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, 2000
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.
35,279,976 shares of Common Stock, $.001 par value,
were outstanding as of October 31, 2000.
<PAGE>
SILICON GAMING, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 30, 2000
INDEX
PAGE
----
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets--September 30, 2000
and December 31, 1999 ............................................ 3
Consolidated Statements of Operations--Three months and nine
months ended September 30, 2000 and September 30, 1999............ 4
Consolidated Statements of Cash Flows--Nine months ended
September 30, 2000 and September 30, 1999......................... 5
Notes to Consolidated Financial Statements.......................... 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations...................................... 11
PART II OTHER INFORMATION
Item 1. Legal Proceedings.............................................. 23
Item 3. Default upon Senior Securities................................. 23
Item 6. Exhibits and Reports on Form 8-K............................... 23
Signature................................................................... 24
2
<PAGE>
PART I--FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SILICON GAMING, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
September 30, December 31,
2000 1999
--------- ---------
(Unaudited)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and equivalents ...................................... $ 5,778 $ 877
Short-term investments .................................... -- 1,000
Accounts receivable (net of allowances of $1,075
in 2000 and $1,169 in 1999) ............................. 1,839 1,188
Inventories ............................................... 4,158 7,331
Prepaids and other ........................................ 591 1,069
--------- ---------
Total current assets ................................. 12,366 11,465
PROPERTY AND EQUIPMENT, NET ................................. 2,940 3,795
OTHER ASSETS, NET ........................................... 368 321
--------- ---------
$ 15,674 $ 15,581
========= =========
LIABILITIES AND SHAREHOLDERS' DEFICIENCY
CURRENT LIABILITIES:
Accounts payable .......................................... $ 1,596 $ 1,389
Accrued liabilities ....................................... 1,499 1,655
Deferred revenue .......................................... 119 240
Line of credit ............................................ 750 622
Current portion of long-term obligations .................. 832 1,165
--------- ---------
Total current liabilities ............................ 4,796 5,071
OTHER LONG-TERM LIABILITIES ................................. 1,603 1,611
LONG-TERM OBLIGATIONS ....................................... 11,954 10,428
LONG-TERM ACCRUED INTEREST .................................. 5,562 5,832
MINORITY INTEREST ........................................... 5,345 --
SHAREHOLDERS' DEFICIENCY
Common Stock, $.001 par value; 750,000,000 shares
authorized; shares outstanding: September 30, 2000--
34,994,042; December 31, 1999-- 30,949,273 .............. 64,139 64,123
Preferred stock, $.001 par value; 6,884,473 shares
authorized; shares outstanding at June 30, 2000--
39,750: (liquidation preference up to $39.75 million).... 20,000 20,000
Warrants .................................................. 6,465 5,542
Notes receivable from shareholders ........................ (343) (345)
Deferred stock compensation ............................... (3,774) (4,646)
Accumulated deficit ....................................... (100,073) (92,035)
--------- ---------
Total shareholders' deficiency ....................... (13,586) (7,361)
--------- ---------
$ 15,674 $ 15,581
========= =========
</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 Nine Months Ended
September 30, September 30,
---------------------- -------------------
2000 1999 2000 1999
-------- -------- -------- --------
<S> <C> <C> <C> <C>
REVENUE:
Hardware .......................................... $ 1,974 $ 932 $ 7,523 $ 8,254
Software .......................................... 425 448 1,761 3,337
Participation and other ........................... 571 619 1,613 1,796
-------- -------- -------- --------
Total revenue................................. $ 2,970 $ 1,999 $ 10,897 $ 13,387
OPERATING EXPENSES:
Cost of sales and related manufacturing expenses... 2,151 1,329 7,105 8,513
Research and development .......................... 1,746 1,191 3,505 5,023
Selling, general and administrative ............... 3,912 2,484 10,429 7,969
Restructuring charges ............................. -- -- -- 3,277
-------- -------- -------- --------
Total costs and expenses .......................... 7,809 5,004 21,039 24,782
-------- -------- -------- --------
Loss from operations .............................. 4,839 3,005 10,142 11,395
Interest (income)/expense, net .................... 69 1,975 178 5,824
-------- -------- -------- --------
Net loss before minority interest ................. 4,908 10,320
Minority Interest ................................. (869) (869)
-------- -------- -------- --------
NET LOSS ............................................ $ 4,039 $ 4,980 $ 9,451 $ 17,219
======== ======== ======== ========
Basic and diluted net loss per share ................ $ 0.12 $ 0.34 $ 0.30 $ 1.20
======== ======== ======== ========
Shares used in computation .......................... 33,942 14,561 31,463 14,361
======== ======== ======== ========
</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,
------------------------
2000 1999
-------- --------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss .................................................... $ (9,451) $(17,219)
Reconciliation to net cash used in operating activities:
Minority Interest .......................................... (869)
Depreciation and amortization .............................. 1,347 3,663
Accrued interest ........................................... (270) 3,376
Accretion of debt discount ................................. -- 1,825
Deferred rent .............................................. (9) (105)
Restructuring charges ...................................... -- 3,277
Provision for bad debt ..................................... (94) (98)
Deferred stock compensation ................................ 872 --
Loss from disposal of property ............................. 84 --
Changes in assets and liabilities:
Accounts receivable ........................................ (557) 3,774
Inventories ................................................ 3,173 1,221
Prepaids and other ......................................... 453 (752)
Participation units ........................................ 445 2,123
Accounts payable ........................................... 207 (841)
Accrued liabilities ........................................ (156) (2,098)
