against the
Company alleging patent infringement. On March 16, 1998 the Company was
unsuccessful in preventing the competitor from issuing a temporary restraining
order that prevents the Company from shipping the disputed product until the
injunction hearing that had been set for April 15, 1998 in Las Vegas. The
Company was able to settle this dispute
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during April and entered into a cross-licensing arrangement with the third party
so that the Company is able to sell its game. The Company will record a
favorable adjustment to income of approximately $500,000 in the second quarter
of 1999 resulting from this settlement, although the company spent a significant
amount of resources on legal and consulting fees related to this dispute. Any
such claims or litigation which may arise can be costly and result in a
diversion of management's attention, which could have a material adverse 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
affect on the Company's business, operating results and financial condition.
Changing Legislative Environment - A number of Nevada gaming sources and
competitors of the Company have disclosed during the first quarter of 1999 that
they are aware of legislation that may be introduced into the 1999 session of
the Nevada Legislature which could impact the Company's revenue and earnings
from its installed base of participation machines in the Nevada market. The
contemplated legislation may restrict or prohibit a gaming machine manufacturer
from receiving a percentage of profits or revenue from a gaming machine placed
on a casino floor in Nevada. Any such legislation, if passed in Nevada or other
jurisdictions, would require the Company to review its business strategy of
placing its premium products on a participation basis with casino operators and
require it to end its practice of placing machines in casinos and sharing in the
net win with the casino operators. Although no legislation has been introduced
to date, any such legislation, if implemented, would have a material adverse
impact upon the Company's business, operating results and financial condition.
The opening of new casinos, including casinos in jurisdictions where gaming
has recently been legalized historically has driven growth for demand in slot
machines. However, in recent years, the legalization of gaming in new
jurisdictions has been significantly reduced; therefore demand based on new
openings will be largely limited to new projects in existing markets. Certain
markets, which currently permit gaming, are contemplating legislation to limit,
reduce or eliminate gaming. If successful such legislation could limit growth
opportunities for the Company. As a result of these factors, there can be no
assurance that the slot machine market will sustain the rate of growth that was
possible in the first half of this decade.
Rapidly Changing Technology - The Company's products utilize hardware
components that have been developed primarily for the personal computer and
multimedia industries. These industries are characterized by rapid technological
change and product enhancements. The Company's ability to remain competitive and
retain any technological lead may depend in part upon its ability to continually
develop new slot machine games that take full advantage of the technological
possibilities of state-of-the-art hardware. Should any current or potential
competitor of the Company succeed in developing a competing software-based
gaming platform, such a 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 adversely affect the Company's operating
results.
Dependence on Single-Source Suppliers - The Company currently obtains a
number of its systems components from single-source suppliers. In particular the
touchscreen and picture tube that comprise the video display are supplied by
MircoTouch Systems, Inc. and Philips Display Components Company, respectively.
The Company does not have long-term supply contracts with these suppliers but
rather obtains these components on a purchase order basis. Although the design
of these components is not unique or proprietary and the Company believes that
it could identify alternative sources of supply, if necessary, there can be no
assurance that the Company would be able to procure, substitute or produce such
components without a significant interruption in its assembly process in the
event that these single sources were unable to supply these components. Even
where the Company has multiple sources of supply for a component, industry-wide
component shortages, such as those that have occurred with various computer
components, could significantly delay productivity, increase costs or both. The
Company is also considering exclusive outsourcing arrangements whereby a single
third party contract manufacturer will assemble all or a significant portion of
new products that the Company is planning to introduce. The failure or delay by
any supplier to furnish the Company with the required components or products
could adversely affect the Company's business, financial condition and results
of operations.
19
<PAGE>
PART II--OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In April 1999 the Company announced the settlement of its patent
infringement litigation with International Game Technology, Inc. ("IGT"). Under
the settlement agreement the Company obtained an exclusive sublicense from IGT
relating to the disputed patents, which will allow the Company to continue to
sell its Lucky Draw Poker and Multi Draw Poker games without any limitations.
The Company's customers who choose to purchase this product will be required to
exercise a separate license agreement with IGT and to pay daily fees for the use
of the game under the terms of the settlement. The Company also cross licensed
certain of its intellectual property to IGT as part of the settlement and in
consideration IGT will pay a per-unit royalty to the Company for each product
sold that incorporates licensed technology upon the occurrence of certain
events. IGT also granted the Company development rights in order to create games
on IGT's current platforms and preferential development and distribution rights
to create and distribute games on IGT's future product platforms. As a result of
settlement of disputed royalties payable to IGT, the Company will record a
favorable adjustment to income in the second quarter of 1999 of approximately
$500,000.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
Number Exhibit Description
------ -------------------
27.1 Financial Data Schedule
_________
(b) Reports on Form 8-K.
None
20
<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.
By /s/ ANDREW S. PASCAL
------------------------------
Andrew S. Pascal
President, Chief Executive Officer,
Acting Chief Financial Officer
(Principal Financial and
Chief Accounting Officer)
Date: May 14, 1999
21
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
QUARTERLY FINANCIAL STATEMENTS OF SILICON GAMING, INC. AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> MAR-31-1999
<CASH> 4,097
<SECURITIES> 0
<RECEIVABLES> 4,043
<ALLOWANCES> (1,552)
<INVENTORY> 11,471
<CURRENT-ASSETS> 21,306
<PP&E> 18,809
<DEPRECIATION> (10,001)
<TOTAL-ASSETS> 31,368
<CURRENT-LIABILITIES> 14,839
<BONDS> 42,156
0
1,666
<COMMON> 57,588
<OTHER-SE> (84,881)
<TOTAL-LIABILITY-AND-EQUITY> 31,368
<SALES> 5,661
<TOTAL-REVENUES> 5,661
<CGS> 4,219
<TOTAL-COSTS> 12,775
<OTHER-EXPENSES> 8,566
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 1,926
<INCOME-PRETAX> (9,040)
<INCOME-TAX> 0
<INCOME-CONTINUING> (9,040)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (9,040)
<EPS-PRIMARY> (0.64)
<EPS-DILUTED> (0.64)
</TABLE>