Other liabilities .......................................... -- 177
Deferred revenue ........................................... (121) (991)
-------- --------
Net cash used in operating activities .................. (4,947) (2,668)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment ....................... (1,032) (238)
Proceeds from disposal of property and equipment ............ 23 --
Sales and maturities of short-term investments .............. 1,000 --
Other assets, net ........................................... -- (66)
-------- --------
Net cash used in investing activities .................. (9) (304)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Sales of Common Stock, net of notes receivable .............. 16 72
Proceeds from sale of Subsidiary Preferred Stock ............ 7,628 --
Proceeds from issuance of warrants for Subsidiary
Preferred Stock ............................................. 889 --
Collection of note receivable ............................... 2 18
Proceeds from debt financing ................................ 2,000 --
Proceeds from term loans and line of credit ................. 750 --
Repayment of bank line of credit ............................ (622) (3,456)
Repayment of term loans ..................................... -- (727)
Repayment of capital lease obligations ...................... (806) (232)
-------- --------
Net cash provided by (used in) financing activities..... 9,857 (4,325)
-------- --------
NET DECREASE IN CASH AND EQUIVALENTS .......................... 4,901 (7,297)
Beginning of period ......................................... 877 8,399
-------- --------
End of period ............................................... $ 5,778 $ 1,102
======== ========
SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for interest .................... $ 248 $ 391
Conversion of preferred stock to Common Stock ............... $ -- $ 410
======== ========
</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, 2000, the
consolidated statements of operations for the three and nine months ended
September 30, 2000 and 1999, and the consolidated statements of cash flows for
the nine months ended September 30, 2000 and 1999, 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, 1999 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 on a
going concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. The Company has
incurred operating losses every year since its inception and at September 30,
2000, had an accumulated deficit of $100,073,000 and a shareholders' deficiency
of $13,586,000. The Company has been required to obtain additional financing
every year to be able to fund its ongoing operations. 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 1999 the
Company completed a substantial restructuring of its capitalization whereby
$39.75 million of Senior Discount Notes and approximately $8.3 million of
accrued interest were converted into Preferred Stock, and the remaining terms of
the Senior Discount Notes were modified to reduce the interest rate thereon and
extend the payment terms. Concurrent with the restructuring, the Company
borrowed $3 million under new Senior Discount Notes and established a facility
whereby up to an additional $2 million of new Senior Discount Notes may be
issued upon meeting certain financial and operational milestones. During the
third quarter, management continued to review financing and other strategic
alternatives available to the Company such as additional equity or debt
offerings in the Company or certain of its subsidiaries, joint ventures,
alternative distribution channels, direct investment by third parties into
several of the Company's strategic business opportunities and sale of all or
part of the Company's assets to improve the Company's liquidity position.
Accordingly the company began discussions with several qualified companies
regarding strategic partnerships. Ultimately management agreed in principle to
be acquired via a plan of merger with International Gaming Technology, a Nevada
corporation, ("IGT"), which management believed to be in the best interests of
the shareholders. While a definitive agreement of merger has not yet been
executed, on October 16, 2000, the company executed a letter of intent from IGT
expressing their interest in a cash for stock transaction as well as a $2.5
million dollar advance from IGT, and is focusing its resources and efforts in
contemplation of completing this proposed merger as its operating plan. (SEE
FOOTNOTE 8, SUBSEQUENT EVENTS, BELOW)
2. SIGNIFICANT TRANSACTIONS
On August 18, 2000, WagerWorks, Inc., (WagerWorks"), formerly known as
uBet.com, Inc. ("uBet"), the Company's wholly owned subsidiary, sold 3.7 million
shares of its Series A Preferred Stock to an outside investor group for $7.6
million. At the time of the investment, WagerWorks, Inc had a retained deficit
of approximately $1.4 million that offset a portion of the minority interest on
a consolidated basis. The Company has allocated the entire net loss of
WagerWorks for the period from August 18, 2000 to September 30, 2000 to the
minority interest based on the requirements outlined in Emerging Issues Task
Force Bulletin No. 99-10, PERCENTAGE USED TO DETERMINE THE AMOUNT OF EQUITY
METHOD LOSSES.
On August 21, 2000, WagerWorks granted warrants to buy 368,098 shares of
its Series A Preferred Stock at a price of $2.0375 and 122,699 shares of its
Series A Preferred Stock at a price of $0.01 to a certain customer and investor.
These warrants were immediately exercisable for Series A Preferred Stock and
6
<PAGE>
expire on August 21, 2005. The warrants were granted in connection with a Web
site development agreement entered into between WagerWorks and the warrant
holder. The agreement called for the agreement partner to make a $1.0 million
non-refundable advance payment for development of the Web site. The fair value
of the warrants, $889,000, was calculated on the date of grant and was deducted
from the $1.0 million payment.
The Web site development agreement also calls for WagerWorks to host Web
sites of the agreement partner on WagerWorks' servers and on WagerWorks'
premises. The agreement partner will reimburse WagerWorks up to $800,000, upon
the purchase of the hardware necessary to host the Web sites. Upon completion of
the Web site, WagerWorks is committed to share 50-60% of advertising revenue
with the agreement partner with the exact percentage depending on the level of
gross advertising revenue generated, as set forth in the agreement.
The Web site development agreement has a term of 5 years but can be
terminated upon 30 days notice after 18 months if the aggregate payments to the
agreement partner or the number of active subscribers do not exceed certain
levels set forth in the agreement. The agreement also can be extended for an
additional 5 years at the option of the agreement partner if certain conditions
are met.
3. 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 reflect the potential dilution that would occur if
securities or other contracts to issue Common Stock were exercised or converted
into Common Stock. Common Stock 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 Nine Months Ended
September 30, September 30
-------------------- -------------------
2000 1999 2000 1999
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net Loss (Numerator):
Net Loss, basic and diluted ..................... $ 4,039 $ 4,980 $ 9,451 $ 17,219
======== ======== ======== ========
Shares (Denominator)
Weighted average common shares outstanding....... 33,942 14,589 31,463 14,433
Weighted average common shares subject to
repurchase .................................... (28) (72)
-------- -------- -------- --------
Shares used in computation ...................... 33,942 14,561 31,463 14,361
======== ======== ======== ========
Net Loss Per Share, Basic
and Diluted ................................... $ 0.12 $ 0.34 $ 0.30 $ 1.20
======== ======== ======== ========
</TABLE>
4. INVENTORIES
Inventories are stated at lower of cost (first-in, first-out) or market and
consist of the following (in thousands):
September 30, December 31,
2000 1999
------ ------
Raw materials ............................ $1,274 $ 849
Work in process .......................... 669 111
Finished goods ........................... 2,215 6,371
------ ------
$4,158 $7,331
====== ======
7
<PAGE>
5. 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 September 30, 2000, three
customers accounted for 15%, 13% and 7% of accounts receivable, respectively. As
of December 31, 1999, one customer accounted for 19% of accounts receivable. For
the three months ended September 30, 2000, two customers accounted for 14% and
6% of revenue and for the nine months ended September 30, 2000, three customers
accounted for 9%, 5% and 4% of revenue, respectively. For the three months ended
September 30, 1999 one customer accounted for 23% of revenue and for the nine
months ended September 30, 1999, one customer accounted for 16% of revenue.
6. BORROWING ARRANGEMENTS
In May 2000, the Company executed a $2 million secured revolving line of
credit agreement based on the Company's eligible accounts receivable which
expires May 25, 2001. Borrowings bear interest at the Bank's prime rate (9.5% at
September 30, 2000) plus 1.5%. As of September 30, 2000, the Company had
$750,000 outstanding under this facility. This agreement requires the Company to
maintain certain ratios of tangible net worth to total debt among other
covenants (as defined in the agreement) and the Company was in non-compliance
with the agreement as of June 30, 2000, and remained in non-compliance as of
September 30, 2000. The lender had given the company an informal notice of
forbearance which was to expire on August 15, 2000, but has agreed informally
not to act on such forbearance as of November 14, 2000. The company has paid
down $250,000 of this outstanding line of credit in October of 2000, and has
purchased a certificate of deposit in the amount of $500,000 with the creditor
bank, and secured the remaining $500,000 open line of credit with this
certificate of deposit. The company is in the process of evaluating the merits
of continuing the current line of credit under the original terms or the option
of paying it off with the security provided by the certificate of deposit.
Borrowing arrangements consist of the following (in thousands):
September 30, December 31,
2000 1999
-------- --------
Senior Discount Notes ...................... $ 11,500 $ 9,500
Capital lease obligations .................. -- 55
Other long-term obligations ................ 1,286 2,038
-------- --------
12,786 11,593
Current obligation ......................... (832) (1,165)
-------- --------
Long-term obligation ....................... $ 11,954 $ 10,428
======== ========
7. OPERATING SEGMENTS
During the second quarter, Silicon Gaming completed a realignment of its
resources around market opportunities by creating a separate business unit to
investigate market opportunities in the growing market for Internet gaming. The
Company incurred expenses for its On-line division of approximately $1,645,000
for the three month period ended September 30, 2000, of which $869,000 was
allocated to the minority interest and $2,308,000 for the nine month period
ended September 30, 2000, of which $869,000 was allocated to the minority
interest.
8
<PAGE>
8. SUBSEQUENT EVENTS
On October 16, 2000, the company executed a letter of intent from
International Gaming Technologies ("IGT") to acquire, via a plan of merger, the
assets and liabilities of the Company. The Company also received a check for
$2,500,000 as an advance from IGT to be applied towards the total consideration
paid by IGT to SGI under the proposed terms of the merger.
Under the terms of the proposed transaction, the total consideration paid
by International Game Technology would be $45 million, with this amount
increased by the amount of Silicon Gaming's current assets on hand at closing
consisting of cash, accounts receivable and prepaid expenses and reduced by the
amount of all indebtedness and other liabilities of Silicon Gaming not yet paid
by SGI by closing, including any unpaid sale transaction expenses. In addition,
an anticipated but undefined adjustment will also be made for any inventory on
hand at the closing date in conjunction with SGI's net operating losses, above
and below certain thresholds.
As part of the proposed transaction, International Game Technology would
also receive up to a 5% interest (on a fully-diluted basis) in WagerWorks Inc.,
a majority-owned subsidiary of Silicon Gaming. As a condition of closing, SGI
will have to either sell or otherwise dispose of its interest in WagerWorks Inc,
prior to the merger closing date.
As of November 20, 2000, no definitive sale agreement has been reached, and
it is not certain whether the parties will reach a definitive agreement. If an
agreement is reached, it is also uncertain whether all necessary gaming
approvals, regulatory approvals, third-party consents and other closing
conditions will be satisfied
9. NEW ACCOUNTING PRONOUNCEMENTS
In December 1999, the Securities and Exchange Commision (SEC) issued Staff
Accounting Bullitin (SAB) No. 101, "Revenue Recognition in Financial
Statements," which provided the SEC staff's views on selected revenue
recognition issues. The guidance in SAB 101 must be adopted during the fourth
quarter of fiscal 2000 and the effects, if any, are required to be recorded
through a retroactive, cumulative-effect adjustment as of the beginning of the
fiscal year, with a restatement of all prior interim quarters in the year. Our
management has not completed its evaluation of the effects, if any, that SAB 101
will have on the Company's income statement presentation, operating results or
financial position.
9
<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
The Company was incorporated on July 27, 1993 with a charter to design,
develop, manufacture and distribute a new breed of interactive gaming machines.
It was the Company's strategy to implement a new product paradigm in which
software-based gaming platforms would displace the traditional fixed-application
slot machines. Through early 1997, the Company focussed on executing it's
product development plans while at the same time preparing to initiate
operations. Substantial investments were made in the infrastructure required to
sell, build, fulfill, and ultimately service machines in each of the major U.S.
gaming markets.
In the third quarter of 1997, the Company introduced the Odyssey gaming
platform and it's suite of six gambling applications. The marketing strategy
called for a conservative, focussed roll-out in which the initial units were
installed in a limited number of Southern Nevada casinos. After an initial
evaluation period the product was refined and ultimately distributed into nearly
every major US market, as well as select international markets. Since that time
the Company has rolled out ODYSSEY into other jurisdictions including
Connecticut, Illinois, Indiana, Iowa, Kansas, Louisiana, Michigan, Minnesota,
Mississippi, Missouri, New Jersey, New Mexico, certain Canadian provinces,
certain international cruise line routes and Uruguay. Since the Company's
initial product launch, it has developed and distributed nearly 40 different
game applications and achieved an installed base of over 4,700 gaming platforms.
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 difficult to attain 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 entertainment(TM). In addition, the product's modular components and
Machine Management System(TM) software provide easy-to-use diagnostics designed
to minimize player inconvenience and machine down time. The Company currently
offers several products including ODYSSEY(TM), a multi-game machine that can
play up to six different games on the same machine, and QUEST, a single-game
machine.
10
<PAGE>
The Company's initial business model was dependent on the proliferation of
its gaming platforms. However, management believes that due to a number of
factors including price resistance, stagnant market growth, increased
competition, and a slower rate of adoption, the Company was unable to achieve
its projected sales volumes. As such the market for high-margin replacement
software never materialized.
In the Spring of '99 the Company re-formulated it's business strategy and
implemented a new plan. The strategy called for the company to more fully
leverage it's development capabilities while minimizing the expenses related to
maintaining it's distribution channel. The result was a 35% reduction in
operating expenses, and the formation of three distinct business units, the
Wagering Content Studio, Product Sales, and WagerWorks.com. The Wagering Content
Studio is focussed on creating new game experiences that can be distributed
off-line into the domestic casino markets through the Product Sales division,
and on-line both domestically and internationally through it's Internet
division.
The Company spent much of the third quarter ending September 30, 2000,
executing its three-tier business plan. The Wagering Content Studio, after
completing the launch of its Family Feud product suite in the second quarter in
partnership with MGM MIRAGE, Inc., continued to evaluate the performance of the
product and implemented changes and enhancements as a result of monitoring the
marketplace and customer response. In addition, more Family Feud units were
produced and rolled out in some of the other MGM Mirage's properties in Southern
Nevada. The Product Sales division continued to place and sell gaming platforms
along with new game applications created by our Wagering Content Studio. The
Company continued to capitalize on the opening of the California market with
sales to the major tribal casinos. In addition, the Company raised capital for
the full development of its Internet business opportunity through its
subsidiary, WagerWorks, along with finalizing a formal customer relationship
with one of its investor/partners. WagerWorks continued to make significant
technological progress towards the completion of its infrastructure in
anticipation of a first or second quarter 2001 launch date for its site.
Through September 30, 2000, the Company has installed 4,714 ODYSSEY, QUEST
and FAMILY FEUD machines in approximately 204 properties throughout Connecticut,
Iowa, Indiana, Louisiana, Michigan, Minnesota, Mississippi, Missouri, Nevada,
New Mexico, certain Canadian provinces, certain international cruise line routes
and Uruguay. Of these machines, 4,567 have been sold outright or placed on a
revenue-sharing basis. After returns, 147 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. This compares to a restated installed base of
4,572 machines at June 30, 2000, of which, 250 machines were installed on a
trial basis.
At September 30, 2000 the Company, on a consolidated basis, had cash and
equivalents of $5,778,000,of which, $5,451,000 was owned by WagerWorks and
$327,000 was owned by Silicon Gaming . The Company has incurred operating losses
each year since inception and as of September 30, 2000 had an accumulated
deficit of $100,073,000 and a deficiency of shareholders' equity of $13,586,000.
The Company has been required to obtain additional financing each year to be
able to fund its ongoing operations. 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 late 1998 and early 1999 the Company took steps
to reduce the level of operating expenses and made a number of management
decisions which resulted in total reductions of the Company's work force by
approximately 70% and made significant cuts in expenditures across the Company.
Management also announced the relocation of its manufacturing to its Las Vegas,
Nevada facility and the closure of its Mountain View, California manufacturing
facility. In November 1999, the Company, with the consent of the holders of its
Senior Discount Notes, was able to convert approximately $40 million principal
amount of debt plus $8.3 million in accrued interest into a 57% equity stake in
the Company, and to obtain commitments for additional financing from the debt
holders. The aforementioned actions resulted in the Company reducing its
operating expenses by approximately 40%, its interest obligations by
approximately 80%, and reduced the cash used in operations by approximately 80%
from the levels of the prior year. Management continued to review financing and
other strategic alternatives available to the Company such as additional share
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or debt offerings in the Company or certain of its subsidiaries, joint ventures,
alternative distribution channels, direct investment by third parties into
several of the Company's strategic business opportunities and sale of all or a
portion of the Company's assets, to improve the Company's liquidity position.
During the third quarter of fiscal year 2000, the Company identified three
candidates to approach to propose joint ventures or strategic alliances
regarding marketing and distributing its products. These discussions eventually
lead to two of the candidates offering to purchase the Company through a merger.
Through negotiations between the candidates and the Company's management, and
approval from the board of directors, on October 16, 2000, the Company agreed in
principle to be acquired via a plan of merger with International Game
Technology, a Nevada corporation, ("IGT"). While a definitive agreement of
merger has not yet been executed, the company executed a letter of intent as
well as receiving a $2.5 million dollar advance from the acquiring corporation,
IGT, and is focusing its resources and efforts in contemplation of completing
this proposed merger as its operating plan. (SEE NOTE 8 TO FINANCIAL STATEMENTS)
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 September 30, 2000 the Company had 92 employees.
REVENUE The Company generates hardware 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 a paid-up or renewable annual
license. The Company places products in casinos under a participation program
where it receives 20% of the net win generated by the product as revenue. 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 September 30, Nine Months Ended September 30,
-------------------------------------- --------------------------------------
2000 1999 2000 1999
----------------- ----------------- ----------------- -----------------
(in $'000 except for machine numbers)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Hardware sales $ 1,974 67% $ 932 47% $ 7,523 69% $ 8,254 62%
Software sales 425 14% 448 22% 1,761 16% 3,337 25%
Participation revenue 571 19% 619 31% 1,613 15% 1,796 13%
------- ------- ------- ------- ------- ------- ------- -------
Total revenue $ 2,970 100% $ 1,999 100% $10,897 100% $13,387 100%
======= ======= ======= =======
Total revenue units 497 43 1,025 639
======= ======= ======= =======
</TABLE>
Total revenue units consist of machines sold outright to customers as well
machines owned by the Company placed in casinos under a participation program.
For the three months ended September 30, 2000, revenue units consisted of 223
machines sold outright, and 274 machines on casino floors under a participation
program. For the nine month period ended September 30, 2000, revenue units
consisted of 751 machines sold outright and 274 machines on casino floors under
a participation program.
Revenue for the quarter ended September 30, 2000 was $2,970,000, an
increase of $971,000, or 49%, from $1,999,000 for the quarter ended September
30, 1999. The change in sales mix reflects an increase in direct sales relative
to sales on a participation basis as a result of introducing the Family Feud
game and the benefit of sales to the new jurisdiction of California. The average
selling price on hardware sales decreased to $8,850 in the quarter ended
September 30, 2000 compared to $9,845 in the quarter ended September 30, 1999.
This reflected the effect of lower selling prices due to the Company selling
used equipment to certain customers during the third quarter of 2000.
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The decrease in software revenues for the three months ended September 30,
2000 of $23,000, or 5%, compared to the same period in 1999 is a direct result
of the lower number of Odyssey units sold outright, the lower selling prices of
used equipment in the current year and the impact of focussing on and delivering
the Family Feud Suite of games in the current period. Participation revenues
decreased by $48,000, or 8%, compared to the comparable period in 1999 due
largely to a reduction in the number of machines on participation programs as
customers have either purchased those machines outright or returned them to the
Company.
Revenue for the nine months ended September 30, 2000 was $10,897,000, a
decrease of $2,490,000, or 19%, from $13,387,000 for the nine months ended
September 30, 1999. For the nine month period ended September 30, 2000 total
software sales decreased by $1,576,000, or 47%, compared to the same period in
1999 reflecting a shift in the company's model for software sales as a
percentage of total revenue. Total participation revenues decreased by $183,000,
or 10%, due to the reductions in the number of machines on participation as the
Company has converted these units to sales or they were returned to the Company
by its customers.
During the three-month period ended September 30, 2000, two different
customers accounted for 14% and 6% of revenue. In the three-month period ended
September 30, 1999, one customer accounted for 23% of revenue. For the nine
month period ended September 30, 2000, three different customers accounted for
9%, 5% and 4% of revenue respectively, and in the nine months ended September
30, 1999, one customer represented 16% of revenue. The Company expects that a
significant portion of its revenues will remain consolidated 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 could
adversely affect the Company's business and results of operations.
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 as well as
depreciation on machines placed on the participation programs. Cost of sales was
$2,151,000, or 72% of revenue, as compared to $1,329,000, or 66% of revenue, for
the quarters ended September 30, 2000 and 1999, respectively. Cost of sales was
$7,105,000, or 65% of revenue, as compared to $8,513,000, or 64% of revenue, for
the nine months ended September 30, 2000 and 1999, respectively.
The increase in cost of sales as a percentage of revenue for the three
month period is a reflection of several factors. The introduction of the Family
Feud suite of games, a unique, fully integrated specialty product, had the
effect of raising per unit costs on that portion of cost of sales that
represented the cost of this product. This was offset slightly by lower
manufacturing overhead costs associated with the refurbishing and reselling of
used machines taken back by the company, benefits derived from the tooling of
certain of its hardware components, and from some cost reductions in some of the
components included in its machines other than the Family Feud suite of games.
Due to significant levels of finished goods inventory, the Company manufactured
minimal new product outside of the new Family Feud games during the quarter
ended September 30, 2000, and this has prevented it from obtaining further cost
reductions in its products. The Company does not anticipate that cost reduction
will continue into future periods. The Company believes that as it introduces
more unique, fully integrated specialty products, per-unit costs may increase in
future periods.
If management's plan to merge into IGT as mentioned earlier in this
document, does not materialize, and the Company is able to continue operating as
a going concern, cost of sales and manufacturing expenses are expected to
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<PAGE>
increase in absolute terms 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 believes that it will be
able to continue to see some benefits of decreased aggregate manufacturing costs
due to the relocation of its manufacturing activities to its Las Vegas, Nevada
location. 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
and its subsidiary companies, 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 $1,746,000,
or 88% of revenue, as compared to $1,191,000, or 60% of revenue, for the
quarters ended September 30, 2000 and 1999, respectively. R&D expenses were
$3,505,000, or 32% of revenue, as compared to $5,023,000, or 38% of revenue for
the nine months ended September 30, 2000 and 1999, respectively.
Of the $1,746,000 in R&D expenses incurred in the second quarter period,
$1,220,000 or 70% was incurred in launching the activity of the Company's
subsidiary, Wager Works, which did not contribute any revenue to the company.
The decrease in R&D expenses (calculated by excluding the WagerWorks portion)
are largely the result of one of the Company's new strategies involving
strategic partnering, where a portion of the Company's expenses incurred for the
Wagering Content Studio were subsidized by an outside strategic
partner/customer, as well as 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 1999, 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. The Company is
focussed on offering additional features in its products that will fully utilize
the underlying technology used as well as continuing to procure new strategic
partner relationships to help subsidize a portion of this effort. This would
result in the expectation requiring continued 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 in future periods.
With the continuing efforts to successfully launch the business of its new
subsidiary company, Wager Works, Inc., management believes the absolute level of
R&D expenses would increase in future periods, if viewed on a going concern
basis.
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. SG&A expenses were $3,912,000, or 131% of revenue, as
compared to $2,484,000, or 124% of revenue for the quarters ended September 30,
2000 and 1999, respectively. SG&A expenses were $10,429,000, or 96% of revenue,
as compared to $7,969,000, or 60% of revenue for the nine months ended September
30, 2000 and 1999, respectively. For the three and nine month periods ended
September 30, 2000 respectively, approximately 24% and 26% of the SG&A expenses
were headcount related.
The increase in SG&A expenses in 2000 reflects higher legal fees in
connection with ongoing patent infringement cases that the Company was party to
during 1999 and a suit by a Company distributor in South Carolina, costs
associated with applying for corporate and product licenses as the Company began
selling product into new jurisdictions during the first two quarters of 2000,
increased patent application activity during the third quarter period as well as
costs incurred in development activity of its subsidiary, Wager Works, Inc.. The
Company intends to restrict the growth in SG&A expenses as much as possible in
future periods and believes SG&A expenses in absolute dollars may increase and
may decline as a percentage of total revenue.
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<PAGE>
INTEREST INCOME AND EXPENSE
Net interest expense was $69,000 for the quarter ended September 30, 2000,
as compared to $1,975,000 for the quarter ended September 30, 1999. Net interest
expense was $178,000 for the nine months ended September 30, 2000, as compared
to $5,824,000 for the nine months ended September 30, 1999. Included in these
totals was interest income of $19,000 and $13,000 for the quarter ended
September 30, 2000 and 1999, respectively, and $46,000 and $88,000 for the nine
months ended September 30, 2000 and 1999, respectively. Changes in interest
income over these periods are directly attributable to fluctuations in the
average level of cash and investment 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 $87,000 and $1,988,000 for the quarters ended
September 30, 2000 and 1999, respectively, and $224,000 and $5,912,000 for the
nine months ended September 30, 2000 and 1999, respectively. The decrease in
interest expense over these periods is substantially due to the restructuring
the Company underwent in November of 1999. The holders of the Senior Discount
Notes exchanged $39.75 million principal notes and accrued interest of $8.3
million for Preferred Stock that is convertible into a 57% voting interest in
the Company. Concurrent with this conversion, the holders of the Senior Discount
Notes invested an additional $3 million of New Senior Discount Notes in the
Company. The company also paid off its revolving line of credit with its former
bank in the first quarter of 2000, did not complete it new bank arrangement
until the second quarter of 2000 and did not begin to use its line of credit
until the end of May 2000. The company also reduced its amount of equipment
financing in 2000 as well as reducing the principal due on capital leases and
other equipment related borrowings in the second quarter of 2000.
INCOME TAXES
The Company has not been required to pay income taxes due to the fact that
it has had net operating losses in each period since the Company's inception.
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. The Company underwent an
ownership change as of the date of the debt restructuring in November, 1999. As
a result, the Company lost the potential tax benefits of the net operating loss
carryforwards and the tax credit carryforwards that existed at that time.
A valuation allowance has been recorded for any deferred tax assets due to
uncertainty regarding the ultimate realization of these assets resulting from
the lack of earnings history of the Company.
LIQUIDITY AND CAPITAL RESOURCES
The Company's financial condition has deteriorated since June of 2000.
While cash and equivalents on a consolidated basis had increased to $5,778,000
at September 30, 2000 compared to $877,000 at December 31, 1999 and increased
compared to $1,102,000 at September 30, 1999, $5,451,000 of cash and equivalents
were owned by its minority owned subsidiary, WagerWorks. Effectively, the
Company's cash position on a non-consolidated basis was $327,000 on September
30, 2000, a decrease of $550,000 from the $877,000 position on December 31,
1999. The decrease in cash in the current period for the Company, excluding the
amount from it minority owned subsidiary, was due primarily from continued
losses from operations, offset by additional borrowings on the Senior Discount
Notes and the Company's continuing successful efforts to convert inventory into
cash, offset by losses from ongoing operations.
As of September 30, 2000 the Company had an accumulated deficit of
$100,073,000 and a shareholder's deficiency of $13,586,000 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. In the
15
<PAGE>
fourth quarter of 1999 the Company completed a substantial restructuring of its
capitalization whereby $39.75 million of Senior Discount Notes and approximately
$8.3 million of accrued interest were converted into Preferred Stock, and the
remaining terms of the Senior Discount Notes were modified to reduce the
interest rate thereon and extend the payment terms. Concurrent with the
restructuring, the Company borrowed $2 million under new Senior Discount Notes
and established a facility whereby up to an additional $3 million of new Senior
Discount Notes may be issued upon meeting certain financial and operational
milestones. In the quarter ended June 30, 2000, the Company met one of the
operational milestones identified and established as part if it's November 1999
restructuring plan. The company borrowed an additional $1 million of Senior
Discount Notes, and an additional $2 million of new Senior Discount Notes may be
issued in the future depending upon the Company's ability to meet certain other
financial and operational milestones.
Management continued to review financing and other strategic alternatives
available to the Company such as additional equity or debt offerings in the
Company or certain of its subsidiaries, joint ventures, alternative distribution
channels, direct investment by third parties into several of the Company's
strategic business opportunities and sale of all or part of the Company's assets
to improve the Company's liquidity position. During the third quarter of fiscal
year 2000, the Company identified three candidates to approach to propose joint
ventures or strategic alliances regarding marketing and distributing its
products. These discussions eventually lead to two of the candidates offering to
purchase the Company through a merger. Through negotiations between the
candidates and the Company's management, and approval from the board of
directors, on October 16, 2000, the Company agreed in principle to be acquired
via a plan of merger with International Game Technology, a Nevada corporation,
("IGT"). While a definitive agreement of merger has not yet been executed, the
company executed a letter of intent as well as receiving a $2.5 million dollar
advance from the acquiring corporation, IGT, and is focusing its resources and
efforts in contemplation of completing this proposed merger as its operating
plan.
The Company's net cash used in operating activities was $4,947,000 and
$2,668,000 for the nine months ended September 30, 2000 and 1999, respectively.
This increase in cash used in operating activities reflects a decrease in the
amount of non-cash items such as depreciation and amortization. The Company was
able to continue to reduce its investments in inventory and increase its level
of payables, offset by an increase in its level of receivables, as it has
improved its asset management and focussed on converting its existing assets
into cash to improve its liquidity situation. For the nine month period ended
September 30, 1999, the company experienced a significantly higher loss from
operations, which was mainly offset by substantial non cash charges to that
period for restructuring charges, accrued interest on a higher level of debt,
and accretion of debt discount. These items were not a factor in the Company's
current nine month period for 2000 due to the restructuring of the Company's
balance sheet as a result of the old Senior Note restructuring that occurred in
November of 1999.
Net cash used in investing activities was $9,000 for the nine months ended
September 30, 2000 compared to net cash used for investing activities of
$304,000 for the nine months ended September 30, 1999. The change was primarily
due to the sale of property and equipment and the sale and maturity of
short-term investments as the Company's available cash balances decreased.
Net cash provided by financing activities was $9,857,000 for the nine
months ended September 30, 2000 compared to net cash used in financing
activities of $4,325,000 for the nine months ended September 30, 1999. The
increase is related primarily to the additional debt funding the Company
obtained through exercising some of its Senior Discount Note funding it was
entitled to through its restructuring agreement in November of 1999 and the sale
of Series A Preferred Stock Financing (for the benefit of minority interest
shareholders) it obtained for its subsidiary, Wager Works, Inc. in the current
period. The period covering the nine months of 2000 also included the conversion
of its old line of credit from one banking facility into another, as compared to
the period ending September 30, 1999, which included a substantial net reduction
in its line of credit.
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<PAGE>
In March 2000, the Company entered into a secured revolving line of credit
with a new bank based upon eligible accounts receivable. Under the terms of this
borrowing arrangement, which will expire in May 2001 (and subject to automatic
renewal provisions), the Company may borrow up to $2 million. Borrowings bear
interest at the bank's prime rate (9.50% at June 30, 2000) plus 1.5%. The
Company issued the bank warrants to acquire $35,000 worth of shares of Common
Stock at a per share price not to exceed $.35 (35 cents) per share, which may be
exercised over a five-year period. The exercise price of the warrants adjust to
the fair market value of the underlying common stock, at the date of exercise,
with a maximum cumulative exercise value of $35,000. In May 2000, the Company
finalized its contract involving this revolving line of credit, and borrowed
$750,000, which was the outstanding amount due as of September 30, 2000.
In March 2000 the Company was served papers in connection with a patent
infringement lawsuit filed against it and one other slot machine manufacturer by
International Game Technology, Inc. (IGT). As disclosed in November 1999, IGT is
alleging infringement of a patent issued to IGT in September 1999 entitled "Game
Machine and Method Using Touch Screen". The Company is presently unable to
determine the financial impact, if any, of this litigation. The costs of
defending this lawsuit, if necessary, may be substantial and may require
significant amounts of senior management time. Any adverse result from such
litigation could materially and adversely affect the Company's liquidity and
capital resources.
In March 2000, a former distributor of the Company's products, filed suit
against the Company in the United States District Court for the District of
South Carolina. The distributor seeks repayment of $1 million, plus damages, in
connection with machines previously shipped to the distributor in 1998. The
Company is in the process of seeking arbitration as required by the Distribution
Agreement, seeking to recover outstanding receivables from the distributor. The
distributor filed in South Carolina an action to stay the arbitration portion of
the agreement between the Company and the distributor and was granted such a
stay. The company filed a motion on August 14th,2000 appealing the decision to
the United States Court of Appeals for the Fourth Circuit. The Company is
currently awaiting a decision from the Court of Appeals. The costs of responding
to and/or defending this lawsuit may be substantial and may require significant
amounts of senior management time. Any adverse result from such litigation could
materially and adversely affect the Company's liquidity and capital resources.
The Company has established a provision for the possible non-collection of this
receivable on its books, and the balance sheet as of September 30, 2000
essentially valuing the account, net of the provision, at zero
FACTORS AFFECTING FUTURE RESULTS
MANAGEMENT OF CHANGING BUSINESS - The Company has spent part of the last
year as well as all of the nine months of the year 2000, trying 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. The Company plans on offering product extensions
and variations of successful existing games in 2000, however the emphasis will
shift from volume-based to one of providing a unique, fully-integrated gaming
experience. 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. Key to effecting this change in business is 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 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
will be materially and adversely affected.
17
<PAGE>
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 September,
2000, the Company had an accumulated deficit of $100,073,000 and a deficiency of
shareholders' equity of $13,586,000. The Company has repaid all amounts due
under the former line of credit and has negotiated a new line of credit with a
different financial institution on better terms. Management of the company began
discussions with several qualified companies regarding strategic partnerships.
Ultimately management agreed in principle to be acquired via a plan of merger
with International Gaming Technology, a Nevada corporation, ("IGT"), which
management believed to be in the best interests of the shareholders. While a
definitive agreement of merger has not yet been executed, on October 16, 2000,
the company executed a letter of intent from IGT expressing their interest in a
cash for stock transaction and is focusing its resources and efforts in
contemplation of completing this proposed merger as its operating plan. 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 have a material
adverse affect upon the Company's business, operating results and financial
condition. To the extent that the Company sells additional shares or issues any
convertible debt securities, this could result in additional dilution to
existing shareholders. There can be no assurance that the Company will 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,
general market conditions and other factors. The Company's stock now trades on
the Over The Counter (OTC) Bulletin Board. This may affect 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, as well as result in
higher levels of volatility in the price of the Company's stock.
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 has experienced some turnover among its senior management during 1999
and the portion of the year through September 30, 2000. The Company also reduced
its workforce by approximately 20% in December 1998 and by a further 40% 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 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.
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 experienced negative reaction
from customers who held these views during 1999 and, to a lesser extent, through
the first nine months of the year 2000. These customers have indicated that they
may not purchase additional product from the Company. Completion of the
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Company's debt restructuring in November 1999 mitigates these risks, however,
the Company continues to experience some negative sentiments from its customers.
Certain of the Company's competitors have significantly greater financial and
marketing resources than the Company and may use their financial position
relative to the Company's' to achieve a competitive advantage. 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 overlap, 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 and three of its competitors were
notified by one of its competitors, IGT, of a potential infringement claim
during November 1999. This required senior management to work with the other
defendants to provide information to IGT that it believes repudiates the claims
alleged by IGT. In March 2000, the Company and one other slot machine
manufacturer were notified by one of its competitors, IGT, of a patent
infringement lawsuit filed against it. The company has not yet presently
responded to this latest lawsuit. Any such claims or litigation can be costly
and 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.
CHANGING LEGISLATIVE ENVIRONMENT -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 reduced; therefore demand
based on new openings may 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. The Company has not updated its
product offering to take advantage of enhanced hardware components since 1998.
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.
DEPENDENCE ON SINGLE-SOURCE SUPPLIERS - The Company currently obtains
certain 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
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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 exploring exclusive outsourcing arrangements whereby a single
third party contract manufacturer might assemble all or a significant portion of
new products that the Company may plan to introduce. The failure or delay by any
supplier to furnish the Company with the required components or products would
have a material adverse effect on the Company's business, financial condition
and results of operations.
ITEM 7A
Market Risk Disclosures: The following discussion about the Company's
market risk disclosures involves forward-looking statements. Actual results
could differ materially from those projected in the forward-looking statements.
The Company is exposed to market risk related to changes in interest rates and
equity security price risk. The Company does not have derivative financial
instruments for speculative or trading purposes.
The Company has fixed rate long-term debt of approximately $11.5 million
outstanding at September 30, 2000 and a hypothetical ten percent increase or
decrease in interest rates would not have a material impact on the fair market
value of this debt. The fair value of the Company's Senior Discount Notes may be
lower than the recorded value, but the Company is unable to estimate the fair
value at this time. The Company does not hedge any interest rate exposures.
PART II--OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In March 2000, a former distributor of the Company's products, filed suit
against the Company in the United States District Court for the District of
South Carolina. The distributor seeks repayment of $1 million, plus damages, in
connection with machines previously shipped to the distributor in December of
1998. The Company responded to the complaint requesting that the proceeding be
stayed while the parties went through arbitration in accordance with the
Distribution Agreement pursuant to which the machines were shipped. The
distributor filed a response requesting the court to reject the stay. The court
ruled in favor of the Distributor and the Company appealed the decision to the
United States Court of Appeals for the Fourth Circuit on August 14, 2000. The
Company is awaiting a decision from the Court of Appeals.
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
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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,
Date: November 21, 2000
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